Achieving IFRS Off-Balance Sheet Treatment in Trade Receivables Securitizations

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Lambert Rice
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1 Achieving IFRS Off-Balance Sheet Treatment in Trade Receivables Securitizations By: Jeremy Blatt Managing Director Finacity Corporation 281 Tresser Blvd., 11th Floor Stamford, CT Jeff Gulbin Chief Financial Officer Finacity Corporation 281 Tresser Blvd., 11th Floor Stamford, CT

2 ABSTRACT Changes in accounting requirements made in response to the financial crisis of have made achieving off-balance-sheet treatment for trade receivables securitizations more challenging, particularly under IFRS. Fortunately, a cost-efficient solution has emerged and is proving practical and efficient. Despite the need to transfer a significant portion of variability of cash flows to a third party, this solution makes it possible to satisfy this requirement in a cost-efficient manner by adding a small, carefully sized and positioned subordinated note. We present techniques to maximize transfer of variability of cash flow while keeping costs associated with this additional tranche down. Ongoing monitoring and occasional resizing ensure that off-balance-sheet treatment is maintained over the entire life of the securitization. In contrast, derecognition under U.S. GAAP is more readily achieved without the need for a subordinated tranche because the requirement to transfer control can be satisfied more directly by transferring ownership of the receivables all the way through to the investor. 2

3 Trade Receivables securitization candidates companies with more than the equivalent of $10 million in accounts receivables outstanding may wish to lower their leverage ratios with offbalance-sheet treatment for the receivables involved in the securitization. This may lead to a host of benefits as a result of an improved balance sheet, possibly including directly lowering other borrowing costs that may be a function of leverage ratios. We review the requirements for achieving off-balance-sheet treatment for trade receivables securitizations under International Financial Reporting Standards (IFRS). We discuss practical solutions that a treasury professional may implement to achieve deconsolidation and derecognition of funded receivables while maintaining an efficient securitization program. IFRS REQUIREMENTS When employing IFRS off-balance-sheet securitization and factoring structures, companies are governed by IFRS 10 (IASB [2011]), which superseded IAS 27 (IASB [2011]) and SIC-12 (IASB [1998]) and IFRS 9 (IASB [2014]), which superseded IAS 39 (IASB [2003]). These standards require an in-depth series of steps necessary to achieve deconsolidation and derecognition. The two primary areas of focus of these standards entail analyzing control and variability of cash flow associated with the transfer of assets. The consolidation principles under IFRS 10 must first be applied to determine which party has substantial power and control over the assets once they have been transferred to a special purpose entity (SPE). Companies must present proper legal documentation (e.g., true sale opinions), noting 3

4 the roles and responsibilities of each party to the transaction to properly substantiate their conclusions to their auditors. Consolidation by an external entity will occur when that entity controls the investee, that is, the SPE. Under IFRS 10, control will exist when that entity has power over the relevant activities of the investee (IFRS 10: 10-14), exposure or right to variable returns of the investee (IFRS 10: 15-16), and a link between power and variable returns (IFRS 10: 17-18). All three conditions must be affirmed to consolidate the SPE by the external entity, thus achieving deconsolidation from the company. Once it has been determined that the company will not consolidate the SPE, the next step in the off-balance-sheet process involves assessing the derecognition of assets under IFRS 9. Companies must analyze whether the rights to the assets cash flows, as well as the exposure to the risks and rewards of the underlying assets, have been transferred. This process can be challenging and must be critically analyzed by examining the transferor s exposure to cash flow variability before and after the transfer. Under IFRS 9, if sufficient transfer of variability of cash flow has been evidenced, assets can be derecognized from the balance sheet. Within this standard there is an illustrative example (IFRS 9: B3.2.1) that lays out the steps that companies must follow to achieve derecognition of financial assets. COMPARISION TO U.S. GAAP To achieve off-balance-sheet treatment under U.S. GAAP, the two pertinent FASB accounting standard codifications involve ASC Transfers and Servicing (FASB [2014]), which 4

