Understanding the DPC adjustment for securitisation transactions in SPVs

Understanding the DPC adjustment for securitisation transactions in SPVs

As part of our independent professional services business LawDeb provides accounting services for structured finance transactions in SPVs (Special Purpose Vehicles). During 2020, the statutory auditors started to propose new adjustments relating to the deferred purchase consideration (DPC) to residual certificate holders. But what is this all about and where has this change come from?

What is the adjustment?

The adjustment requested requires the recognition of a liability in the accounts being the expected future payments on residual notes because there’s a contractual obligation to deliver cash to the residual note holder, contingent on future events. This is done by forecasting the future cashflows over the remaining life of the structure and then discounting this to get the present value of the liability. This liability can be subject to estimates such as interest rates and effects of COVID-19, for example, and so assumptions made are sensitised in the financial statements. Subsequent measurement is then at amortised cost using the Effective Interest Rate method (EIR).

The potential liability has always been there but was not commonly recognised as it was always considered remote or negligible when transactions commence and the payments to residual noteholders occurs towards the bottom of the cash waterfalls.  As such, cash outflows to residual noteholders are non-existent or minimal towards the start of the transaction.  The non-recourse nature of the transactions also means that payments are only made to the extent that cash is actually available, and any excess liabilities are erased on winding up of the structure. However, as transactions age, and cash flows further down the waterfalls payments to residual noteholders can occur. 

In determining the adjustment, the exact redemption date has to be estimated.  This can be tricky but as most transactions allow the noteholders to request the redemption of all of the outstanding notes if certain conditions are met an estimated of the operational redemption date can be estimated without deferring to the contractual redemption date when the notes have to be repaid.

Implications

Recognising this adjustment in an established SPV affects not only an adjustment in the current year but also a prior year restatement to reflect the liability from the prior year as well. However, this should not affect the bottom line. The EIR adjustment, taken to be the inverse of the deferred consideration adjustment, will also need to be shown separately in the notes to the financial statements. This whole process can lead to additional audit costs for such companies but it is necessary to ensure compliance with Accounting Standards.

Adjusting only the deferred consideration would put the entity into a significant net liability position. Whilst this is not impossible, SPVs are normally limited recourse and are structured such that cash inflows and outflows are generally a zero-sum game - if the entity does not receive cash in, then it is not required to make payments out (with the lowest tranches of liabilities suffering the loss first). Whilst SPVs retain a notional profit annually, the assets and liabilities are structured such that they mirror one another. As such, the recognition of the liability due to the residual noteholders will be matched by an increase in the carrying value of the securitised asset pool (e.g. mortgages, receivables etc). The increase in carrying value of the securitised asset pool reflects the fact that the securitised assets are expected to generate additional cash above that needed to service the more senior levels of debt and expenses.

Whilst the financial statements will now show an amount payable to the residual noteholders, these payments may or may not actually occur as any payments are down to the actual cashflows and strict legal payment flows in the transaction waterfalls.  Securitisations are basically cashflow structures with the cash and payment order being determined at each payment date.  Whilst this may lead to some residual noteholders trying to claim that they are owed large sums, the reality of any payment will come down to the availability of the cash and any excess liabilities being quashed by the limited recourse nature of the transactions.  As such it is important to disclose the inherent estimation uncertainties and provide adequate disclosure of the facts.

It is important to note that declining to post the proposed auditor’s adjustment, could result in a qualified opinion in the auditors’ report of the financial statements.

How to overcome the challenges involved

LawDeb understand that it is important to work with and keep in constant contact with the auditors to navigate this issue and understand how this will impact the financial statements. There is further liaison within the LawDeb Corporate Services team to collaborate and determine the work/responsibilities involved going forward.  It is necessary to fully understand this adjustment as the Deferred Purchase Consideration liability will likely be impacted by these adjustments and is likely to need adjusting at every balance sheet date going forward.

This is only one of the many challenges that Structured Finance team at LawDeb has dealt with over the years.  It has a team with significant experience  in dealing with these types of challenges and they are well equipped to tackle these problems head-on. For more information about LawDeb's Corporate Services business visit our Corporate Services pages.