Securitization, with its use of special purpose entities (SPEs)
and potential (in some jurisdictions) for off-balance-sheet
financing, has not been exempt from the controversies caused by the
accounting scandals of recent years. The International Accounting
Standards Board (IASB) and the US Financial Accounting Standards
Board (FASB) are among those that have responded. Over the last
year, the FASB and IASB have introduced new standards and modified
others to provide greater clarity and certainty as to the
appropriate accounting treatment for securitizations. The boards
hope to move towards a single global framework but, although they
have a convergence programme, much remains to be done. In the UK,
meanwhile, the Accounting Standards Board is seeking to converge to
International Financial Reporting Standards (IFRS), commonly
referred to as International Accounting Standards (IAS).
UK Gaap
Accounting is not usually the main rationale for an originator
contemplating a securitization transaction, but it is an important
consideration. This is particularly true for regulated
institutions, such as banks and building societies, which are often
treated under the Financial Reporting Standards (FRS) 5 accounting
standards.
Under UK generally accepted accounting principles (Gaap), the
relevant rules are included under the FRS 5 section on the
substance of transactions. FRS 5 sets out criteria that enable the
originator to conclude whether the securitization transaction
should be accounted for as a:
- derecognition of the securitized assets and funding with a
gain/loss on sale;
- linked presentation with the balance sheet showing an
offset of the non-recourse finance against the securitized
assets but with no gain or loss on sale; or
- separate recognition of the securitized assets and the
funding within assets and liabilities respectively.
Few originators have achieved derecognition because the risks
and rewards are retained to some degree in most securitization
transactions. The most common accounting treatments in the UK have
been either linked presentation or separate presentation.
FRS 5 introduces the concept of quasi subsidiaries and requires
the consolidation of such entities. FRS 5 defines a quasi
subsidiary of a reporting entity (such as an originator) as a
"company, trust, partnership or other vehicle that, though not
fulfilling the definition of a subsidiary, is directly or
indirectly controlled by the reporting entity and gives rise to
benefits for that entity that are in substance no different from
those that would arise were the vehicle a subsidiary".
In practice, most SPEs in securitization transactions meet the
definition of a quasi subsidiary and are required to be
consolidated. If the conditions set out in paragraphs 26 and 27 of
FRS 5 are met, then linked presentation applies at both the solo
and consolidated level, that is, the group would record the
securitized assets and the non-recourse funding on the same side of
the balance sheet.
Although linked presentation developed from a compromise and led
to some initial confusion, it is now widely accepted. It provides
all information on the face of the balance sheet for creditors and
equity holders and is not an all-or-nothing bright line approach
(that is, it is not a case of the assets being all on or all off
the balance sheet). Linked presentation has its critics,
particularly from the accounting purists, and is perhaps in the
need of a little refreshing, but it is regarded generally in the UK
as a sensible and pragmatic solution for the accounting
industry.
International Accounting Standards
The concept of linked presentation does not exist under IFRS,
which is a significant change for those about to adopt those
standards. Originator/transferors and investors most affected by
the adoption of and changes to IFRS will be those with securities
listed on EU stock exchanges for accounting periods beginning on or
after January 1 2005. From this date, listed companies in all EU
countries will be required to present group financial statements in
accordance with IAS.
Companies with listed debt are within the scope of this
regulation. The rule gives EU member states the option of deferring
the use of IFRS for two years for companies with only quoted debt
securities. But it only applies to consolidated accounts. Many SPEs
that only have listed debt are single companies, which are not
required to prepare consolidated accounts. It is possible, however,
that the national listing authorities in member states may choose
to require such companies to use IFRS under their listing rules. In
the UK, the Financial Services Authority is already consulting on
this.
Under IFRS, the relevant standards are:
- IAS 39 (revised), which covers the recognition, measurement
and derecognition of financial assets and liabilities;
- IAS 27, which details the accounting principles under which
an entity should consolidate another entity; and
- SIC-12, which focuses on the consolidation of SPEs.
The history of IAS 39
When IAS 39 was first issued in 1998, derecognition was based in
part on loss of control of contractual rights. But for assets that
were readily obtainable in the market it was a question of
assessing who had the risks and rewards of ownership associated
with such assets. The transferor could not derecognize a
transferred asset if the asset was not readily obtainable in the
market and the transferor had retained substantially all the risks
and rewards. These requirements and some of the detailed questions
and answers appended to the original IAS 39 led to confusion and
ambiguity as to the treatment of even straightforward transactions.
