A European example of problems in derecognizing financial instruments

Here’s another of the issues from some extracts of enforcement decisions recently issued by the European Securities and Markets Authority (ESMA) (for more background see here):

• “In 2011, the issuer granted a loan to its ultimate parent through a facility agreement and arranged issuance of preferred securities through an offer document with a support agreement. The issuer argued that the entire transaction has been set up with the intention of being a ‘pass-through’ arrangement, with no commercial substance from the issuer’s perspective. Accordingly, the issuer accounted for the combined transactions as one.
• The issuer stated that both financial assets resulting from granting the loans and financial liabilities resulting from issuance of the preferred securities should be derecognized upon inception of the contracts because they had the same contractual terms and cash received from the assets was used to repay the liability.
• In the view of the issuer, the derecognition of the assets is required by IAS 39, because:

1. Paragraph 19(a) of IAS 39 requires an entity to have no obligation to pay amounts to the eventual recipients unless it collects equivalent amounts from the original asset. As the terms of the issuer assets and liabilities are matched exactly and the issuer had no other assets from which it could possibly fund its obligations, the commercial substance of the transaction meets this condition.
2. Paragraph 19(b) of IAS 39 requires an entity to be prohibited by the terms of the transfer contract from selling or pledging the original asset other than as security to the eventual recipients for the obligation to pay them cash flows. Although the facility agreement could, in theory, potentially be sold or pledged, the support agreement may not be sold or pledged without the agreement of the preferred security holders. As the issuer believed both agreements should be considered together, the commercial substance of the transaction meets this condition.
3. Paragraph 19(c) of IAS 39 requires an entity to pass on the cash flows without material delay. As the terms of the assets and liabilities are exactly matched, the issuer believed the commercial substance of the transaction meets this condition.

• The issuer argued that the financial liability should be derecognized in accordance with paragraph 39 of IAS 39, which requires derecognition of a financial liability when it is extinguished (i.e. when the obligation specified in the contract is discharged or cancelled or expires). As the issuer’s transactions were entered into concurrently and in contemplation of each other, the liability should be considered concurrently with the assets when considering the derecognition criteria. The issuer transferred substantially all of the risks and rewards of ownership of the assets to the holders of the preferred securities, leading to their derecognition. Such transfer discharges the issuer’s obligations under the preferred securities, as the issuer has no further obligation other than to remit such cash flows as they are received from the assets.”

The enforcer (as ESMA likes to term it) disagreed, taking the view that the financial assets and liabilities should both be recognized in the statement of financial position. As set out above, the issuer analyzed the application of the various criteria in IAS 39.19 with reference to their “commercial substance” rather than with reference to the strict rights and obligations set out in the agreements. But where financial instruments in particular are concerned, it’s often hard to find much wriggle room between the commercial substance and the legal form – after all, financial instruments arise from contracts that were specifically drawn up and entered into, and it’s reasonable to assume that everything in the contract is there for a reason. If in this case the participants were both happy to set up a pure pass-through arrangement, then it shouldn’t have been too difficult to achieve. The fact that they didn’t do that suggests that the issuer (or, presumably, its ultimate parent) wanted to retain some residual control over things, which makes it appropriate to continue to recognize the instruments on its balance sheet.

Everyday problems…

Smaller Canadian entities aren’t too likely to engage in such financial engineering, so this particular kind of fact pattern won’t arise often. Problems can still arise though with regard to derecognizing financial liabilities. One fairly common example relates to liabilities that apparently don’t have to be paid anymore, because the creditor has disappeared, or forgotten about it, or whatever the case may be. It may be tempting to remove these items from the balance sheet, recognizing a gain in the process, but this is difficult to do when (with reference to IAS 39.39) the liabilities have neither been discharged nor cancelled nor expired. Perhaps in some situations the operation of law achieves this (for instance, certain liabilities may expire just through the passage of time), but in others, it doesn’t. At least, in such cases, preparers can be philosophical – they may be stuck with the liability on their balance sheet, but they never handed over the cash, which probably puts them ahead in the big scheme of things…

The opinions expressed are solely those of the author