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CASE STUDY 4
This case illustrates the application of the principle for derecognition of financial assets
Facts
During the reporting period, Entity A has sold various financial assets:
1. Entity A sells a financial asset for $10,000. There are no strings attached to the sale, and no other rights or obligations are retained by Entity A.
2. Entity A sells an investment in shares for $10,000 but retains a call option to repurchase the shares at any time at a price equal to their current fair
value on the repurchase date.
3. Entity A sells a portfolio of short-term account receivables for $100,000 and promises to pay up to $3,000 to compensate the buyer if and when
any defaults occur. Expected credit losses are significantly less than $3,000, and there are no other significant risks.
4. Entity A sells a portfolio of receivables for $10,000 but retains the right to service the receivables for a fixed fee (i.e., to collect payments on the
receivables and pass them on to the buyer of the receivables). The servicing arrangement meets the pass-through conditions.
5. Entity A sells an investment in shares for $10,000 and simultaneously enters into a total return swap with the buyer under which the buyer will
return any increases in value to Entity A and Entity A will pay the buyer interest plus compensation for any decreases in the value of the
investment.
6. Entity A sells a portfolio of receivables for $100,000 and promises to pay up to $3,000 to compensate the buyer if and when any defaults occur.
Expected credit losses significantly exceed $3,000.
Required
Help Entity A by evaluating the extent to which derecognition is appropriate in each of the aforementioned cases.
Solution
1. Entity A should derecognize the transferred financial asset, because it has transferred all risks and rewards of ownership.
2. Entity A should derecognize the transferred financial asset, because it has transferred substantially all risks and rewards of ownership. While Entity
A has retained a call option (i.e., a right that often precludes derecognition), the exercise price of this call option is the current fair value of the asset
on the repurchase date. Therefore, the value of the call option should be close to zero. Accordingly, Entity A has not retained any significant risks
and rewards of ownership.
3. Entity A should continue to recognize the transferred receivables because it has retained substantially all risks and rewards of the receivables. It has
kept all expected credit risk, and there are no other substantive risks.
4. Entity A should derecognize the receivables because it has transferred substantially all risks and rewards. Depending on whether Entity A will
obtain adequate compensation for the servicing right, Entity A may have to recognize a servicing asset or servicing liability for the servicing right.
5. Entity A should continue to recognize the sold investment because it has retained substantially all the risks and rewards of ownership. The total
return swap results in Entity A still being exposed to all increases and decreases in the value of the investment.
6. Entity A has neither retained nor transferred substantially all risks and rewards of the transferred assets. Therefore, Entity A needs to evaluate
whether it has retained or transferred control. Assuming the receivables are not readily available in the market, Entity A would be considered to
have retained control over the receivables. Therefore, it should continue to recognize the continuing involvement it has in the receivables, that is,
the lower of (1) the amount of the asset ($100,000) and (2) the maximum amount of the consideration received it could be required to repay
($3,000).
Derecognition of Financial Liabilities
The derecognition requirements for financial liabilities are different from those for financial assets. There is no requirement to assess the extent to which the entity
has retained risks and rewards in order to derecognize a financial liability. Instead, the derecognition requirements for financial liabilities focus on whether the financial
liability has been extinguished. This means that derecognition of a financial liability is appropriate when the obligation specified in the contract is discharged or is
cancelled or expires. Absent legal release from an obligation, derecognition is not appropriate even if the entity were to set aside funds in a trust to repay the liability
(so-called insubstance defeasance).