There was also some confusion as to the interaction between IAS 39
and SIC12, which gave rise to the possibility that a company could
achieve derecognition on transferring a portfolio of assets to a
special purpose vehicle (SPV) only for those assets to return onto
the consolidated balance sheet if the originator was required to
consolidate the SPV.
Much of the debate since the issue of the original standard
concerned the resolution of these ambiguities. The standard was
re-exposed in July 2002. The exposure draft sought to remove the
mixed model approach based on risks and rewards, and controls, and
removed the concept of readily obtainable in the market. Under the
draft, derecognition was based on the concept of continuing
involvement in the contractual rights that constitute a financial
asset. The draft also introduced the concept of pass-through
arrangements where derecognition of an asset could be achieved
without relinquishing the rights to the contractual flows that
constitute an asset. The exposure draft provoked more than 150
comment letters, in response to which the IASB held roundtable
discussions in February and March 2003. But there was still no real
consensus around the concepts of continuing involvement or
pass-through arrangements.
IAS 39 (revised) was eventually issued on December 17 2003 and
is effective for periods beginning on or after January 1 2005.
Elements of the exposure draft were retained but within a wider
framework. The delay in issuing the revised IAS 39 (due to the
debates discussed above) has led to a delay in the endorsement by
the EU, which, at the date of publication, is outstanding. Elements
of the draft were retained but within a wider framework.
IAS 39 (revised) introduced the decision tree shown in figure 1,
which illustrates how to evaluate whether and to what extent a
financial asset is derecognized.
IAS 39 (revized) dealt with some of the earlier concerns, in
particular derecognition principles and tests apply at both
consolidated and entity level (that is, apply SIC-12 before
considering derecognition). The principal of risks and rewards,
control and continuing involvement that were present in the
original standard and in the draft are retained but the decision
tree illustrates the order in which they must be considered,
removing any ambiguity.
| Figure 1 |
 |
Further clarifications
The standard is helpful in removing some of the ambiguities, but
there are still areas that are open to interpretation and where
further guidance is required or standard market practice needs to
evolve.
What is meant by substantially all and significant in
paragraph 20?
Under paragraph 20, an entity has retained
substantially all risks and rewards of ownership if there is no
significant change to the exposure to the variability in the net
cash flows. An entity has transferred substantially all risks and
rewards of ownership of a financial asset if its exposure to such
variability is no longer significant in relation to the total
variability in the present value of future net cashflows.
If substantially all the risks and rewards have been
transferred, therefore, the asset is derecognized. If substantially
all the risks and rewards have been retained, then derecognition of
the asset is precluded.
This standard does not provide a definition of substantially all
or significant, or provide a quantitative benchmarks or any
rebuttable presumption in percentage terms, but it does give
guidance in paragraphs 21 and 22.
To avoid retaining substantially all risks and rewards, some
economic risk transfer from the originator to a third party is
required as a minimum.
One strong indication of risk is the pricing of the relevant
tranches. In many structures, the originator holds the junior
tranche of notes or provides a subordinated loan or some other type
of credit enhancement so that the senior notes achieve AAA
ratings.
To achieve such ratings, the senior noteholders are bearing
almost no risk at all and consequently the risk is taken by the
junior noteholders and derecognition is not appropriate. If,
however, a third party were to provide credit enhancement in the
form of an insurance wrap or a third party subscribed to the junior
tranche of notes or provided a subordinated loan, the originator
could claim to have transferred some risk.
IAS39:AG40 provides examples where substantially all risks and
rewards are retained. Example (e) is the most readily relevant to
securitization structures. This is a sale of trade receivables in
which the entity guarantees to compensate the transferee for credit
losses that are likely to occur. The standard says that such
structures will fail paragraph 20(b) and require continued
recognition of the asset. This view is confirmed by reading "Basis
for Conclusion BC63".
The standard does not specify what statistic should be used to
measure variability or provide an example of such a model. Until
interpretation and market practice have led to a universally
accepted model, therefore, there will inevitably remain a degree of
uncertainty and subjectivity in the application of paragraph
21.
Conduits
It is possible that the sponsoring bank of
a multi-seller conduit (issuing commercial paper to provide finance
for trade receivable securitizations) could be required under
SIC-12 to consolidate its conduit.
The activities of the conduit were designed for the benefit of
the conduit; any decision making powers (for example, which assets
to accept into the conduit) probably lie with the sponsoring bank.
On the other hand it is each originator who bears the downside risk
and who benefits from lower funding costs albeit that the
sponsoring bank has access to an attractive fee stream.
What does transfer mean?
