International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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3880 Chapter 48
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Chapter 48
Financial instruments:
Derecognition
1 INTRODUCTION
This Chapter deals with the question of when financial instruments should be removed
(‘derecognised’) from financial statements. At what point should an item already recognised
in financial statements cease to be included? If an entity sells a quoted share in the financial
market, it may cease to be entitled to all the benefits, and exposed to all the risks, inherent
in owning that share somewhat earlier than the date on which it ceases to be registered as
the legal owner. However, the question of derecognition goes much further than this, as it
encroaches on what is commonly referred to as ‘off-balance sheet’ finance.
1.1
Off-balance sheet finance
In order to understand the rationale for the requirements of IFRS for the derecognition
of financial assets and financial liabilities, it is necessary to appreciate the fact that those
requirements, and those in equivalent national standards, have their origins in the
response by financial regulators to the growing use of off-balance sheet finance from
the early 1980s.
‘Off-balance sheet’ transactions can be difficult to define, and this poses the first problem
in discussing the subject. The term implies that certain things belong on the statement of
financial position and that those which escape the net are deviations from this norm. The
practical effect of off-balance sheet transactions is that the financial statements do not
fully present the underlying activities of the reporting entity. This is generally for one of
two reasons. The items in question may be included in the statement of financial position
but presented ‘net’ rather than ‘gross’ – for example, by netting off loans received against
the assets they finance. Alternatively, the items might be excluded from the statement of
financial position altogether on the basis that they do not represent present assets and
liabilities. Examples include operating lease commitments (prior to IFRS 16 – Leases –
being effective – see Chapter 24) and certain contingent liabilities.
The result in all cases will be that the statement of financial position may suggest less
exposure to assets and liabilities than really exists, with a consequential flattering effect
on certain ratios, such as the debt/equity ratio and return on assets employed. There is
usually an income statement dimension to be considered as well, perhaps because assets
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taken off-balance sheet purport to have been sold (with a possible profit effect), and
also more generally because the presentation of off-balance sheet activity influences
the timing or disclosure of associated revenue items. In particular, the presence or
absence of items in the statement of financial position usually affects whether the
finance cost implicit in a transaction is reported as such or included within another item
of income or expense.
Depending on their roles, different people react differently to the term ‘off-balance sheet
finance’. To some accounting standard setters, or other financial regulators, the
expression carries the connotation of devious accounting, intended to mislead the reader
of financial statements. Off-balance sheet transactions are those which are designed to
allow an entity to avoid reflecting certain aspects of its activities in its financial statements.
The term is therefore pejorative and carries the slightly self-righteous inference that those
who indulge in such transactions are up to no good and need to be stopped. However,
there is also room for a more honourable use of the term ‘off-balance sheet finance’.
Entities may wish, for sound commercial reasons, to engage in transactions which share
with other parties the risks and benefits associated with certain assets and liabilities.
In theory, it should be possible to determine what items belong in the statement of
financial position by reference to general principles such as those in the IASB’s
Conceptual Framework for Financial Reporting and similar concepts statements. In
practice, however, such principles on their own have not proved adequate to deal with
off-balance sheet finance, including routine transactions such as debt factoring and
mortgage securitisation.
Accordingly, standard-setters throughout the world, including the IASB, have
developed increasingly detailed rules to deal with the issue. This ‘anti-avoidance’ aspect
of the derecognition rules helps to explain why, rather unusually, IFRS considers not
only the economic position of the entity at the reporting date, but also prior transactions
which gave rise to that position and the reporting entity’s motives in undertaking them.
For example, an entity that enters into a forward contract to purchase a specified non-
derivative asset for a fixed price will normally recognise that arrangement as a
derivative. However, an entity which previously owned the specified non-derivative
asset and entered into an identical forward contract at the same time as selling the asset
would normally recognise the entire arrangement as a financing transaction. It would
leave the (sold) asset on its statement of financial position and recognise a non-
derivative liability for the purchase price specified in the forward contract.
The IASB has proposed changes to its conceptual framework, including the addition of
new guidance addressing derecognition which is covered in more detail at 7 below.
