By Team IFRS & Valuation Services (firstname.lastname@example.org) (email@example.com)
Direct assignment (DA) is a very popular way of achieving liquidity needs of an entity. With the motives of achieving off- balance sheet treatment accompanied by low cost of raising funds, financial sector entities enter into securitisation and direct assignment transactions involving sale of their loan portfolios. DA in the context of Indian securitisation practices involves sale of loan portfolios without the involvement of a special purpose vehicle, unlike securitisation, where setting up of an SPV is an imperative.
The term DA is unique to India, that is, only in Indian context we use the term DA for assignment of loan or lease portfolios to another entity like bank. Whereas, on a global level, a similar arrangements are known by various other names like loan sale, whole-loan sales or loan portfolio sale.
In India, the regulatory framework governing Das and securitisation transactions are laid down by the Reserve Bank of India (RBI). The guidelines for governing securitisation structures, often referred to as pass-through certificates route (PTCs) were issued for the first time in 2006, where the focus of the Guidelines was restricted to securitisation transactions only and direct assignments were nowhere in the picture. The RBI Guidelines were revised in 2012 to include provisions relating to direct assignment transactions.
Until the introduction of Indian Accounting Standards (Ind AS), there was no specific guidance regarding the accounting of direct assignment transactions, therefore, a large part of the accounting was done is accordance with the RBI Guidelines. The introduction of Ind ASes have opened up several new challenges for the financial entities.
Following issues are relevant:
- Whether DA would lead to de-recogntion?
- Whether there will be a gain on sale upon such de-recognition?
- Whether DA should be be treated as a partial transfer of asset or transfer of the whole asset?
- Continuing valuation of retained interest?
In this article, we intend to discuss those issues and suggest potential solutions for those as well.
Prior to addressing the above issues, the following is a comparison between DA and securitisation for a better understanding:
|Text Box 1: Comparison between Securitisation and Direct Assignment|
|PTC Securitisation||Direct assignments|
|Legal format||Assignment required||Assignment required|
|Transferability of a single loan||No||Yes|
|Bankruptcy remoteness||Yes, provided SPV does not get consolidated||Yes|
|Special purpose vehicle||Yes||No|
|Participation by multiple investors||Yes||Yes, but as a joint ownership|
|Nature of investment made by the investor||Purchase of the securities of the SPV||Purchase of the underlying pool|
|Risk retention||Usually by credit enhancement||Mandatorily pari-passu|
|Rating of the securities||Usually uplifted, and may go up to AAA||No question, as investor buys a pool of loans|
|Upfront encashment of profit||Possible||Required|
|Due diligence by investor||Only based on the evaluation of the securities of SPV||Based on individual loans|
|Use of excess spread to meet losses||Most commonly yes||No|
|Subordination of servicing fee||Not common||Yes, possible|
|Cap on the extent of investment||20%||No such cap|
|Partial assignment||Yes||Necessarily yes|
|Exposure of the investor for concentration norms||On the underlying loans||On underlying loans|
|Accounting in the books of the investor||Purchase of a security||Purchase of loans|
|MTM requirements||Applicable||Not applicable|
|Capital relief||Capital eaten up to the extent of first loss support||Full capital relief, as originator provides no credit enhancement|
|Pricing||Based on the rating of the resulting securities||May be worked out after considering losses and prepayments up to a certain level|
|Liquidity from investor perspective||Yes, the PTCs are transferable. The platform may allow other investors to buy PTCs being sold by an outgoing investor||No. Loans may be bought and resold but not very convenient|
|Conversion into a standard marketable denomination, say Rs 1 lac per unit||Possible and very common||Not possible. The whole loan has to be transferred|
|Simplicity||Not usually very simple to execute||Very simple to execute|
|Tax deduction at source by the borrower||Does not apply||Applies|
|Distribution tax||Applies, up to 1st June 2016||Does not apply|
|Off balance sheet treatment||Yes, subject to conditions||Yes, subject to conditions|
|Credit Enhancement||Allowed||Not Allowed|
De recognition in case of Direct Assignment
Ind AS 109, provides a clear guidance as to the de recognition principles to be followed. Para 3.2.2 says that:
“3.2.2 Before evaluating whether, and to what extent, derecognition is appropriate under paragraphs 3.2.3–3.2.9, an entity determines whether those paragraphs should be applied to a part of a financial asset (or a part of a group of similar financial assets) or a financial asset (or a group of similar financial assets) in its entirety, as follows.
