If an asset is in a hold-to-collect or hold-to-collect or sell business model, an entity assesses whether the cash flows from the financial asset meet the ‘solely payments of principal and interest’ (SPPI Test) benchmark – i.e. whether the contractual terms of the financial asset give rise, on specified dates, to cash flows that are solely payments of principal and interest.
‘Principal’ is the fair value of the financial asset on initial recognition. The principal may change over time – e.g. if there are repayments of principal.
‘Interest’ is consideration for the time value of money and credit risk. Interest can also include consideration for other basic lending risks and costs, and a profit margin.
A financial asset that does not meet the SPPI Test is always measured at FVPL, unless it is a non-trading equity instrument and the entity makes an irrevocable election to measure it at FVOCI. Here is the decision tree to put the narrative in context:
Contractual cash flows that meet the SPPI Test are consistent with a basic lending arrangement in the banking industry.
debt instruments measured at fair value through other comprehensive income
contract assets (as defined in IFRS 15 ‘Revenue from Contracts with Customers’)
loan commitments that are not measured at fair value through profit or loss
financial guarantee contracts (except those accounted for as insurance contracts).
IFRS 9 requires an expected loss allowance to be estimated for each of these types of asset or exposure. However, the Standard specifies three different approaches depending on the type of asset or exposure:
* optional application to trade receivables and contract assets with a significant financing component, and to lease receivables
IFRS 9 contains an important simplification that, if a financial instrument has low credit risk, then an entity is allowed to assume at the reporting date that no significant increases in credit risk have occurred. The low credit risk concept was intended, by the IASB, to provide relief for entities from tracking changes in the credit risk of high quality financial instruments. Therefore, this simplification is only optional and the low credit risk simplification can be elected on an instrument-by-instrument basis.
This is a change from the 2013 ED, in which a low risk exposure was deemed not to have suffered significant deterioration in credit risk. The amendment to make the simplification optional was made in response to requests from constituents, including regulators. It is expected that the Basel Committee SCRAVL consultation document will propose that sophisticated banks should only use this simplification rarely for their loan portfolios.
For low risk instruments, the entity would recognise an allowance based on 12-month ECLs. However, if a financial instrument is not considered to have low credit risk at the reporting date, it does not follow that the entity is required to recognise lifetime ECLs. In such instances, the entity has to assess whether there has been a significant increase in credit risk since initial recognition that requires the recognition of lifetime ECLs.
The standard states that a financial instrument is considered to have low credit risk if: [IFRS 9.B5.22]
The financial instrument has a low risk of default
The borrower has a strong capacity to meet its contractual cash flow obligations in the near term
Adverse changes in economic and business conditions in the longer term may, but will not necessarily, reduce the ability of the borrower to fulfil its contractual cash flow obligations Low credit risk operational simplification
A financial instrument is not considered to have low credit risk simply because it has a low risk of loss (e.g., for a collateralised loan, if the value of the collateral is more than the amount lent (see collateral) or it has lower risk of default compared with the entity’s other financial instruments or relative to the credit risk of the jurisdiction within which the entity operates.
In December 2015, the Basel Committee on Banking Supervision (‘the Committee’) issued its Guidance on credit risk and accounting for expected credit losses (‘Basel Committee IFRS 9 Guidance’). The Guidance sets out supervisory guidance on sound credit risk practices associated with the implementation and ongoing application of expected credit loss (ECL) accounting frameworks, such as that introduced in IFRS 9, Financial Instruments.
The Committee expects a disciplined, high-quality approach to assessing and measuring ECL by banks. The Basel Committee IFRS 9 Guidance emphasises the inclusion of a wide range of relevant, reasonable and supportable forward looking information, including macroeconomic data, in a bank’s accounting measure of ECL. In particular, banks should not ignore future events simply because they have a low probability of occurring or on the grounds of increased cost or subjectivity.
In addition, the Basel Committee IFRS 9 Guidance notes the Committee’s view that that the use of the practical expedients in IFRS 9 should be limited for internationally active banks. This includes the use of the ‘low credit risk’ exemption and the ‘more than 30 days past due’ rebuttable presumption in relation to assessing significant increases in credit risk.
Obviously, banks keep in continued talks to their local regulator about the extent to which their regulator expects the (below) Banking IFRS 9 Guidance to apply to them.
Principles underlying the Banking IFRS 9 Guidance – in Summary
Supervisory guidance for credit risk and accounting for expected credit losses
A bank’s board of directors and senior management are responsible for ensuring appropriate credit risk practices, including an effective system of internal control, to consistently determine adequate allowances.
The measurement of allowances should build upon robust methodologies to address policies, procedures and controls for assessing and measuring credit risk
Banks should clearly document the definition of key terms and criteria to duly consider the impact of forward-looking information including macro-economic factors, different potential scenarios and define accounting policies for restructurings
Credit Risk Rating
A bank should have a credit risk rating process in place to appropriately group lending exposures on the basis of shared credit risk characteristics
A bank’s aggregate amount of allowances should be adequate and consistent with the objectives of the applicable accounting framework
Banks must ensure that the assessment approach (individual or collective) does not result in delayed recognition of ECL, e.g. by incorporating forward-looking information incl. macroeconomic factors on collective basis for individually assessed loans
Validation of models
A bank should have policies and procedures in place to appropriately validate models used to assess and measure expected credit losses
Experienced credit judgment
Experienced credit judgment in particular with regards to forward looking information and macroeconomic factors is essential
Consideration of forward looking information should not be avoided on the basis that banks consider costs as excessive or information too uncertain if this information contributes to a high quality implementation
A bank should have a sound credit risk assessment and measurement process that provides it with a strong basis for common systems, tools and data
A bank’s public disclosures should promote transparency and comparability by providing timely, relevant, and decision-useful information
Assessment of Credit Risk Management
Banking supervisors should periodically evaluate the effectiveness of a bank’s credit risk practices
Approval of Models
Supervisors should be satisfied that the methods employed by a bank to determine accounting allowances lead to an appropriate measurement of expected credit losses
Assessment of Capital Adequacy
Banking supervisors should consider a bank’s credit risk practices when assessing a bank’s capital adequacy
The second simplification available in IFRS 9 sets out a rebuttable presumption that the credit risk on a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due. [IFRS 188.8.131.52]
When payments are 30 days past due, a financial asset is considered to be in stage 2 and lifetime expected credit losses are recognised.