2 DEVELOPMENT
OF
IFRS
Under IFRS, many definitions relating to financial instruments are in IAS 32 – Financial
Instruments: Presentation – while derecognition of financial assets and financial
liabilities is currently addressed in IFRS 9 – Financial Instruments.
Financial
instruments:
Derecognition
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IFRS 9 replaced IAS 39 – Financial Instruments: Recognition and Measurement – and
was required to be applied for year beginning 1 January 2018. The derecognition
requirements of IAS 39 were brought forward into IFRS 9 without amendment.
The provisions of IFRS 10 – Consolidated Financial Statements – are also very relevant
to certain aspects of the derecognition of financial assets and financial liabilities. IFRS 10
is discussed in Chapter 6, but it is also referred to at various points below.
Whilst IFRS 9 introduces major changes to the way in which financial instruments are
reflected in financial statements, its requirements relating to derecognition are
substantially the same as those in IAS 39. Accordingly, consideration by the
Interpretations Committee of the application of these parts of IAS 39 continue to be
relevant under IFRS 9. Therefore references to such discussions are included in this
chapter as if the committee was considering IFRS 9.
Disclosure requirements in respect of transfers of financial assets are included in IFRS 7
– Financial Instruments: Disclosures – and these are discussed in Chapter 50 at 6.
2.1 Definitions
The following definitions in IAS 32, IFRS 9 and IFRS 13 – Fair Value Measurement –
are generally relevant to the discussion in this chapter.
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A financial instrument is any contract that gives rise to a financial asset of one entity and
a financial liability or equity instrument of another entity. [IAS 32.11].
A financial asset is any asset that is:
(a) cash;
(b) an equity instrument of another entity;
(c) a
contractual
right:
(i) to receive cash or another financial asset from another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under
conditions that are potentially favourable to the entity; or
(d) a contract that will or may be settled in the entity’s own equity instruments and is:
(i)
a non-derivative for which the entity is or may be obliged to receive a variable
number of the entity’s own equity instruments; or
(ii) a derivative that will or may be settled other than by the exchange of a
fixed amount of cash or another financial asset for a fixed number of the
entity’s own equity instruments. For this purpose the entity’s own equity
instruments do not include puttable financial instruments classified as
equity ..., instruments that impose on the entity an obligation to deliver to
another party a pro rata share of the net assets of the entity only on
liquidation and are classified as equity ..., or instruments that are
themselves contracts for the future receipt or delivery of the entity’s own
equity instruments. [IAS 32.11].
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A financial liability is any liability that is:
(a) a
contractual
obligation:
(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavourable to the entity; or
(b) a contract that will or may be settled in the entity’s own equity instruments and is:
(i)
a non-derivative for which the entity is or may be obliged to deliver a variable
number of the entity’s own equity instruments; or
(ii) a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entity’s
own equity instruments. For this purpose the entity’s own equity instruments
do not include puttable financial instruments classified as equity ...,
instruments that impose on the entity an obligation to deliver to another party
a pro rata share of the net assets of the entity only on liquidation and are
classified as equity ..., or instruments that are themselves contracts for the
future receipt or delivery of the entity’s own equity instruments. [IAS 32.11].
An equity instrument is any contract that evidences a residual interest in the assets of
an entity after deducting all of its liabilities. [IAS 32.11].
A derivative is a financial instrument or other contract within the scope of IFRS 9 (see
Chapter 42 at 2) with all three of the following characteristics:
• its value changes in response to the change in a specified interest rate, financial
instrument price, commodity price, foreign exchange rate, index of prices or rates,
credit rating or credit index, or other variable, provided in the case of a non-
financial variable that the variable is not specific to a party to the contract
(sometimes called the ‘underlying’);
• it requires no initial net investment or an initial net investment that is smaller than
would be required for other types of contracts that would be expected to have a
similar response to changes in market factors; and
• it is settled at a future date. [IFRS 9 Appendix A].
Fair value is the price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants at the measurement date.
[IFRS 13.9, Appendix A].