(a) Paragraphs 3.2.3–3.2.9 are applied to a part of a financial asset (or a part of a group of similar financial assets) if, and only if, the part being considered for derecognition meets one of the following three conditions.
(i) The part comprises only specifically identified cash flows from a financial asset (or a group of similar financial assets). For example, when an entity enters into an interest rate strip whereby the counterparty obtains the right to the interest cash flows, but not the principal cash flows from a debt instrument, paragraphs 3.2.3–3.2.9 are applied to the interest cash flows.
(ii) 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). For example, when an entity enters into an arrangement whereby the counterparty obtains the rights to a 90 per cent share of all cash flows of a debt instrument, paragraphs 3.2.3–3.2.9 are applied to 90 per cent of those cash flows. If there is more than one counterparty, each counterparty is not required to have a proportionate share of the cash flows provided that the transferring entity has a fully proportionate share.
(iii) 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). For example, when an entity enters into an arrangement whereby the counterparty obtains the rights to a 90 per cent share of interest cash flows from a financial asset, paragraphs 3.2.3–3.2.9 are applied to 90 per cent of those interest cash flows. If there is more than one counterparty, each counterparty is not required to have a proportionate share of the specifically identified cash flows provided that the transferring entity has a fully proportionate share.
(b) In all other cases, paragraphs 3.2.3–3.2.9 are applied to the financial asset in its entirety (or to the group of similar financial assets in their entirety). For example, when an entity transfers (i) the rights to the first or the last 90 per cent of cash collections from a financial asset (or a group of financial assets), or (ii) the rights to 90 per cent of the cash flows from a group of receivables, but provides a guarantee to compensate the buyer for any credit losses up to 8 per cent of the principal amount of the receivables, paragraphs 3.2.3–3.2.9 are applied to the financial asset (or a group of similar financial assets) in its entirety.”
If the de recognition criteria is not met in entirety, then all the conditions mentioned in para 3.2.2(a) has to be satisfied, which talks about fully proportionate share of total cash flows from the financial asset and fully proportionate share of specifically identified cash flows of the financial asset. If these conditions are met, then partial de recognition is possible. The part that is still recognized, is not connected with de recognition and further accounting related to de recognition. However, for actually de recognizing the asset, the de recognition criteria in para 3.2.3 and para 3.2.6 has to be looked at.
Para 3.2.3 goes as follows:
“3.2.3 An entity shall derecognise a financial asset when, and only when:
(a) the contractual rights to the cash flows from the financial asset expire, or
(b) it transfers the financial asset as set out in paragraphs 3.2.4 and 3.2.5 and the transfer qualifies for derecognition in accordance with paragraph 3.2.6.”
Thus, if the contractual rights to the cashflows expire, then the asset can be de-recognized. If the condition is not met, then it has to be seen that whether the asset is transferred as per para 3.2.5 and the transfer meets the de recognition conditions set out para 3.2.6.
Para 3.2.6 states that:
“3.2.6 When an entity transfers a financial asset (see paragraph 3.2.4), it shall evaluate the extent to which it retains the risks and rewards of ownership of the financial asset. In this case:
(a) if the entity transfers substantially all the risks and rewards of ownership of the financial asset, the entity shall derecognise the financial asset and recognise separately as assets or liabilities any rights and obligations created or retained in the transfer.
(b) if the entity retains substantially all the risks and rewards of ownership of the financial asset, the entity shall continue to recognise the financial asset.
(c) if the entity neither transfers nor retains substantially all the risks and rewards of ownership of the financial asset, the entity shall determine whether it has retained control of the financial asset. In this case:
(i) if the entity has not retained control, it shall derecognise the financial asset and recognise separately as assets or liabilities any rights and obligations created or retained in the transfer.
