Derecognition of Financial Assets (IFRS 9)

Derecognition is the removal of a previously recognised financial asset from an entity’s statement of financial position. In general, IFRS 9 criteria for derecognition of a financial asset aim to answer the question whether an asset has been effectively ‘sold’ and should be derecognised or whether an entity obtained a kind of financing against this asset and simply an additional financial liability should be recognised. See also separate page on derecognition of financial liabilities.

Derecognition criteria for financial assets are summarised in the decision tree below. This is a very useful framework that helps go through the discussion that follows.

Decision tree for derecognition of financial assets (IFRS 9.B3.2.1)
Decision tree for derecognition of financial assets (IFRS 9.B3.2.1)

The question ‘have the rights to the cash flows from the asset expired?’ is the first step in the derecognition decision tree and is covered in paragraph IFRS 9.3.2.3(a). The most obvious examples of situations when the contractual rights to the cash flows from the financial asset expire are repayment of a financial asset or expiry of an option. Other less obvious instances are discussed below.

Some modifications of contractual cash flows will result in derecognition of a financial instrument and the recognition of a new financial instrument in accordance with IFRS 9. The derecognition criteria in the context of renegotiations and modifications of contractual terms are set out quite well for financial liabilities, but not so for financial assets. IFRIC tried to tackle the lack of specific requirements, but ultimately decided that it could not resolve it in an efficient manner and not to further consider such a project (May 2016 IFRIC update).

A useful discussion is contained in May 2012 and September 2012 IFRIC updates in the context of the restructuring of Greek government bonds in the aftermath of 2007/2008 financial crisis. IFRIC concluded that, in determining whether a debt restructuring results in the derecognition of the financial asset, the best approach is to make an analogy (based on IAS 8 hierarchy) to derecognition criteria for financial liabilities referring to an exchange between an existing borrower and lender of debt instruments with substantially different terms.

A sure thing is that even if a renegotiated asset is not derecognised, a one–off modification gain/loss should still be recognised.

Write-offs can relate to a financial asset in its entirety or to a portion of it. For example, an entity plans to enforce a collateral on a financial asset and expects to recover no more than 30% of the financial asset through the collateral. If the entity has no reasonable prospects of recovering any further cash flows from the financial asset, it should write off the remaining 70% of the financial asset  (IFRS 9.5.4.4; B5.4.9).

The next steps in the derecognition decision tree concern transfers of financial assets. Financial assets should be derecognised if they are transferred and this transfer qualifies for derecognition (IFRS 9.3.2.3(b)). An entity transfers a financial asset if, and only if, it either (IFRS 9.3.2.4):

  1. transfers the contractual rights to receive the cash flows of the financial asset, or
  2. retains the contractual rights to receive the cash flows of the financial asset, but assumes a contractual obligation to pay the cash flows to one or more recipients (‘pass through‘ transfers).

Disclosure requirements relating to transfers of financial assets are set out in paragraphs IFRS 7.42A-42G; B29-B39.

The question ‘has the entity transferred its rights to receive the cash flows from the asset?’ is a next step in the decision tree and is reflected in paragraph IFRS 9.3.2.4(a). There is not much guidance on this point, as it is self-explanatory in most instances. Transferring an asset is usually effected by transferring a legal title to it. Additionally, IFRIC November 2005 update notes that retaining by the transferor the role of an agent to administer collection and distribution of cash flows does not affect the determination of whether an entity transfers the contractual rights to receive the cash flows from a financial asset.

It should be also noted that this condition for derecognition is also met when a legal title is not transferred. In its September 2006 update, the IASB  indicated that a transaction in which an entity transfers all the contractual rights to receive the cash flows (without necessarily transferring legal ownership of the financial asset), would not be treated as a pass through transfer. In other words, such a transaction also falls into the scope of paragraph IFRS 9.3.2.4(a) and the assessment against the ‘pass through’ criteria (discussed below) is not applicable.

Transfers can be conditional and conditions attaching to a transfer can be grouped into two broad categories:

  1. contractual provisions ensuring the existence and quality of transferred cash flows at the date of transfer or
  2. conditions relating to the future performance of the asset.

IASB expressed its view (IASB September 2006 update) on conditional transfers so that the conditions set out above do not affect whether the entity has transferred the contractual rights to receive cash flows under paragraph IFRS 9.3.2.4(a). However, existence of conditions relating to the future performance of the asset (point 2. above) can affect the conclusion related to transfer of all risks and rewards discussed below.

This step from the decision tree is reflected in paragraphs IFRS 9.3.2.4(b) and IFRS 9.3.2.5.

A ‘pass through’ transfer is a transaction where an entity keeps the legal title and rights to cash flows from a financial asset (hence condition in IFRS 9.3.2.4(a) is not met), but enters into an arrangement with a third party under which those cash flows will be passed to this party. Securitisation is a typical example of a ‘pass through’ transfer. Such an arrangement is accounted for as a transfer of the original asset if, and only if, all the following three conditions are met (IFRS 9.3.2.5):

  1. The entity has no obligation to pay amounts to the eventual recipients unless it collects equivalent amounts from the original asset.
  2. The entity is 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.
  3. The entity has an obligation to remit any cash flows it collects on behalf of the eventual recipients without material delay.