An entity can rebut this presumption when it has reasonable and supportable information available that demonstrates that even if payments are 30 days or more past due, it does not represent a significant increase in the credit risk of a financial instrument.
This 30 days past due simplification permits the use of delinquency or past due status, together with other more forward-looking information, to identify a significant increase in credit risk. The IASB decided that this simplification should be required as a rebuttable presumption to ensure that its application does not result in an entity reverting to an incurred loss model.[IFRS 9.BC5.190]
The IASB is concerned that past due information is a lagging indicator. Typically, credit risk increases significantly before a financial instrument becomes past due or other lagging borrower-specific factors (for example, a modification or restructuring) are observed.
Consequently, when reasonable and supportable information that is more forward-looking than past due information is available without undue cost or effort, it must be used to assess changes in credit risk and an entity cannot rely solely on past due information. However, if more forward-looking information (either on an individual or collective basis) is not available without undue cost or effort, an entity may use past due information to assess changes in credit risks.
have to be distinguished by an issuer of more complex financial instruments
For many (most!), simpler financial instruments the classification as a financial liability or equity works well. So, classifying more complex financial instruments under IAS 32 – e.g. those with characteristics of equity – can be more challenging, leading to diversity in practice. IAS 32 Equity and Financial Liabilities
An instrument, or its components, is classified on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument.
A financial instrument is a financial liability if it contains a contractual obligation to transfer cash or another financial asset.
A financial instrument is also classified as a financial liability if it is a derivative that will or may be settled in a variable number of the entity’s own equity instruments or a non-derivative that comprises an obligation to deliver a variable number of the entity’s own equity instruments.
An obligation for an entity to acquire its own equity instruments gives rise to a financial liability, unless certain conditions are met.
As an exception to the general principle, certain puttable instruments and instruments, or components of instruments, that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation are classified as equity instruments if certain conditions are met.
The contractual terms of preference shares and similar instruments are evaluated to determine whether they have the characteristics of a financial liability.
The components of compound financial instruments, which have both liability and equity characteristics, are accounted for separately.
A non-derivative contract that will be settled by an entity delivering its own equity instruments is an equity instrument if, and only if, it will be settled by delivering a fixed number of its own equity instruments.
A derivative contract that will be settled by the entity delivering a fixed number of its own equity instruments for a fixed amount of cash is an equity instrument. If such a derivative contains settlement options, then it is an equity instrument only if all settlement alternatives lead to equity classification.
Incremental costs that are directly attributable to issuing or buying back own equity instruments are recognised directly in equity.
is about impairment in a ‘normal’ business not complicated accounting but straightforward accounting calculations.
Although the focus for IFRS 9 Financial Instruments is on financial institutions such as banks and insurance companies, ‘normal’ operating entities are also affected by IFRS 9. Maybe their investment and loan portfolios are less complex but in operating a business and as part of the internal credit risk management practice policy making it is still important to implement the impairment model under IFRS 9 Financial Instruments.
The objective of these approaches to expected credit losses or timely recording of impairments/loss allowances is to provide approaches that result in a situation in which very different reporting entities all … Read more
Amortised cost at subsequent periods: a numerical example Amortised cost and EIR calculations
Example Amortised cost and EIR calculations
The following example illustrates the principles underlying the calculation of the amortised cost and the effective interest rate (EIR) for a fixed-rate financial asset:
On 1 January 2019, entity A purchases a non-amortising, non-callable debt instrument with five years remaining to maturity for its fair value of €995 and incurs transaction costs of €5. The instrument has a nominal value of €1,250 and carries a contractual fixed interest of 4.7% payable annually at the end of each year (4.7% * €1,250 = €59). Its redemption amount is equal to its nominal value plus accrued interest.
The instrument qualifies for a measurement at amortised cost. As explained in the preceding section, its initial carrying amount is the sum of the initial fair value plus transaction costs, i.e. €1,000.
The Effective Interest Rate (EIR) is the rate that exactly discounts the expected cash flows of this financial asset, presented in the table below, to its initial gross carrying amount (i.e. €995 + €5 = €1,000 in this example). In practice, entities will need to establish a timetable of all the expected cash flows of the financial instrument (see the table below) and then use for example an Excel formula to determine this rate. The table below summarises the timing of the expected cash flows of the instrument:
In the present case, using an Excel formula, the EIR amounts to 10%. The following table shows that the sum of the discounted cash flows amounts to zero:
Important to remember, where does IFRS 9 come from – the International Accounting Standards Board (IASB) developed if as a response to the financial crisis and it was issued on 24 July 2014. The standard includes the requirements previously issued and introduces limited amendments to the classification and measurement requirements for financial assets as well as the expected loss impairment model. It includes:
Classification and measurement of financial assets – principle-based, as opposed to rule-based, classification and measurement categories for financial assets;
Classification and measurement of financial liabilities – new requirements for handling changes in