Impairment of financial assets

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Impairment of financial assets

Impairment of financial assets

The following table summarises how the key concepts of the model are explained throughout this narrative.

1. Scope of the impairment requirements

3. General approach

Special cases

3.1 Expected credit loss model

6. Assets that are credit impaired at initial recognition

7. Simplified approach for trade and lease receivables and contract assets

3.2.1 12-month ECL

3.2.2 Lifetime ECL

3.4.6 Modifications

4 Measurement

5 Write-offs

1 Scope of the impairment requirements

1.1 General requirements

The following table sets out instruments that are in and out of the scope of IFRS 9’s impairment requirements. (IFRS 9.2, IFRS 9.4.2.1, IFRS 9.5.5.1)

In scope

Out of scope

IFRS 9 has a single impairment model that applies to all financial instruments in its scope.

Food for thought – Scope of the impairment requirements

(IAS 39.2(h), IAS 39.63-70, IAS 39.AG4(a), IFRS 9.BC5.259)

The existence of several impairment models under IAS 39 creates complexity. Under IAS 39, there were different models for:

In addition, losses relating to loan commitments and financial guarantees issued by banks were generally accounted for under IAS 37 Provisions, Contingent Liabilities and Contingent Assets. This has created a practical issue for banks, because they often manage credit risk on financial guarantees and loan commitments in the same way as credit risk on loans and other debt instruments, whereas for accounting purposes they are treated differently.

In addition, for revolving credit facilities (see 4.3.2) banks often manage the amount receivable and the undrawn amount of the commitment together for risk management purposes – i.e. on a facility level.

Under IFRS 9, a single set of impairment requirements applies to all instruments in the scope of IFRS 9 that are not accounted for at FVTPL. This may simplify the requirements and align them more closely with the way banks manage their credit risk. However, differences may arise in practice between the way banks perform the calculations for internal risk management purposes and the specific requirements of IFRS 9. These are discussed further in 4.2.2 in respect of loan commitments.

The new model may also have an impact on corporates that apply IAS 39 to issued financial guarantee contracts, and therefore recognise a provision on such contracts only when it is probable that an outflow will occur. For discussion of the IFRS 9 impairment model’s impact on financial guarantee contracts issued, see 4.9.1.

Food for thought – FVOCI category

(IFRS 9.BC5.124)

Under IAS 39, the impairment of available-for-sale debt instruments is measured as the difference between the acquisition cost and the current fair value. This approach has been criticized, because once an impairment trigger occurs the impairment has to be recognised based on changes in fair value – even though fair value changes would be impacted by variables other than credit risk, such as changes in interest rates.

The IASB believes that applying a single impairment model to both financial assets measured at amortised cost and financial assets measured at FVOCI will:

  • facilitate comparability of amounts that are recognised in profit or loss for assets with similar economic characteristics; and
  • reduce a significant source of complexity for both users and preparers of financial statements compared with IAS 39.

Accordingly, under IFRS 9 financial assets classified as at FVOCI and financial assets classified as at amortised cost are subject to the same single impairment model.

1.2 Equity investments

Investments in equity instruments are outside the scope of the new impairment requirements, because under IFRS 9 they are accounted for either:

Accordingly, equity investments in the scope of IFRS 9 are no longer tested for impairment.

Food for thought – Impairment of equity investments

(IAS 39.61, IAS 28.41A-C)

Under IAS 39, specific requirements apply for recognising and measuring the impairment of equity investments. In addition to the general impairment triggers, equity investments are impaired if there is a ‘significant or prolonged’ decline in their fair value below cost. This test has proved difficult to apply, and has resulted in diversity in practice. The fact that equity investments in the scope of IFRS 9 are no longer tested for impairment will result in a helpful simplification.

However, IFRS 9 amends IAS 28 Investments in Associates and Joint Ventures to require the use of similar criteria to those currently in IAS 39 to determine whether there is objective evidence of impairment for investments in associates or joint ventures after applying the equity method. The criteria include an assessment of whether there is a significant or prolonged decline in the fair value of an investment. This means that the ‘significant or prolonged’ criterion will still be relevant for such investments.

2 Overview of the new impairment model

Under the IFRS 9 impairment model, expected credit losses are measured as either 12-month expected credit losses or lifetime expected credit losses. The flowchart below sets out a decision tree to follow in deciding which measurement basis to apply to a particular financial instrument.

Is the asset credit-impaired at initial recognition?

>> YES >>

Recognise changes in lifetime expected losses

˅˅ NO ˅˅

Is the asset a trade receivable or a contract asset with a significant financing component, or a lease receivable for which the lifetime expected credit losses measurement has been elected?