This criterion has the effect that all transactions where cash flows are passed through to a third party, but that third party has recourse to the transferor, do not qualify as transfers under IFRS 9.

Paragraph IFRS 9.3.2.5(a) clarifies that short-term advances by the entity with the right of full recovery of the amount lent plus accrued interest at market rates do not violate this condition.

Pass through transfers often concern groups of financial assets and it would be impracticable to remit cash flows on a daily basis from every individual financial asset. IFRS 9 does not allow a ‘material delay’, therefore an ‘immaterial delay’ is allowed. Exact period is of course not specified, but payments on a quarterly basis are not considered to be a material delay in practice.

In addition, in order to fulfil the criterion being discussed, the entity cannot be entitled to reinvest cash flows received from financial assets in question, except for investments in cash or cash equivalents during the short settlement period from the collection date to the date of required remittance to the eventual recipients, and interest earned on such investments is passed to the eventual recipients.

If, based on criteria in previous steps, an entity has transferred a financial asset, next steps in the decision tree relate to risks and rewards. These steps are set out in paragraphs IFRS 9.3.2.6(a)-(b). If the entity transfers substantially all risks and rewards, it derecognises the asset. If entity retains substantially all risks and rewards, it continues to recognise the asset. If the entity neither transfers nor retains substantially all risks and rewards, it assesses whether it has retained control of the asset (the step that follows).

If there are any rights and obligations created or retained in the transfer, they should be recognised separately as assets or liabilities (IFRS 9.3.2.6(a)).

The transfer of risks and rewards is evaluated by comparing the entity’s exposure, before and after the transfer, with the variability in the amounts and timing of the net cash flows of the transferred asset. Often it will be obvious whether the entity has transferred or retained substantially all risks and rewards of ownership and there will be no need to perform any computations. In other cases, it will be necessary to compute and compare the entity’s exposure to the variability in the present value of the future net cash flows before and after the transfer. Computations and comparison are made using an appropriate current market interest rate as the discount rate. All reasonably possible variability in net cash flows is considered, with greater weight being given to those outcomes that are more likely to occur (IFRS 9.3.2.7-8).

IFRS 9 does not set any threshold that would represent ‘substantially’ all risks and rewards.

Examples of when an entity has or has not transferred substantially all the risks and rewards of ownership are given in paragraphs IFRS 9.B3.2.4-5. Finally, examples of when an entity has neither retained nor transferred substantially all the risks and rewards are given in paragraphs IFRS 9.B3.2.16(h)-(i) and IFRS9.B3.2.17.

When an entity transferred an asset, but has retained substantially all the risks and rewards, the asset is not derecognised. Instead, any proceeds received are recognised as a financial liability. In subsequent periods, an entity recognises income on the transferred asset and expense incurred on the financial liability as if they were separate financial instruments (IFRS 9.3.2.15).

Note that this is not the same as continuing involvement in transferred assets covered below.

An example in the section on factoring presents a simple analysis showing whether an entity has transferred substantially all risks and rewards of its trade receivables by comparing the entity’s exposure, before and after the transfer, with the variability in the amounts and timing of the net cash flows of the transferred assets.

This is the last question to be answered in the derecognition decision tree. It should be answered when an entity transferred an asset, but has neither retained nor transferred substantially all risks and rewards. If the entity has not retained control, it should derecognise the financial asset and recognise separately as assets or liabilities any rights and obligations created or retained in the transfer. If the entity has retained control, it continues to recognise the financial asset to the extent of its continuing involvement in the financial asset (IFRS 9.3.2.6(c)).

Whether the entity has retained control of the transferred asset depends on the transferee’s (i.e. a party to whom the asset was transferred) ability to sell the asset. If the transferee has the practical ability to sell the asset in its entirety to an unrelated third party and is able to exercise that ability unilaterally and without needing to impose additional restrictions on the transfer, the entity has not retained control. In all other cases, the entity has retained control (IFRS 9.3.2.9).

Paragraphs IFRS 9.B3.2.7-9 elaborate on what is meant by practical ability to sell the asset. It starts with a sentence saying that ‘transferee has the practical ability to sell the transferred asset if it is traded in an active market because the transferee could repurchase the transferred asset in the market if it needs to return the asset to the entity’. Some tend to interpret this as a condition that an asset must be traded in an active market irrespective of the circumstances. In my opinion this is not the case, as the explanation goes on to say that an active market is needed when the transferee would need to repurchase the transferred asset in the market if it needs to return the asset to the entity. If the transferee would never be obliged to repurchase a transferred asset, there need not be an active market in order to conclude that the control has been transferred. In any case, accounting consequence will often be essentially the same, as retaining control means accounting for continuing involvement in the asset (see below), which will often be similar to recognition of any assets or liabilities resulting from rights and obligations created or retained in the transfer under paragraph IFRS 9.3.2.6(c).

