The Expected Credit Losses (ECL) requirement in IFRS 9 makes the initial selection of bonds for fixed income investments by financial institutions much more important, as selecting bonds with good long-term credit health is key to reducing the risk of future P&L fluctuations caused by changes in ECL. This is especially important for insurers that would like to adopt a buy-and maintain bond investment strategy.
Under the “expected credit loss” model, an entity calculates the allowance for credit losses by considering on a discounted basis the cash shortfalls it would incur in various default scenarios for prescribed future periods and multiplying the shortfalls by the probability of each scenario occurring. The allowance is the sum of these probability weighted outcomes. Because every loan and receivable carries with it some risk of default, every such asset has an expected loss attached to it—from the moment of its origination or acquisition.
IFRS 9 establishes not one, but three separate approaches for measuring and recognising expected credit losses:
- A general approach that applies to all loans and receivables not eligible for the other approaches;
- A simplified approach that is required for certain trade receivables and so-called “IFRS 15 contract assets” and otherwise optional for these assets and lease receivables.
- A “credit adjusted approach” that applies to loans that are credit impaired at initial recognition (e.g., loans acquired at a deep discount due to their credit risk).
The transition to IFRS 9 generally resulted in an increase in impairment allowances. The impacts on financial statements and CET1 ratio are, in most cases, lower than previously estimated, reflecting in part more favourable economic conditions.
The increase in allowances ranged from a few millions to EUR 4 billion
From 2016 to 2017, total coverage ratios under IAS 39 decreased, likely reflecting improving macro-economic conditions, followed by an increase on transition to IFRS 9. The impact on total coverage ratios ranges from -5 bps to approximately 40 bps, with a couple of exceptions, notably for UK Bank 3 (a 100 bps increase, mainly due to increased impairment allowances on credit cards), Italian Bank 2 (a 70 bps increase, due to the incorporation of sale strategies in Stage 3 impairment allowances).
Changes in write-off policies leading to earlier write-offs explain why some banks (such as Italian Bank 1) did not experience a higher increase in coverage ratios.
Many assume that the accounting for financial instruments is an area of concern only for large financial entities like banks. This is not the case. Almost every entity has financial instruments that they need to account for. In particular, almost every entity has trade receivables and the new financial instruments standard changes the way entities must think about impairment. In this publication, we focus on the new impairment requirements in IFRS 9. Specifically, we will focus on the impairment guidance for trade receivables, contract assets recognised under IFRS 15 and lease receivables under IAS 17 (or IFRS 16).
Why specifically consider on the above items? The impairment guidance in IFRS 9 is complex and requires a significant amount of judgement, however, certain simplifications have been made specifically for trade receivables, contract assets and lease receivables. Almost every entity has one of (if not all) these items, therefore it is important that all entities understand the impact of the new accounting requirements. ECL ECL
Any measurement of expected credit losses under IFRS 9 shall reflect an unbiased and probability-weighted amount that is determined by evaluating the range of possible outcomes as well as incorporating the time value of money. Also, the entity should consider reasonable and supportable information about past events, current conditions and reasonable and supportable forecasts of future economic conditions when measuring expected credit losses. [IFRS 9 paragraph 5.5.17] ECL ECL
The Standard defines expected credit losses as the weighted average of credit losses with the respective risks of a default occurring as the weightings. [IFRS 9 Appendix A] Whilst an entity does not need to consider every possible scenario, it must consider the risk or probability that a credit loss occurs by considering the possibility that a credit loss occurs and the possibility that no credit loss occurs, even if the probability of a credit loss occurring is low. [IFRS 9 paragraph 5.5.18] ECL ECL
In particular, for lifetime expected losses, an entity is required to estimate the risk of a default occurring on the financial instrument during its expected life. 12-month expected credit losses represent the lifetime cash shortfalls that will result if a default occurs in the 12 months after the reporting date, weighted by the probability of that default occurring. ECL ECL
An entity is required to incorporate reasonable and supportable information (i.e., that which is reasonably available at the reporting date). Information is reasonably available if obtaining it does not involve undue cost or effort (with information available for financial reporting purposes qualifying as such). ECL ECL
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