(ii) if the entity has retained control, it shall continue to recognise the financial asset to the extent of its continuing involvement in the financial asset (see paragraph 3.2.16).”
Para 3.2.6 brings out that, if all the risks and rewards of ownership of financial asset is transferred, then the asset shall be de recognized. If the risks and rewards incidental to ownership of financial asset is not transferred, then obviously the asset cannot be de recognized. However, if there is a partial transfer of risks and rewards of ownership, then the surrender of control has to be evaluated. If there is surrender of control, then the asset can be de recognized. If not, there shall be partial de-recognition, that is, the asset shall be recognized in the books of the seller only to the extent of continuing involvement.
Computation of Gain on Sale
It is a general notion that a sale results in a gain or loss, be it arbitrary or anticipated, the same is required to be accounted for. In case of a direct assignment, there is a sale of the loan portfolios, however, the same completely depends upon whether the assigned loan portfolio is getting derecognised from the books of the assignor or not. If it is not derecognised from the books of the assignor, then the question of recognising a gain or loss on sale does not arise. However, if the sale qualifies for de-recognition, then the seller must book gain or loss on sale in the year of sale.
Upon reading of Ind AS 109 and study of example stated in application guidance in para B3.2.17, the way of computing the same can be derived as follows:
Gain on sale = Sale consideration – Carrying value of asset*Fair value of transferred portion/(Fair value of transferred portion + Fair value of retained portion)
This can be explained with the help of the following example:
The gain or loss on sale does not depend on the sale consideration completely. There may be cases where the carrying value of the transaction and sale consideration are same, i.e. at par transactions. As per Ind AS 109, the computation of gain on sale remains same in cases of at-par or premium structured transactions, however, even at-par transactions could lead to a gain or loss on sale..
The reason for same is that the computation of gain on sale takes into account the retained interest by the Assignor comprising of the difference between the interest on the loan portfolio and the applicable rate at which the direct assignment is entered into with the assignee, also known as the right of excess interest spread (EIS) sweep.
The above settles for the computation of the gain/loss, however, the bigger change seen in the present regime is on the part of recognition of such a gain in the books of the Assignor.
In the present scenario, Ind AS 109 prescribes that the gain on sale or de recognition be recorded upfront in the profit and loss statement.
For reference, para 3.2.12 states that:
“3.2.12 On derecognition of a financial asset in its entirety, the difference between:
(a) the carrying amount (measured at the date of derecognition) and
(b) the consideration received (including any new asset obtained less any new liability assumed) shall be recognised in profit or loss.”
Further in case of de recognition of a part of financial asset, para 3.2.13 states that:
“3.2.13 If the transferred asset is part of a larger financial asset (eg when an entity transfers interest cash flows that are part of a debt instrument, see paragraph 3.2.2(a)) and the part transferred qualifies for derecognition in its entirety, the previous carrying amount of the larger financial asset shall be allocated between the part that continues to be recognised and the part that is derecognised, on the basis of the relative fair values of those parts on the date of the transfer. For this purpose, a retained servicing asset shall be treated as a part that continues to be recognised. The difference between:
(a) the carrying amount (measured at the date of derecognition) allocated to the part derecognised and
(b) the consideration received for the part derecognised (including any new asset obtained less any new liability assumed) shall be recognised in profit or loss.”
Hence, it is clear that the gain on de recognition should be recorded in the profit and loss statement.
From a practical standpoint, the above recognition is seen as a demotivation for entering into a direct assignment transaction, since the same would result in a volatility or irregularity in the profit or loss statement of the NBFCs.
This approach is in stark contrast to what has been prescribed in the RBI Guidelines on Securitisation, which requires gain on sale to be amortised over the life of the transaction. As per the RBI Guidelines provide the following:
As per para 20.1 of RBI Guidelines on Securitisation of Standard Assets issued in 2006:
“In terms of these guidelines banks can sell assets to SPV only on cash basis and the sale consideration should be received not later than the transfer of the asset to the SPV. Hence, any loss arising on account of the sale should be accounted accordingly and reflected in the Profit & Loss account for the period during which the sale is effected and any profit/premium arising on account of sale should be amortised over the life of the securities issued or to be issued by the SPV.”