Accounting for continuing involvement in transferred assets is covered in paragraphs IFRS 9.3.2.16-21 and applies when an entity:

  1. neither transfers nor retains substantially all the risks and rewards of ownership of a transferred asset and
  2. retains control of the transferred asset.

See also the discussion contained in basis for conclusions paragraphs IFRS 9.BCZ3.27-28.

If a guarantee provided by an entity to pay for credit losses on a transferred asset prevents the transferred asset from being derecognised to the extent of the continuing involvement, the transferred asset at the date of the transfer is measured at the lower of (IFRS 9.3.2.16(a); B3.2.13(a)):

  1. the carrying amount of the asset and
  2. the guarantee amount

Example is given in paragraph IFRS 9.B3.2.17.

If a put or call option prevents a transferred asset from being derecognised and the entity measures the transferred asset at amortised cost, the associated liability is measured at the consideration received adjusted for the amortisation of any difference between that cost and the gross carrying amount of the transferred asset at the expiration date of the option (IFRS 9.B3.2.13(b)).

If a put or call option prevents a transferred asset from being derecognised and the entity measures the transferred asset at fair value, the asset continues to be measured at its fair value. The associated liability is measured at (IFRS 9.B3.2.13(c)):

  1. the option exercise price less the time value of the option if the option is in or at the money, or
  2. the fair value of the transferred asset less the time value of the option if the option is out of the money.

Paragraph IFRS 9.B3.2.17 illustrates accounting for continuing involvement in a part of a financial asset.

Derecognition criteria in IFRS 9 should be applied to a part of an asset if, and only if, the part being considered for derecognition meets one of the following three conditions (IFRS 9.3.2.2):

  1. The part comprises only specifically identified cash flows from a financial asset or a group of similar financial assets.
  2. The part comprises only a fully proportionate (pro rata) share of the cash flows from a financial asset or a group of similar financial assets.
  3. The part comprises only a fully proportionate (pro rata) share of specifically identified cash flows from a financial asset or a group of similar financial assets.

These conditions should be applied strictly as illustrated in examples given in paragraph IFRS 9.3.2.2(b). If none of them is met, derecognition criteria are applied to the financial asset in its entirety.

The discussion on derecognition on this page refers to ‘a financial asset’ but is important to keep in mind that ‘a financial asset’ may refer to a part of an asset if the criteria above are met.

‘A group of similar financial assets’

The criteria to decide whether derecognition criteria should be applied to the financial asset in its entirety or to a part of it refer also to ‘a group of similar financial assets’. It is not further explained in IFRS 9 what is meant by a group of similar financial assets and IASB acknowledged that there is a diversity in determining what a group of similar financial assets is. It is quite common that non-derivative assets (e.g. loans) are transferred together with derivative financial instruments (e.g. interest rate swaps). The September 2006 IASB update indicated that derecognition tests in IAS 39 (now in IFRS 9) should be applied to non-derivative financial assets (or groups of similar non-derivative financial assets) and derivative financial assets (or groups of similar derivative financial assets) separately, even if they are transferred at the same time. The IASB also indicated that transferred derivatives that could be assets or liabilities (such as interest rate swaps) would have to meet both the financial asset and the financial liability derecognition tests. However, there is no binding interpretation addressing this issue, therefore entities can develop their own accounting policies in this respect.

It is worth noting that the derecognition decision tree starts with a reminder that all subsidiaries should be consolidated. This might seem to be a trivial reminder, but it’s possible that an arrangement for transferring financial assets to a third party may trigger its consolidation under IFRS 10 and hence  financial assets will stay in consolidated financial statements.

On derecognition of a financial asset in its entirety, the difference between its carrying amount and the consideration received is recognised in profit or loss (IFRS 9.3.2.12).

Paragraphs IFRS 9.3.2.13-14; B3.2.11 cover the accounting for a transaction where the transferred asset is part of a larger financial asset (e.g. when an entity transfers interest cash flows that are part of a debt instrument) and the part transferred qualifies for derecognition in its entirety.

For some transfers that qualify for derecognition, an entity retains the right (or obligation) to service the asset, e.g. to collect payments. In such cases, servicing asset or servicing liability could be recognised depending on whether the servicing fee is expected to compensate the entity adequately for performing the servicing (IFRS 9.3.2.10; B3.2.10).

If a transferred asset continues to be recognised, the asset and the associated liability cannot be offset. Similarly, the entity cannot offset any income arising from the transferred asset with any expense incurred on the associated liability (IFRS 9.3.2.22).

Paragraph IFRS 9.3.2.22 covers accounting for non-cash collaterals provided by transferor to the transferee.

If an entity determines that as a result of the transfer, it has transferred substantially all the risks and rewards of ownership of the transferred asset, it does not recognise the transferred asset again in a future period, unless it reacquires the transferred asset in a new transaction (IFRS 9.B3.2.6).

Paragraph IFRS 9.B3.2.16 provides numerous examples that illustrate the application of the derecognition principles. Some of them are helpful, other just repeat the requirements.

See also an example on factoring of trade receivables.

See other pages relating to financial instruments:

© 2018-2020 Marek Muc

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