Servicing Asset and Servicing Liability: A new by-product of securitization under Ind AS 109

By Beni Agarwal (finserv@vinodkothari.com)

Securitisation has gained popularity in India in the recent times, however, one more concept that has grown parallel to it is, direct assignment. In fact, at times, direct assignments have overpowered securitisation in the Indian market[1]. Financial institutions have been using these extensively to address their liquidity issues. However, if there is anything that affected the financial institutions dearly, then it is the change in the accounting treatment under the Indian Accounting Standards (Ind AS).

The Ind AS 109 has given securitization/ direct assignment accounting in the books of the transferor and the transferee a whole new shape[2]. One of the new concept that has arisen under the new standard is creation of servicing asset or servicing liability.

In this article we intend to cover this new concept at length.

Servicing Asset and Servicing Liability

In a securitization/ direct assignment transaction, the servicing of the underlying pools is retained by the transferor, for which it earns a servicing fee. Where, the compensation received for performing the servicing function is more than adequate, then, a servicing asset has to be created for the excess amount. However, where the compensation received for the servicing function is inadequate, the same must be recognized as a servicing liability in the books of the transferor.

In order to clarify the nature of a “servicing asset” and a “servicing liability”, reference is drawn from para 3.2.10 of Ind AS 109 which states that:

If an entity transfers a financial asset in a transfer that qualifies for de recognition in its entirety and retains the right to service the financial asset for a fee, it shall recognise either a servicing asset or a servicing liability for that servicing contract. If the fee to be received is not expected to compensate the entity adequately for performing the servicing, a servicing liability for the servicing obligation shall be recognised at its fair value. If the fee to be received is expected to be more than adequate compensation for the servicing, a servicing asset shall be recognised for the servicing right at an amount determined on the basis of an allocation of the carrying amount of the larger financial asset in accordance with paragraph 3.2.13.

Why is it a part of securitization?

The so-called servicing asset arises as an integral part of a transaction of securitisation or direct assignment. It arises when the financial asset is transferred to the Special Purpose Entity (SPE), but the originator retains the right to service the asset in exchange for a fee, which might give rise to a servicing asset or a servicing liability. Servicing asset or servicing liability arises as a by-product of securitization. The originator may or may not assume the role of a servicer, but if it does, then he charges a servicing fee for that. The relationship between actual servicing fee and normal servicing fee, results in either a servicing asset or servicing liability. In that sense, it is a carve-out from the composite asset, that is, the larger asset pre-securitisation. However, for creation of servicing asset or servicing liability, de-recognition of the assets is an important precondition.

Splitting of Composite Asset

Servicing asset or servicing liability is created after dismantling or de recognizing the larger pre securitization financial asset. For this purpose, splitting up of composite asset is to be done. When carrying out the splitting exercise, Ind AS 109 clearly lays out the method of decomposing the composite larger financial asset into the transferred portion and the retained servicing asset.

Please refer to the following paragraph:

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.

In case of recognizing a service liability, liability for service obligation is recognised at Fair Value. In case of servicing asset, service asset is recognised for servicing right at an amount after carving out the servicing asset from the carrying amount of larger financial asset. The carrying amount of the larger composite asset is split between a part that is transferred, hence de recognised and another part that is recognised as servicing asset. This splitting of composite asset is done based on the fair value of both the parts as on the date of transfer. When allocating the carrying amount, it is required to measure the servicing asset at its fair value. This fair value can be arrived in two ways. One, when there exists a history of sale of similar parts or when market transactions for such parts exist, it would be best to take the actual transaction as an estimate of fair value. Two, if there are no such sale history or market quotes available, fair value can be arrived at by deducting the purchase consideration from the fair value of entire financial assets.

How does servicing asset translate into income over time?

Since the carrying value of the servicing asset is the present value, the present value will be unwound over time. Given the fact that the servicing fee in the present case is collected only at the end of the term, assuming that the valuation estimates do not change, the discounting charges will regularly be credited, with a corresponding debit to the value of the servicing asset. As a result, at the point of time when the servicing fee is to be received, the carrying value of the servicing fee is the same as the nominal amount of servicing fee receivable.

How does the value of servicing fee get re-evaluated over time

In the present case, possibly, the valuation of the asset will change as the probabilities of hitting the benchmark change over time. This will be a valuation gain/loss. Over time, as the chances or probability of collection from the obligor improve, then the servicing fee to be collected from the bank will also increase. However, if the probabilities of collection deteriorate, then service fee to be collected from bank will go down.

Recognition of Income- as Gain on Sale

When an originator assumes the responsibility of servicing the underlying loan pool, he undertakes to collect the payment from obligors, keep a certain percentage of it as servicing fee and transfer the remaining cashflow to the SPE. Here, the originator is assuming two roles – first, that of a transferor or assignor and second, that of a collection and servicing agent.