Also, as per para 1.4.1. of RBI Guidelines on Securitisation of Standard Assets issued in 2012:
“The amount of profit in cash on direct sale of loans may be held under an accounting head styled as “Cash Profit on Loan Transfer Transactions Pending Recognition” maintained on individual transaction basis and amortised over the life of the transaction.”
As the accounting treatment offered by Ind AS defaces the profit and loss statement by distorting the income recognition pattern of the NBFCs, NBFCs are not in favour of recording this gain upfront. The concern is aggravated due to the liquidity crunch currently faced by the NBFCs caused by recent downfall of IL&FS. The default on payment obligations of loans and deposits amounting to approximately Rs. 90,000 crore, by India’s leading infrastructure finance company, shook the confidence of the lenders and triggered a panic sentiment amongst the market lenders including NBFCs. As a result of the panic, banks are unwilling to lend to the NBFCs and their cost of funds are going up. However, the banks are showing interest in acquiring their loan portfolios instead. Therefore, the NBFCs are somewhat being forced to accept this distortion in their profit or loss statement.
Another question that arises is- whether de-recognition in books of assignor affects recognition in the books of the assignee.
As per para 3.1.1 of Ind AS 109, an entity shall recognise a financial asset or a financial liability in its balance sheet when, and only when, the entity becomes party to the contractual provisions of the instrument. Therefore, the transferee should recognise the financial asset or financial liability in its balance sheet only when he becomes a party to the contractual provisions of the instrument.
Para B3.2.15 of the same standard, provides that if a transfer of a financial asset does not qualify for de-recognition, the transferee does not recognise the transferred asset as its asset. In such a case the transferee is required to derecognise the cash or other consideration paid and recognises a receivable from the transferor. The transferee may measure the receivable at amortised cost (if it meets the criteria in paragraph 4.1.2) if the transferor has both a right and an obligation to reacquire control of the entire transferred asset for a fixed amount (such as under a repurchase agreement).
Therefore, de-recognition from the books of the seller is clearly a determinant for recognition in the books of the buyer.
Impact on GST on the gain on sale
In the last couple of years, if there is anything that has bothered the financial entities in India, other than IndAS, then it has to be GST. Therefore, it becomes pertinent to take a look at whether GST will become applicable in any manner whatsoever.
Under GST regime, assignment of loans are treated as dealing in securities and are therefore exempted from GST. Link to our detailed writeup in this regard has been provided in the footnote.
Reporting of Retained Interests
A partial de-recognition is where the transferor transfers only a part of the asset and retains a part of it.
Currently, as per the RBI Guidelines, NBFCs are required to comply with the minimum retention requirement of 10%, that is, they should have a continuing interest of 10% on the loans that it intends to transfer. Therefore, if an NBFC is intending to sell of a portfolio of Rs. 100 crores, it has to retain at least 10% of the said portfolio and can sell of only Rs. 90 crores representing the remaining part.
Therefore, this becomes a classic case of partial de-recognition.
The value of retained interest should be accounted for as per the original accounting criteria as and when it was originated. For instance, if the pool recognised under FVOCI method, the retained interst must continue to be valued at FVOCI.
The manner of recognition or valuation of the retained interest will not change when a part of the pool is sold off.
Before the introduction of Indian Accounting Standards, RBI guidelines were followed for de recognizing the asset and recording the gain on sale after de recognition. There was no accounting guidance for financial instruments and their de recognition. In the absence of it, RBI guidelines were followed which talked about true sale. In case, the conditions of true sale were satisfied, then the asset was de recognized and the gain was regularised over the period by amortising the gain on de recognition.
While a well-documented piece of legislation is welcomed, however, every new thing has some shortcomings. In this case, the irregularities in the profit and loss and the complexities surrounding the de-recognition test comes as shortcomings. However, it is expected, with the passage of time, these shortcomings will also be settled.