UK: IAS 39 Modelling

Last Updated: 2 May 2007
Article by Deloitte Audit Group

Most Read Contributor in UK, August 2017

An example of evaluating the amount of risk and reward transferred and retained in a transfer in accordance with IAS 39 Financial Instruments Recognition and Measurement

Measuring the relative amount of risk retained by the transferor will be key to determining the accounting treatment for that transfer under IAS 39. The different treatments under IAS 39 are depicted below:

Often it will be obvious whether the transferor has transferred substantially all risks and rewards of ownership or retained substantially all risks and rewards 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. The computation and comparison is made using as the discount rate an appropriate current market interest 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 [IAS 39.22]. This guidance is reminiscent of the principles in FIN 46R, the US consolidation standard applicable to vehicles know as "variable interest entities" found in many securitisation transactions. However, the IASB did not specify what statistic (eg standard deviation, variance, or mean absolute deviation as in FIN 46R) should be used to measure "variability."

The IASB did provide a numerical example to illustrate the application of the continuing involvement approach in IAS 39.AG52. That example assumes, but does not demonstrate, the conclusion that the transferor has passed some significant risk and rewards of ownership of the transferred assets (eg prepayment risk) while continuing to retain some significant risks and rewards (eg credit risk). The worksheet below shows one method, based on the standard deviation statistic1, which might be used when calculations are required. The calculations require information about various possible future scenarios that are not included in the IAS 39 example. So we needed to imagine the necessary data, while trying to keep it as consistent as possible to what information was given in IAS 39.AG52. In real life, one would probably need more than four scenarios and they should be based on real, supportable expectations and experience. With that said, the assumed scenarios are as follows:

Scenario 1: Prepay immediately – All loans prepay all outstanding principal of £10,000 immediately after the closing of the securitisation. There are no defaults and no interest has accrued since the closing date. The senior investors are entitled to 90% of the principal proceeds, or £9,000 and the transferor is entitled to the remaining £1,000. Probability = 20%

Scenario 2: Prepay in one year – All loans prepay all outstanding principal and accrued interest of £1,000 on the coupon payment date, which is the first anniversary of the securitisation closing. There are no defaults. The senior investors are entitled to 90% of the principal proceeds plus interest at the rate of 9.5% thereon for a total of £9,855 and the transferor is entitled to the remaining £1,145. Probability = 30%

Scenario 3: Mature in two years – All loans run to their contractual maturity at the end of two years. They pay timely the £1,000 coupon interest payment due on the first anniversary of the securitisation closing and all outstanding principal and accrued interest of £1,000 on the maturity date, which is the second anniversary of the securitisation closing. There are no defaults. The senior investors are entitled to one coupon payment of £855 and a final payment of £9,855 and the transferor is entitled to the remaining coupon payment of £145 and final payment of £1,145. Probability = 30%

Scenario 4: Default in one year – All loans default on all outstanding principal and accrued interest on the coupon payment date, which is the first anniversary of the securitisation closing. Through immediate foreclosure and sale of the collateral properties, a total of £10,741 is recovered and applied to repay principal and accrued interest, first to the senior bond, then the subordinated bond. No recovery proceeds are available to the IO strip. The senior investors are entitled to the same £9,855 as in Scenario 2, while the transferor is receives the remaining £886. Probability = 20%

IAS 39 does not differentiate based on how the risk is allocated among the transferees. Similarly, IAS 39 does not care how or in how many tranches the transferor’s risk is retained. Therefore, the analysis can be simplified by dividing the asset cash flows for each scenario into two buckets – the total amount attributable to the transferor and everything else, which represents the net amount attributable to all the transferees taken as a group.

That method is illustrated in the tables below. Obviously we had to reverse engineer the assumptions in order to make this example that tie to the IAS 39 example. Please forgive the occasional liberty we took in rounding trying to keep the numbers as simple as possible.

Notice that the sum of the standard deviations of the Transferred Senior portion and the Retained Subordinated and IO portions add up to more than the standard deviation of the loans as a single portfolio. Try to visualize this effect with the following picture of a triangle. We us arrows for the sides of the triangle, because risk has a direction associated with it (eg a long or short position). The diagram shows that in total, we start at the same beginning spot and arrive at the same end point before and after the transaction. The paths are simply different.

One way to evaluate the amount of risk transferred would be to sum up the total risk exposure of the transferor after the transaction and the net risk exposure of the transferees as a group to create a new, larger denominator. Then you could divide the transferor’s total risk after the transaction by that sum. This is a simplified method, and it could be argued is an acceptable approach. However, you could argue that because IAS 39 focuses on the proportion of the risk of ownership of the assets that has been transferred or retained, not the absolute amount of risk exposure of the transferor or transferee, an alternative approach that is described below can be applied.

This distinction is important, because risk does not add or subtract in simple, arithmetic ways. The portfolio diversification effect of the loans as a group reduced the total risk of the portfolio to something less than the arithmetic sum of the risks of each loan. The subordination structure of the transaction acts in a similar fashion, but in the opposite direction. Rather than reducing risk through diversification, it increases risk by introducing to both the transferor and transferees as a group an equal and offsetting new risk that is completely uncorrelated with the aggregate asset portfolio risk. In essence, the transferor and transferee have made a small "side bet" using a portion of the asset portfolio as the amount of the wager. Visualize this by breaking the previous diagram into two parts.

Again, each diagram shows the same beginning and end to represent the total risk to the transferor and the net risk to the transferees as a group. It also reveals the portion of the risk of the assets retained and transferred. If we knew how the asset portfolio risk correlated with the total risk to the transferor or the net risk to the transferees as a group, it would be a simple matter to measure the numerical amount of the asset risk retained and transferred. A simple multiplication of the transferor’s total risk or the transferees’ net risk amounts by their individual correlation coefficients (their respective r statistics) will yield the answer.

However, calculating those correlation coefficients is a tedious and cumbersome numerical exercise. Readers that remember their trigonometry lessons from school will recognise the multiplication step described above using the correlation coefficient as the same multiplication that could be done using the cosine of the angle between a leg and hypotenuse of a right triangle. In this case, the cosine of the angle between the two arrows with the same starting spots in the transferor diagram would represent the transferor’s correlation coefficient. Similarly, the cosine of the angle between the two arrows with the same ending points in the transferee diagram would represent the correlation coefficient of the transferees as a group. Using that idea and some more trigonometry, you can prove a pair of easier formulas to calculate the percentage of asset risk retained and transferred that use only the risk amounts we have already calculated. The formulas use the length of each line squared. Fortunately, if our arrows represent standard deviation statistics, the squared amounts are the previously calculated variance statistics (abbreviated as Var below). The formulas work out to:

IAS 39 does not did establish any bright-line guidance on the cutoff levels for what represents "substantially all". If the transferor believes that something in the region of 80% to 90% it equivalent to "substantially all", then in this hypothetical case the entity would conclude that the transferor had neither transferred nor retained substantially all of the risk and reward of the portfolio following transfer.

Footnotes

1. Other risk measures could also be used. For example, FIN 46R bases its risk measurements on a variation of the mean absolute deviation statistic. IAS 39 does not specify any particular statistical concept to measure risk. We chose standard deviation for this example because it is a common risk measure and can be easier to work with, in a mathematical sense, in some circumstances.

2. For example, the deviation of the total loan amount in Scenario 1 from the overall average is the difference between £10,000 and £10,100, which equals £100. Squaring that deviation gets us to 10,000 and weighting it by the 20% probability of Scenario1 yields 2,000.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.