Financial
instruments:
Derecognition
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3 DERECOGNITION
–
FINANCIAL ASSETS
3.1 Background
The requirements of IFRS 9 for derecognition of financial assets are primarily designed
to deal with the accounting challenges posed by various types of off-balance sheet
finance. As a result, the real focus of many of the rules for derecognition of assets is in
fact the recognition of liabilities. The starting point for most of the transactions
discussed below is that the reporting entity receives cash or other consideration in
return for a transfer or ‘sale’ of all or part of a financial asset. This raises the question of
whether such consideration should be treated as sales proceeds or as a liability. IFRS 9
effectively answers that question by determining whether the financial asset to which
the consideration relates should be derecognised (the consideration is treated as sales
proceeds and there is a gain or loss on disposal) or should continue to be recognised
while the consideration is treated as a liability.
This underlying objective of the derecognition criteria helps to explain why IFRS 9
considers not only the economic position of the entity at the reporting date, but also
prior transactions which gave rise to that position and the reporting entity’s motives in
undertaking them. For example, if, at a reporting date, an entity has two identical
forward contracts for the purchase of a financial asset, the accounting treatment of the
contracts may vary significantly if one contract relates to the purchase of an asset
previously owned by the entity and the other does not.
This is because the derecognition rules of IFRS 9 are based on the premise that, if a
transfer of an asset leaves the transferor’s economic exposure to the transferred asset
much as if the transfer had never taken place, the financial statements should represent
that the transferor still holds the asset. Thus, if an entity sells (say) a listed bond subject
to a forward contract to repurchase the bond from the buyer at a fixed price, IFRS 9
argues that the entity is exposed to the risks and rewards of that bond as if it had never
sold it, but has simply borrowed an amount equivalent to the original sales proceeds
secured on the bond. IFRS 9 therefore concludes that the bond should not be removed
from the statement of financial position and the sale proceeds should be accounted for
as a liability (in effect the obligation to repurchase the bond under the forward contract
– see 4 below).
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By contrast, if the entity were to enter into a second identical forward contract over
another bond (i.e. one not previously owned by the entity), IFRS 9 would simply
require it to be accounted for as a derivative at fair value (see Chapter 42). This might
seem a rather counter-intuitive outcome of a framework that purports to report
economically equivalent transactions in a consistent and objective manner. However,
the IASB would argue that the two transactions are not economically equivalent: they
are distinguished by the fact that, on entering into the forward contract over the
originally owned asset, the entity received a separate cash inflow (i.e. the ‘sale’
proceeds from the counterparty), whereas, on entering into the second con
tract, it
did not. This reinforces the point that the real focus of IFRS 9 is to determine the
appropriate accounting treatment for that cash inflow and not that of the previously
owned bond per se.
3.2 Decision
tree
The provisions of IFRS 9 concerning the derecognition of financial assets are complex,
but are summarised in the flowchart below. [IFRS 9.B3.2.1]. It may be helpful to refer to
this while reading the discussion that follows.
It will be seen that the process presupposes that the reporting entity has correctly
consolidated all its subsidiaries in accordance with IFRS 10, including any entities
identified as consolidated structured entities, often called special purpose entities (SPEs)
(see Chapter 6).
Under IFRS, a vehicle (or a structured entity) that, though not meeting a traditional
definition of a subsidiary based on ownership of equity, is still controlled by the entity
is often referred to as a (consolidated) special purpose entity or SPE. IFRS 10 requires a
reporting entity to consolidate another entity, including an SPE, when the reporting
entity is exposed, or has rights, to variable returns from its involvement with the
investee entity and has the ability to affect those returns through its power over the
investee entity (see 3.6 below).
It is clearly highly significant from an accounting perspective that an entity to which a
financial asset or liability is transferred is a subsidiary or a consolidated SPE of the
transferor. A financial asset (or financial liability) transferred from an entity to its
subsidiary or consolidated SPE (on whatever terms) will continue to be recognised in
the entity’s consolidated financial statements through the normal consolidation
procedures set out in IFRS 10. Thus, the requirements discussed at 3.3 to 3.9 below are
irrelevant to the treatment, in an entity’s consolidated financial statements, of any
transfer of a financial asset by the entity to a subsidiary or consolidated SPE. Requiring
consolidation of subsidiaries and certain SPEs means that the same derecognition
analysis applies whether the entity transfers the financial assets directly to a third party
investor or to a subsidiary or consolidated SPE that carries out the transfer.