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IFRSs for investors in securitised transactions Back  
Vincent Reilly reveals the intricacy of accounting for financial instruments under IFRSs, and its potentially significant impact for investors in securitised transactions. He writes that the complexity of IFRSs, and the volume of guidance surrounding it will pose a significant challenge not just to investors, but also to the SPV administration industry in Ireland.
The introduction of IAS 32 Financial Instruments: Disclosure and Presentation and revised IAS 39 Financial Instruments: Recognition and Measurement has been the subject of much debate and controversy which was partially fuelled by the initial decision of the EU not to endorse the standards for use in Members States. Eventually the discussions provoked the International Accounting Standards Board to amend several aspects of IAS 39, particularly in relation to the optional use of fair value accounting. The purpose of this article is to explore the complexity of IFRS in the context of one particular financial instrument, the Credit Linked Note (CLN) found in cash funded - collateralised debt obligations (CDOs) and synthetic CDO structures.
Vincent Reilly

Since the early 1990s, the growth in CDOs through the use of special purpose vehicles (SPVs) has been phenomenal. These SPVs issued debt and ‘equity-type’ instruments secured against a portfolio of assets or more specifically credit risk and gave investors the opportunity to gain access to highly diversified asset class pools and the ability to select a degree of risk/return and maturity profile through the CDOs capital structure.

The early securitisations utilised a cash funded structure. The note is issued by the SPV being secured on the primary risk assets purchased by the SPV from the note proceeds. The cash inflows derived from these primary risk assets were then used to pay coupons and principal on the securities as well as the costs of operating the SPV.

The introduction of credit derivatives radically altered the way credit risk was originated, managed and transferred in the international financial markets. It also led to the growth in the synthetic CDO market. Credit derivatives are a means of exchanging credit risk and involve both a seller and a buyer.

Synthetic structures typically involve an SPV whose securities and credit performance is linked to the performance of a reference pool. This reference pool is essentially the primary risk asset. Although, the proceeds of the credit linked note are invested in eligible assets, these assets are not normally the primary risk assets as they tend to be AAA rated, and become in essence a secondary risk asset. The cash flows derived from the secondary risk assets, supplemented by a fee earned from the sale of credit protection on the primary risk asset are then used to pay the coupons and principal of the CLN as well as the costs of the SPV.

Under old UK GAAP, there was no guidance on the recognition and measurement of derivative
financial instruments. The CLN issued by the SPV would normally be accounted for in line with any other debt instrument which is to be measured on an amortised cost basis. The credit linked note was not split into its component parts for accounting purposes – part debt instrument and part derivative.

Finance costs were then calculated by deducting the net proceeds received on issue from the total payments – redemptions, interest, premium or discount which were to be made over the whole term of the CLN. The amount was then allocated to accounting periods such that it gave a constant rate of financing over the term of the debt, on the outstanding carrying amount of the

In Ireland, this has been the principal approach adopted in accounting for these complex instruments and has been relatively straightforward to apply in practice, once an estimate of future cash flows was determined.

Under IFRS, a credit linked note is effectively treated as a debt instrument (or host contract) that is bundled with an embedded credit derivative.

IAS 39 requires an embedded derivative to be separated from the host contract and accounted for as a derivative if all of the following conditions are met:
1. The economic characteristics and risks of the embedded derivative are not closely related to those of the host contract.
2. A separate instrument with the same terms as the embedded derivative would the meet the definition of a derivative.
3. The hybrid instrument is not measured at fair value with changes in fair value recognised in the profit and loss account.

This assessment is carried out at inception of the contract.

Under IAS 39, all derivatives are measured at fair value in the balance sheet – which includes the embedded derivative, should all the above conditions be met.

In evaluating whether the holder of an investment in the CDO needs to separate an embedded derivative, it is important to distinguish between cash CDOs and synthetic CDOs.

Cash CDOs expose investors to the credit risk of the CDO SPV holding the reference assets that are subject to default. Therefore, a note holder in a cash-funded CDO is generally not required to separate an embedded credit derivative because it is exposed only to the risk inherent in non-derivative assets held directly by the SPV.

However, a note holder in a synthetic CDO holds high quality cash collateral or highly rated eligible securities - the secondary assets. These secondary assets have effectively little or no default risk. The exposure to credit risk is created synthetically, by writing credit default swaps on the reference assets – the primary risk assets. In respect of the accounting of this note, the holder is required to separate the embedded credit default swap because the credit risk inherent in the embedded derivative is not closely related to the credit risk of the SPV( see condition 1 above).
Rather the credit risk of the embedded derivative remains the credit risk of the underlying pool of credit derivatives, and not the credit risk of the SPV itself.

Indeed, the fact that junior and senior tranches are issued does not change the fact that each tranche of bonds contains a separate embedded derivative, although the value of the embedded derivatives in senior tranches might well be, very small.

The separated embedded derivatives would then be measured at fair value in the balance sheet and the volatility included in the income statement.

As the derivative component is measured separately at fair value upon initial recognition, the carrying amount of the host contract at initial recognition is the difference between the cost of the hybrid instrument and the fair value of the embedded derivative. Where the fair values of the hybrid instrument and the host contract are more reliably measurable than that of a derivative component, it may be acceptable to use those values to determine the fair value of the derivative upon initial recognition indirectly i.e. as a residual amount.

The purpose of this article is not necessarily to highlight one particular accounting difference arising from the use of different securitisation technology, but rather to reveal the intricacy of accounting for financial instruments under IFRS and its potentially significant impact for investors in securitised transactions. The complexity of IFRSs and the volume of guidance surrounding it will pose a significant challenge not just to investors but also to the SPV Administration industry in Ireland. IFRS implementation will require coming to terms with the onerous obligations imposed by IFRS, whether in understanding the accounting implications of particular financial instruments or in obtaining the additional information and disclosures that will be required to be fully compliant with IFRS.

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