Please refer to the following paragraph from Ind AS 109: 

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.

Example:

Co. X is the originator of the loans, say 90% of the portfolio is sold, and Co. X assumes the role of a servicer. The disbursements from the portfolio is to be collected by X and then is to be disbursed to Bank Y (SPE). Upon successful collection by X, it will be compensated with the contractual cash flows as compensation. These cash flows are the retained servicing asset portion out of the transaction. Meaning, it is a carve-out of the part transferred leaving a lesser value. These contractual cash flows are to be recognised instead of the part de-recognised as the servicing asset.

The pre securitisation asset must be de recognised from the books of the originator if it meets the de recognition principles laid down in Ind AS 109. Then, separately a servicing asset or servicing liability will be recognised as discussed above.

Please refer to the following paragraph from Ind AS 109:

3.2.12 On de recognition 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. 

Based on above excerpt, once the servicing asset comes out from the composite asset [Servicing asset debit, composite asset credit], the carrying value of the composite asset stands reduced. Hence, the difference between the Purchase consideration and the appropriated value of the composite asset (after all retained assets have been carved out) leads to a gain on sale. Hence, the income that needs to be recognised upon creation of servicing asset is – a gain on sale.

Accounting of servicing asset or liability- upfront/ over the period/ rear-ended?

The accounting is to be upfront as the originated asset (loan portfolio) is to be derecognized upon transfer and a servicing asset/liability is to be reported depending upon the compensation. The servicing asset is the present value of the servicing fee. The discounting rate applied on the servicing fee depends on the seniority of the servicing fee. For example, in a model where computation of the expected value of the servicing fee is done using various scenarios and their respective probabilities, the risk inherent has already been captured in the expected value computation.

Some relevant FAQs

Servicing fee is receivable as per the collection agent. The SPE has the right to change the collection agent in the specified scenarios. Whether this has any impact on the timing of recognition of the income?

The ability of the SPE to change the servicing asset is, hopefully, on incurring of any events of default. It is not intuitive that the incentive servicing fee may be declined by arbitrary change of servicing agent. 

If the originator is required to raise invoice for servicing fee at the end of the tenure. How the same would be accounted?

The GST invoice for the servicing fee will be raised only when the same is actually accrued as per contract. Yes, there is a disconnect between GST invoicing and recognition of the servicing asset. Incidentally, the servicing income that comes into books as per the above method is only the normal servicing fee.

Will the unwinding of servicing asset be affected by implications of Ind AS 115- Revenue of Contracts from Customers?

The objective of Ind AS 115 is to lay down principles that an entity should apply to report useful information to financial statement users regarding nature, amount, timing and uncertainty of revenue and cash flows from a contract with customer.

However, the application of this standard does not extend to financial instruments and other contractual rights/obligations within the scope of Ind AS 109.

For reference, the extract is presented below:

  1. An entity shall apply this Standard to all contracts with customers, except the following:

Xxx

(c) financial instruments and other contractual rights or obligations within the scope of Ind AS 109, Financial Instruments, Ind AS 110, Consolidated Financial Statements, Ind AS 111, Joint Arrangements, Ind AS 27, Separate Financial Statements and Ind AS 28, Investments in Associates and Joint Ventures; and

Xxx

Thus, as securitization and its inherent servicing asset and servicing liability is covered under Ind AS 109, Revenue recognition as per Ind AS 115 does not apply to it.

Conclusion

Servicing asset or liability is a by-product of the process of securitization. When the servicing facility is retained by the originator, he does that in exchange of a servicing fee. Now comparison of the actual servicing fee with the expected servicing fee charged normally, gives rise to a servicing asset or liability. Servicing obligation becomes servicing liability and servicing right becomes servicing asset. The carve-out from the larger financial asset and its split accounting is discussed at length above.


[1] Read our articles on Indian securitisation market at:

http://vinodkothari.com/secart/

http://vinodkothari.com/sechome/

http://vinodkothari.com/secconc/

[2] Read our article on impact of Ind AS on securitisation transactions at:

http://vinodkothari.com/2017/05/accounting-for-securitization/

http://vinodkothari.com/2018/12/accounting-for-direct-assignment-under-indian-accounting-standards-ind-as/

http://vinodkothari.com/wp-content/uploads/2018/08/Securitisation-Differences-between-RBI-Guidelines-and-Ind-AS.pdf

http://vinodkothari.com/2018/11/impact-of-fair-value-changes-on-retained-earnings-during-first-time-ind-as-adoption/

http://vinodkothari.com/accountingissues/

 

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