The standard does not
provide an interpretation of transfer. Our interpretation is that
transfer in this sense means an economic transfer or risk and
rewards rather than simply a transfer in the legal sense, for
example, the appointment of a third-party servicer may well achieve
a transfer of cash flows in the legal sense but not in the economic
sense. Interpretation is evolving.
Does paragraph 19(c) mean that revolving structures,
structures with reinvestment periods, controlled amortization or
reserve funds automatically lead to continued
recognition?
Unless the three criteria set out in
Paragraph 19(a)(c) of the standard are met, the assets must
continue to be recognized by the originator.
Paragraph 19(c) will prove problematic. This says that the
originator has an obligation to remit cashflows relating to the
assets to the eventual recipients without material delay. Material
delay is not defined or interpreted in the standard: does it mean
failure to pass cashflows on the due date set out in the
contractual agreements or within a certain period after
collection?
In many structures, the interest earned in the settlement period
is retained within the SPE within a reserve fund and ultimately
forms part of the residual profit returned to the originator after
all contracted priority of payments defined in the legal
documentation have been discharged. Accordingly, this retention of
profits by the SPE could potentially give rise to a material delay
and cause the requirements of paragraph 19(c) to be failed.
Similarly in structures with controlled amortization, where
principal collections are retained within a reserve account or are
reinvested before payment to the noteholders, this retention of
principal collections could give rise to material delay and so give
rise to problems.
In other forms such as revolving structures, cash collections
are used by the SPE to acquire new loans from the originator and
replenish the portfolio to extend the life of the securitization.
In such cases the collections from the assets are not being passed
to the eventual recipients without material delay and 19(c) is,
prima facie, failed.
How will existing UK structures be treated under IAS
39?
In the bases for conclusion (BC63), the IASB acknowledges that
many securitizations will fail the pass-through tests in paragraph
19 and fail to show that they have not retained substantially all
the risks and rewards under paragraph 20b. Failure to pass these
criteria will lead to continued recognition. The adoption of IAS 39
may result in continued recognition for many structures that at
present achieve linked presentation under UK Gaap. It is unlikely
that any structures achieving linked presentation under FRS 5 could
achieve derecognition under IAS 39. IAS 39 and SIC-12 may require
full consolidation of the SPE. Such originator/transferors will
need to examine the impacts this may have on performance ratios,
bank covenants and, for financial institutions, the regulatory
treatment.
The future regulatory treatment for bank originator/transferors
depends on the outcome of the latest Basel negotiations. The thrust
of the Basel proposals is that the regulatory impact of
securitization should reflect the extent of the economic transfer
of risk. The UK's banking regulator, the Financial Services
Authority, has not yet issued a policy statement on how the
regulatory treatment of such transactions will be affected in the
period between the introduction of IFRS with effect from January 1
2005 and the implementation of the Basel proposals expected in
2007.
Many changes ahead
As there are only a relatively small number of IFRS reporters in
the UK, the adoption of IAS will probably result in significant
changes in the presentation of existing securitization
transactions. The uncertainty before Basel II concerning the future
regulatory treatment of securitization structures only adds to
this. The outcome, together with any tax consequences arising from
the introduction of IAS 39, requires careful consideration of both
existing and proposed securitization structures.
Author
biographies
David Barnes
Deloitte & Touche
LLP
David is a partner, the head of securitization in the UK at
Deloitte and a member of the global securitization team. David has
been involved in the securitization industry since the late 1980s
and has advised a range of banks and issues on accounting,
regulatory, due diligence and feasibility issues. His clients
include The Royal Bank of Scotland, Bank One, Lloyds TSB, ING,
Cabot Square Capital, Mortgages and Barclays. David is an active
member of the European Securitization Forum accounting
sub-committee.
Edward
Marshall
Deloitte & Touche
LLP
Edward is a senior manager in the UK securitization and global
securitization team at Deloitte. Since 1999, Edward has specialized
in providing technical advisory services, due diligence, regulatory
and accounting opinions and managing securitization services to
clients. Clients include Abbey and Hitachi Capital
(UK).
Contact details
Deloitte & Touche LLP
Stonecutter Court
1 Stonecutter Street
London EC4A 4TR
UK
David Barnes
Tel: +44 (0) 20 7303 2888
Fax: +44 (0) 20 7303 5436
Email:
djbarnes@deloitte.co.uk
Edward Marshall
Tel: +44 (0) 20 7303 5106
Fax: +44 (0) 20 7303 6633
Email:
emarshall@deloitte.co.uk
Web:
www.deloitte.co.uk