5 superseded FAS 166 (FASB [2009]), and ASC Consolidation (FASB [2009]), which superseded FAS 167 (FASB [2009]). In a typical off-balance-sheet securitization transaction, the principles within ASC 860 are first evaluated to determine whether a transfer of financial assets has occurred. The first step in this securitization structure entails selling the receivables in their entirety to a bankruptcy-remote SPE. This is required to ensure that the financial assets are out of the reach (legally isolated) of the transferor or its creditors in a bankruptcy situation. (ASC 860: ). There is a second transfer of the receivables in their entirety that is made to the investor. This transfer or sale is accomplished via a cash purchase price/deferred purchase price (CPP/DPP) structure, which involves a portion of the assets being purchased in cash and the remaining purchase of assets deferred and recorded as a liability due to the SPE from the Investor. The deferred amount owed to the SPE from the investor (DPP) would be recorded as a receivable and retained on the transferor s balance sheet. ASC 860 is like IFRS 9 in that both standards require companies to evaluate whether principles should be applied to part or all the asset or a group of similar assets. (ASC 860: D). These two standards are also similar in that they both critically evaluate continuing involvement from the transferor to determine if the transferor has rights to pledge or sell the assets transferred. The main area where IFRS 9 is different from ASC 860 is that IFRS 9 requires an analysis of whether the entity has transferred substantially all the variability of risk and rewards associated with the assets (IFRS 9: (a)). This involves a thorough evaluation of the cash flow variability before and after the transfer. 5

6 Risk variability under U.S. GAAP is primarily analyzed in ASC 810 by reviewing areas such as credit, foreign exchange, commodity, equity, operational and interest rate risk. Under ASC 810, the variable interest model is used to first determine if the legal entity is a variable interest entity. In most securitization transactions, the SPEs qualify as variable interest entities. By examining risks and other documentation, companies will determine if a variable interest in an entity exists which will require consolidation. This analysis entails identifying who is the primary beneficiary of the entity, which involves determining which party has both power and benefits over the entity. This is an extensive exercise that involves analyzing the entity s governing documents, formation documents, other contractual agreements, risk items as noted earlier, and related party and de facto agent relationships. IFRS 10 has similar language in that power, exposure to benefits, and a link between power and benefits must be analyzed to determine who will consolidate the entity. One main area where ASC 810 differs from IFRS 10 is that ASC 810 allows scope exceptions for government organizations and certain investment companies. There are also scope exceptions that apply to using the variable interest model. These exceptions include not-for-profit organizations, separate accounts of life insurance companies and companies that cannot provide adequate information. Whether reporting under IFRS (principles based) or U.S. GAAP (rules based), qualitative and quantitative analysis with fully documented conclusions must be prepared to substantiate the effect on the company s financial statements with its auditors. 6

THE FOUR-TRANCHE SOLUTION The basic structure of a trade receivables securitization is a two-tranche structure (see Exhibit 1), consisting of an externally funded senior note and a seller-retained

7 THE FOUR-TRANCHE SOLUTION The basic structure of a trade receivables securitization is a two-tranche structure (see Exhibit 1), consisting of an externally funded senior note and a seller-retained subordinated note. The senior note represents the safest portion of the receivables cash flow and typically is designed to qualify for an investment-grade rating. Meanwhile, the subordinated note represents the remaining, riskier cash flows. 7

8 This structure would not qualify for IFRS off-balance-sheet treatment because virtually all the risks and rewards are retained by the seller in the form of the subordinated note. This is by design, as the senior note is meant to qualify for an investment-grade rating, which generally means that extremely little variability of cash flows is being transferred. One theoretical solution would be to try to transfer the necessary variability of cash flows by creating a third tranche, splitting the subordinated note in two parts: 1) a first-priority, subordinated portion, being retained by the seller, as in the two-tranche solution, and 2) a second-priority subordinated portion representing the riskiest portion of the cash flow (i.e., the first loss position) being sold to a third-party (see Exhibit 2). This second-priority subordinated portion would be sized to capture enough transfer of variability to qualify for off-balance-sheet treatment. While this solution would theoretically work, in practice it would likely fail because the transferred second-priority tranche would be rather expensive, given that it is in a first-loss position. This three-tranche solution can be improved, once we note that the focus is on transferring variability of cash flow, not necessarily losses themselves. Transferring all the losses is, commercially, unduly expensive because the likelihood of at least a small number of losses is quite high. The cost of transferring these first few losses is high because the expected return is extremely poor; meanwhile, the transferred variability of cash flow associated with these first few losses is limited because the cash flow is reliably poor. This makes it expensive and inefficient to transfer these first few losses; while the risk of loss itself is high, the variability of cash flow is comparatively low. 8

