SPE financial reporting - avoiding the common pitfalls

www.pwc.com/securitisation

How important is it to you to get the answers right? In this publication we discuss the common pitfalls in SPE financial reporting and how these can be avoided.

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Special Purpose Entitiesfinancial reporting –avoidingthe common pitfallsIn the UK the Special Purpose Entities (SPEs) through which asset backed securities(ABS) are issued are usually public limited companies required to file annual audited financial statements prepared under EU-adopted IFRS or UK GAAP. Audited financial statements are also required in locations such as Jersey, Holland,Ireland and Luxembourg.

Being a public document it is importantfor the SPE financial statements to be ofgood quality. But what are the mostchallenging areas of financial reportingfor the typical SPE? What are the mostcommon pitfalls? And what can bedone to minimise the risk of errors?

SPE financial reporting often includes anumber of complex issues such as therecognition and derecognition offinancial instruments, offsetting ofassets and liabilities and income andexpenses, the impairment of financialassets, fair value measurements, theIFRS7 financial instruments disclosurerequirements and wider issues such as the assessment of the SPE’s going concern.

To avoid common pitfalls it is importantto make sure the necessary lines ofcommunication between the SPEdirectors, financial statementspreparers and the Originator areestablished early and maintainedthroughout the life of the securitisation.All parties need to plan in advanceregarding the information required toprepare the SPE financial statements.

With our experience in securitisationsand the statutory audits of SPEfinancial statements, PwC can helpOriginators and SPE directors plan andmanage the SPE accounts preparationprocess in a way that avoids thesecommon pitfalls and ensures a smoothand efficient audit.

Setting the scene Let’s first set the scene in the context of a typical securitisation transaction(see case study overleaf) and let’s usethe details to illustrate some of thepotential issues in the SPEs’ financial statements preparation process.

Should the SPE recognisethe securitised assets on its balance sheet?The practical application of the IAS39derecognition requirements can becomplex and require a significantdegree of professional judgement to beapplied. Originators will invariablyspend a significant amount of time andeffort to make sure they get to the rightanswer for their own financialreporting. Based on our experience, ithas not been uncommon for SPEs toprepare their accounts in a way thatcontradicts the judgement calls madeby the Originator. For an SPE facing asimilar set of facts to those in our casestudy that would be to prepare itsfinancial statements showing the £1bnof residential mortgages on its balancesheet, contradicting the view taken bythe Originator who also kept the sameassets on its own balance sheet.International accounting standardsmake it clear that assets should onlyappear on one balance sheet. Based onthe facts of our case study a deemedloan should be recognised between the

Originator and the SPE. This is a pitfallthat can be easily avoided if the matteris discussed at an early stage betweenthe SPE and the Originator.

When is offsetting the right answer?Offsetting is a consideration that isrelevant to balances and transactionsbetween the SPE and the Originator.Financial assets and liabilities are offsetand the net amount reported in thebalance sheet when there is a legallyenforceable right to offset therecognised amounts and there is anintention to settle on a net basis, orrealise the asset and settle the liabilitysimultaneously. Questions that mayarise would include whether to accountfor separately or offset against otheritems the subordinated loan from theOriginator, the interest rate swapbetween the SPE and the Originatorand the relevant income and expense.In some cases it needs to be consideredwhether balances meet the definition ofassets or liabilities. The answers tothese questions may not be obvioussimply by the SPE consulting with theOriginator and the SPE directors mayinstead have to form a view with directreference to the relevant accountingstandards (IAS1, IAS32 and IAS39).

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How much are thesecuritised assets impaired by?The impairment of the securitised assetsis a key area of focus for ABS investorsand therefore the readers of the SPEfinancial statements. The practicalapplication of the IAS39 requirements inrelation to impairment anduncollectibility of financial assets can becomplex and involve significantjudgements and estimates. Indeed inthe case of a deemed loan this may notbe impaired despite the underlying loanportfolio being impaired. Althoughinformation on the credit quality of thesecuritised assets, such as defaults andarrears, will usually be supplied by theServicer on a regular basis this may notgive the IAS39 impairment lossprovision amount. It is important toensure at an early stage that the

necessary information for the SPE’sstatutory financial reporting is availablefrom the systems of the Servicer.

What is the fair value?Usually the only financial instrumentson the balance sheet of the SPEmeasured at fair value are derivativessuch as the interest rate swaps. However,IFRS7 requires the disclosure of the fairvalue of financial instruments measuredat amortised cost in a way that it can becompared with the relevant carryingamount. This requirement would applyto the ABS issued by the SPE, thesecuritised assets if recognised by theSPE (or alternatively the deemed loan tothe Originator) and the subordinatedloan from the Originator. Unless anactive market price is readily availablecalculating the fair value of financialinstruments can present a challengegiven the assumptions and judgements

required. In principle the fair valueinformation required for the SPE’sfinancial statements should be availablefrom the Originator. However, inpractice this may not be the case if forexample the amounts in question are notmaterial in the context of theOriginator’s balance sheet.

