For many consumer lenders, business growth is achieved by obtaining substantial borrowings or funding. Whilst the way these funds are accessed might be straight forward from a business perspective, the accounting involved is often complicated and not always easy to get right – which means financial statements could be materially misstated.
When a lending business sells its receivables to another entity, the transferor might still be required to keep the receivable balances on its own balance sheet. The terms of the transaction will determine whether the seller can remove the assets from its balance sheet – ie, derecognise the receivables or continue to keep (recognise) the receivables in its balance sheet.
In cases where one entity sells its financial assets to another entity, it is not always the case that such a transaction qualifies for a derecognition in the financial statements of the first entity and for recognition in the other entity. Under FRS 102, whether the transaction qualifies for derecognition is determined by considering whether the risks and rewards of ownership have transferred from one party to the other, regardless of whether control of the asset has been transferred.
However, in cases where the transferor has retained some but not substantially all of the risks and rewards of ownership, it is also necessary to consider whether control has been passed to the receiving entity.
A consumer lender and its holding company: a case study
Consider a situation where Company S is 100% owned by Company H. The operations of Company S involve lending short-term personal loans to retail customers. Company H is responsible for raising funding for the group in order to finance the consumer lending. Where Company S needs to raise additional short term funds, it ‘sells’ portions of its loan book to Company H.
What would be the implications and resulting accounting treatment and financial reporting of such an arrangement and such transactions in the books of both companies under FRS102?
Company H – the acquiring company
In the financial statements of Company H, the accounting treatment is fairly straightforward. Suppose Company S wants to raise £80m and does this by selling £80m of its loan book (loans receivable from retail customers) at book value to Company H. At the same time, Company H proceeds to obtain a loan of £100m from Bank A to fund the purchase of the £80m loan book from Company S. The loan from Bank A to Company H is a financial liability, while the £80m transferred to Company S is a financial asset. However, the risks and rewards of the £80m acquisition by Company H from Company S of the loan need to be considered to determine whether it’s a deemed loan to Company S or a purchase of the loan book.
This would be accounted for by Company H as follows (ignoring any transaction costs and assuming that this is a basic financial instrument as defined by FRS102[1]):
Journal A
| Dr. Cash & Bank | £100m |
| Cr. Loan payable | £100m |
Journal B
| Dr. Loan(s) receivable / Deemed loan | £80m |
| Cr. Cash & Bank | £80m |
Company H would then account for both the loan receivable and the loan payable at amortised cost using the effective interest rate method.
Ignoring any interest and split between long term and short term, the amounts disclosed in the Company H balance sheet will be as follows, depending on whether the receivable is deemed a loan to Company S or loans to customers.
Company H – Balance Sheet extract after the transaction (without derecognition in Company S)
| Current and non-current assets | |
| Cash and bank | £20m |
| Deemed loan receivable (intercompany) | £80m |
| Non-current liabilities | |
| Loan payable (to Bank A) | £100m |
Company H – Balance Sheet extract after the transaction (with derecognition in Company S)
| Current and non-current assets | |
| Cash and bank | £20m |
| Loans receivable (from retail customers) | £80m |
| Non-current liabilities | |
| Loan payable (to Bank A) | £100m |
Company S
Assuming that Company S already has a loan book of £200m, it goes to Company H to obtain an additional £80m to grow its loan book. As explained above, Company S thus sells £80m of its loan receivables to Company H for a value of £80m.
The transaction will be recorded in one of two ways. To determine the appropriate accounting treatment, Company S needs to assess whether the sale of the loans receivable to Company H meets the criteria for derecognition, ie whether Company S has transferred the risks and rewards associated with the loans to Company H, or whether those risk and rewards been retained. The accounting treatment would be as follows:
Journal 1: where risks and rewards of ownership are not transferred to Company H
| Dr. Cash and bank | £80m |
| Cr. Deemed loan payable | £80m |
Journal 2: where risks and rewards of ownership are transferred to Company H
| Dr. Cash and bank | £80m |
| Cr. Loans receivable (from retail customers) | £80m |
Assessing whether the risks and rewards have been transferred
The key risk related to loans receivable or the loan book in the above example is credit risk – ie, the risk that the retail customers will fail to repay the loans. The main reward here is the interest earned on the loans.
Where Company S can demonstrate that it has transferred substantially all of the risks and rewards of ownership of the loan book to Company H, then Company S can derecognise the loans receivable. This may be the case, for example, if Company S:
- will continue to handle the collections, including sending out monthly statements, for the loans receivable from customers on behalf of Company H for an administrative market rate fee
- will remit promptly all collections to Company H
- has no obligation to Company H for late payments and/or defaults on the loans.
The obligation of Company H to take the risk of default after sale would be a key consideration in an evaluation of the risks.
On the other hand, an arrangement where Company S guarantees to pay Company H for any losses incurred as a result of late payments or non-repayments by customers, for example, is likely not to qualify for de-recognition. This is because Company S, in this case, retains the principal risk, which is the credit risk. Depending on the outcome of the assessment of risk and rewards post sale, either Journal 1 or Journal 2 will be recorded (or not recorded). The results of such an assessment can have a material impact on how the financial statements are presented as can be seen in the extracts below.
Company S – Balance Sheet extract before the transaction:
| Current and non-current assets | |
| Cash and bank | – |
| Loans receivable | £200m |
| Non-current liabilities | |
| Loan payable | – |
| Equity | £200m |
Company S – Balance Sheet extract after the transaction (without derecognition):
| Current and non-current assets | |
| Cash and bank | £80m |
| Loans receivable | £200m |
| Non-current liabilities | |
| Deemed loan payable (intercompany) | £80m |
| Equity & Reserves | |
| Equity | £200m |
Company S – Balance Sheet extract after the transaction (with derecognition):
| Current and non-current assets | |
| Cash and bank | £80m |
| Loans receivable | £120m |
| Non-current liabilities | |
| Loan payable | – |
| Equity & Reserves | |
| Equity | £200m |
Disclaimer: A simplistic example has been used to illustrate the topic discussed in this article. In reality, these transactions will involve varying levels of complexity and further research should be undertaken.
As previously mentioned, getting the accounting treatment wrong could mean that your financial statements are materially misstated. Evaluation of risk and rewards is not straightforward and judgemental. Not structuring a loan sale in the right way may give you unintended accounting consequences.
How can we help?
At PKF, we have a number of experts in consumer lending and we are here to help. Our Consumer Credit team acts for some of the largest and fastest growing consumer credit businesses in the UK and Europe – from those offering secured asset-backed lending to short term consumer credit firms offering loans through an online platform. We draw on our industry knowledge to inform every aspect of our work, including an audit that focusses on understanding and harnessing your IT systems, and providing guidance on authorisation and ongoing regulatory compliance.
If you have any queries on the deemed loan accounting topic discussed in this article and how it might affect your firm, or if you have any consumer lending questions in general, please contact Knowledge Muchemwa, James Wilkinson or Azhar Rana.
[1] FRS102 – The Financial Reporting Standard applicable in the UK and Republic of Ireland (UnitedKingdom Generally Accepted Accounting Practice)