9 The four-tranche solution, then, is to split the subordinated note into three parts, rather than just two, and to transfer the middle part. Thus, under the senior note, we have a retained senior subordinated note, a transferred intermediate subordinated note, and a retained junior subordinated note (see Exhibit 3). In terms of variability, two retained notes represent the low-variability portions of the cash flow, the senior subordinated note being the low-risk, low-variability portion and the junior subordinated note being high-risk, low-variability portion. The intermediate 9

10 subordinated note then represents the sweet spot in the middle, reflecting the high-variability portion of the cash flow where it is less predictable as to whether a loss will occur or not. This solution is commercially efficient because it keeps the size of the intermediate subordinated note to a rather small portion of the overall facility and offers the intermediate subordinated investor a modest amount of subordination, making it more commercially viable. Provided 10

11 sufficient risks and rewards are transferred and other conditions are met, receivables corresponding to both the senior note and the intermediate subordinated note (the two externally funded tranches) qualify for off-balance-sheet treatment. ASSESSING VARIABILITY At a high level, the variability of cash flow is assessed by identifying a number of scenarios reflecting future losses. The projected cash flow for each tranche is determined for each scenario. Variability is a measure of the extent to which a scenario s cash flows differ from the expected cash flows for a given tranche. Typically, this is taken as the simple distance (absolute value) from the mean cash flow for that tranche across all scenarios. The sum of the variability of each scenario represents the total variability for each tranche. If the tranches are sized appropriately, sufficient variability may be transferred to a third party via the intermediate subordinated tranche to qualify for off-balance-sheet treatment. Beneath this high level, there is considerable detail and complexity. The number and nature of the scenarios must be designed to capture the realistic possibilities of a termination of the transaction, appropriately reflecting the probabilities of various favorable and unfavorable outcomes. This, in turn, requires an analysis of the historical performance of the receivables, determining losses, recoveries, and their timing. 11

12 Note that the determination of losses for this purpose is a specialized function and may differ from the determination of losses for purposes of normal servicing and collections or even for the sizing of reserves for the senior note. The concepts are similar, but the objectives are different. What is considered to be a loss for the purpose of determining how risks and rewards are allocated may not be the same as what is considered to be a loss for general accounting purposes or from the point of view of an investment-grade investor. Nevertheless, such decisions can influence the calculations of the variability of cash flow. Consequently, there is an advantage to having a third party make these determinations. To cover the range of relevant outcomes, a Monte Carlo simulation with a large number of randomly generated scenarios (see, for example, Ayres, Schmutte, and Stanfield [2017]) is typical. Care must be taken so that the scenarios reflect the appropriate random distribution and that this distribution is appropriate for the structure of the transaction. Although the transfer of variability is the sole concern of this exercise for the purpose of determining whether a transaction qualifies for off-balance-sheet treatment, the Monte Carlo simulation may also provide additional insight into the risks involved in such transactions, and other statistical metrics may be helpful to investors. Although the current expectations of credit losses model for recognizing credit impairment (FASB [2016]) applies only to U.S. GAAP and not IFRS, assessing variability involves a similar exercise. In both models, historical loss performance is considered, but current conditions and reasonable scenarios forecasting future performance are required. It is interesting to note the parallels in the accounting regimes. 12

13 REASSESSING VARIABILITY Although a trade receivable securitization is a revolving facility, an accounting determination can only be made for receivables that already exist. Once receivables are sold and determined to qualify for derecognition, there is no need to revisit this question. However, on a continuous, revolving basis, new receivables are sold into the securitization facility, and variability must be reassessed periodically to determine whether these new receivables also qualify for derecognition. These new receivables may not have the same risk profile as previous receivables, so the calculations must be updated to reflect new risk information and to accurately determine expected cash flows during projected termination scenarios. The securitization must be designed to handle certain changes based on these periodic reassessments. In particular, there must be a mechanism by which the subordinated notes can be resized (subject to commercial agreement) in order to return the transfer of risks and rewards to the required range, whether it is a change in risk profile or portfolio size that causes the transfer to fall outside the intended range. Typically, the transfer of risks and rewards is reassessed monthly and the subordinated note sizes are adjusted shortly after each reassessment. This ensures that new receivables also qualify for derecognition on an ongoing basis. As the senior and junior subordinated notes are internally funded, this is usually handled with a few accounting entries. The intermediate subordinated note 13