Are all the IFRS7 financialinstrument disclosures inplace?In addition to fair value disclosuresIFRS7 requires a number of otherquantitative and qualitative disclosuresto enable the understanding of thenature and extent of credit, liquidity andmarket risks arising from financialinstruments. Again the challenge for theSPE is to identify those disclosurerequirements and make sure a plan is inplace regarding how the relevantinformation will be obtained.

Case study - setting the sceneA retail bank (the ‘Originator’ or ‘Servicer’ or ‘Seller’) wants to obtain funding through the securitisationof a pool of £1bn of UK residential mortgages it has on its balance sheet. For this, an SPE is incorporatedin the UK with its entire share capital owned by a charitable trust that is independent from theOriginator. Independent directors are appointed under a corporate services agreement between the SPEand an independent professional services firm. The SPE raises £1bn from the issue of a single class ofABS listed on the London Stock Exchange and uses the same amount to acquire the legal title to the poolof £1bn of UK residential mortgages from the Originator. The Originator also provides the SPE with asubordinated loan of £100m which the SPE keeps on its balance sheet as a cash reserve. The securitisedassets comply with the minimum credit quality criteria set in the securitisation transaction documentsand the income from them is expected to exceed the interest expense on the ABS. The SPE will retainthis excess spread to build up its cash reserve from the initial £100m to a target £200m. After that anyfurther excess spread will be returned to the Originator. Also, in order to make sure the interest incomefrom the securitised assets and the interest expense on the ABS are matched the Originator and the SPEenter into an interest rate swap. All the necessary due diligence has been done and the ABS get a creditrating of AAA. The final legal maturity of the ABS is 2035.The Originator continues to service the securitised assets (i.e. maintain the necessary bookkeepingrecords on its systems, manage collections, monitor the credit risk etc) and in accordance with thederecognition requirements in IAS 39 considers it appropriate to continue to recognise the securitisedmortgages on its balance sheet. Also, in accordance with SIC 12 – Consolidation – Special purposeentities, the Originator considers it appropriate to consolidate the SPE.

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How remote is bankruptcy?In most cases securitisations aredesigned so that the risk of the SPEhaving to declare bankruptcy is remote.The assets securitised are legallyseparated from the rest of the assets ofthe Seller, legal ownership istransferred to the SPE and the ABSinvestors have limited recourse whichmeans that if the SPE does not have thefunds to repay investors in full it doesnot technically become insolvent.However, in practice the protectionfrom insolvency can become subject tochallenge in court for example on thetechnical details of how the limitedrecourse is designed. Also, the SPE maynot be able to continue to operate asexpected for operational reasons suchas for example where the Servicer is nolonger in a position to continue toperform that role and a replacementservicer is not available. It is thereforeimportant for the SPE directors to beclear on how sensitive their goingconcern assessment is to these factors.

Other issuesOther areas that can present achallenge include the completeness ofrelated party transactions, the correctapplication of effective interest ratecalculations and the treatment of issuecosts, planning to provide sufficientevidence to the auditors that theinformation on the securitised assetsobtained from the Servicer and thewaterfall calculations are free frommaterial errors and drafting the fronthalf of the SPE’s financial statements togive a transparent view of the SPEsactivities, business and risks –consistent with the relevantdescriptions in the securitisationtransaction documents.

The IAS39 replacement project iscurrently in progress with the issue ofIFRS9. In addition, there is a number ofother new and changes to existing

financial reporting standards includingthe recent issues of IFRS10Consolidated Financial Instruments,IFRS12 Disclosure of Interests in OtherEntities and IFRS13 Fair ValueMeasurement. All these need to beconsidered for their impact on SPEfinancial statements.

Also under the current ASB proposals toend the use of UK GAAP, SPEs currentlyreporting under UK GAAP will have toapply EU-adopted IFRS. Although theexact implementation timetable is notclear yet preparers of SPE financialstatements should familiarisethemselves with the current proposalsand monitor the developments in thisarea.

ConclusionSpending the time early to make surereporting and informationrequirements are understood andbuilding relationships between theparties that need to work together isalways an important ingredient forsuccess. SPE financial reporting is noexception. The number of relevantfinancial reporting requirements islarge and many of these requirementsare complex. How important is it to youto get the answers right? Talk to us tofind out more about how we can help.

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ContactsTo discuss any of the issues raised in more detail, please speak to your usual PwC contactor one of our structured finance leadership team listed below:

Global & European

Peter Jeffrey+44 (0)20 7212 5214peter.c.jeffrey@uk.pwc.com

UK

James Hewer+44 (0)20 7804 9605james.hewer@uk.pwc.com

Australia

Colin Heath+61 (2) 8266 1124colin.heath@au.pwc.com

Americas

Frank Serravalli+1 646 471 2669frank.serravalli@us.pwc.com

David Lukach+1 646 471 3150david.m.lukach@us.pwc.com

This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publicationwithout obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to theextent permitted by law, PricewaterhouseCoopers does not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, inreliance on the information contained in this publication or for any decision based on it.

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