14 is externally funded, however, so any change would require an actual movement of funds. The arrangement with the intermediate subordinated lender must allow for such increases and decreases in the intermediate subordinated note. CONTROL PARTY If substantially all the risks and rewards are transferred, the receivables may qualify for derecognition. Although there are no bright lines in the IFRS 10 and 9 literature, we have seen the major audit firms use less than 10% as an assessment of retained variability after the transfer as meeting the threshold of substantially all. However, this is often not commercially viable because the third party would need to be compensated for taking such a large exposure. Conversely, if substantially all (i.e., more than 90% in practice) the risks and rewards are retained, the receivables would not qualify for derecognition. Typically, the variability transferred falls somewhere between these extremes (in practice somewhere between 10% and 90%). In such cases, derecognition depends on a further test: whether enough control has been transferred to a third party. Such securitizations typically have a control-party role that has the right to exercise these transferred powers over the receivables. In practice, the control party and the intermediate subordinated investor are the same or related entities. This arrangement gives teeth to the rights held by the control party, as there may be an economic motivation to actually exercise those rights in certain disaster scenarios. If the control 14

15 party is not also an investor, accountants may be concerned that the rights are transferred on paper only and not in reality, and, therefore, deny derecognition of the receivables. The rights transferred include general rights regarding the servicing and sale of receivables and additional rights regarding impaired receivables. The control party is also responsible for updating the estimates of variability and the required note sizes as needed to maintain derecognition for newly purchased receivables. The exact rights may vary; however, the accountants must be satisfied that sufficient control and variability have been transferred. Nevertheless, outside a disaster scenario, the seller normally remains as servicer of the receivables. SUMMARY The four-tranche solution allows deconsolidation and derecognition under IFRS for a trade receivables securitization. Additional liquidity is gained through an externally funded intermediate subordinated note, and the presence of the retained junior subordinated note keeps transferred risk manageable and all-in pricing efficient. Third parties must be retained to handle the control party function, to provide the additional liquidity, and to assess the transferred risks and rewards. There is a market, albeit limited, for these specialized functions. 15

16 In practice, operations are very similar to the traditional two-tranche structure, with a few additional accounting entries to reflect the four-tranches and the derecognition of receivables. Servicing and collections continue as usual. External funding of the intermediate subordinated note increases liquidity slightly while lowering overall financial risk and uncertainty. Leverage ratios and other metrics are improved due to the derecognition of receivables equal to the funding provided by both the senior note and the intermediate subordinated note. REFERENCES Ayres, D., J. Schmutte, and J. Stanfield. Expect the Unexpected: Risk Assessment using Monte Carlo Simulations. Journal of Accountancy, November 1, Financial Accounting Standards Board (FASB). ASC 810 Consolidation. FASB Accounting Standards Codification, December ASC 860 Transfers and Servicing, FASB Accounting Standards Codification, December FAS 166 Statement of Financial Accounting Standards No June FAS 167 Statement of Financial Accounting Standards No June FASB Update Financial Instruments Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, June 16, International Accounting Standards Board(IASB). IAS 27 Separate Financial Statements (as amended in 2011), May 12,

17 . IAS 39 Financial Instruments: Recognition and Measurement (2004). December 17, IFRS 9 Financial Instruments. July 24, IFRS 10 Consolidated Financial Statements. May 12, SIC-12 Consolidation Special Purpose Entities. November Adapted from the submitted version of the article: Achieving IFRS Off-Balance-Sheet Treatment in Trade Receivables Securitizations, Jeremy Blatt and Jeff Gulbin, The Journal of Structured Finance, Winter 2018 Volume 23, Copyright 2018, Institutional Investor Inc., which has been published in final form at: 17

Board Meeting Handout Consolidation of Certain Special-Purpose Entities September 25, 2002

Board Meeting Handout Consolidation of Certain Special-Purpose Entities September 25, 2002 The Board will discuss the following matters related to consolidation of special-purpose entities (SPEs). Multiparty