>> YES >>

Recognise lifetime expected losses

(see 3.2.2 and 4)

˅˅ NO ˅˅

Is the asset a trade receivable or a contract asset without a significant financing component?

>> YES >>

˅˅ NO ˅˅

Has there been a significant increase in credit risk since initial recognition?

>> YES >>

˅˅ NO ˅˅

Impairment of financial assets

Recognise 12-month expected credit losses

(see 3.2.1 and 4)

3 The general approach to impairment

3.1 The expected credit loss concept

The IAS 39 incurred loss model was criticized for delaying the recognition of losses, for the complexity of having multiple impairment approaches, and for being difficult to understand, apply and interpret. IFRS 9 replaces this model with an expected credit loss approach.

Under the new approach, it will no longer be necessary for a loss event to occur before an impairment loss is recognised and so, generally, all financial assets will carry a loss allowance (however, certain exceptions from recognising a loss allowance are available – see Credit impaired assets). (IFRS 9.B5.5.7)

Expected credit losses are the present value of all cash shortfalls over the expected life of the financial instrument. The definition of ‘cash shortfalls’ and the measurement of expected credit losses are discussed in 4. (IFRS 9.B5.5.28)

Food for thought – Day one loss

(IFRS 9.BC5.198)

The new impairment model generally requires entities to recognise expected credit losses in profit or loss for all financial assets – even those that are newly originated or acquired. Although IFRS 9 does not require the loss allowance to be recognised at initial recognition of the new financial asset but rather at the next reporting date, the effect is akin to recognising a day one loss. This is different from IAS 39, under which no impairment is recognised unless and until a loss event occurs after the initial recognition of a financial asset.

However, the initial amount of expected credit losses recognised is equal to 12-month expected credit losses (see 3.2.1) – except for certain trade and lease receivables, and contract assets (see simplified approach). Therefore, the day one loss does not reflect all of the expected credit losses on the financial asset. In addition, no day one loss is recognised for POCI assets.

The IASB has acknowledged that the impairment model in IFRS 9 will result in an overstatement of expected credit losses for financial instruments, and that the initial carrying amount of financial assets will be below their fair value. However, the Board explained that this measurement of expected credit losses serves as a practical approximation of the model originally proposed in November 2009, which was operationally very complex to implement.

Other things being equal, IFRS 9 means that banks that are growing their loan books will suffer a drag on their currently reported earnings, relative to IAS 39’s incurred loss model.

Food for thought – Financial assets acquired in a business combination

(IFRS 3.B41)

A financial asset acquired as part of a business combination does not attract a loss allowance at its date of acquisition. IFRS 3 explains that this is because the effects of uncertainty about future cash flows are included in the fair value measurement.

This rationale applies equally to financial assets that are originated or acquired outside of a business combination.

It appears that the guidance in IFRS 3 is provided specifically for the purpose of calculating goodwill, as any reduction in fair value by the expected credit loss allowance would have resulted in an overstatement of goodwill.

Accordingly, it appears that under IFRS 9 an asset acquired in a business combination would attract a loss allowance at the first reporting date after it is recognised, even if that date is the date on which the business combination has taken place. This effectively means that, for the recognition of impairment, such assets will be treated in the same way as other financial assets and attract a day one loss.

Food for thought – Impact on equity on initial adoption and in future periods

(IFRS 9.BCE131-BCE140)

Initial application of the IFRS 9 impairment requirements may result in a negative impact on equity. This is because equity will reflect not only incurred credit losses but also expected credit losses. This impact may be particularly large for banks and, potentially, insurers and other financial services entities.

Initial application may also affect covenants and banks’ regulatory capital, principally through the reduction of Common Equity Tier 1 capital for the latter. The magnitude of the impact on an entity may be substantially influenced by:

  • the size and nature of its financial instruments and their classifications;
  • the judgements that it makes in applying the IAS 39 requirements – e.g. judgements relating to the length of the emergence period for identifying losses that have been incurred but not reported (IBNR) and identifying impairment on individual assets; and
  • the judgements that it makes in applying the new impairment requirements of IFRS 9.

Most banks subject to IFRS 9 are also subject to Basel III Accord capital requirements and, to calculate credit risk-weighted assets, use either standardized or internal ratings-based approaches. The new IFRS 9 provisions will impact the P&L that in turn needs to be reflected in the calculation for impairment provisions for regulatory capital.

The infrastructure to calculate and report on expected loss drivers of capital adequacy is already in place. The data, models, and processes used today in the Basel framework can in some instances be used for IFRS 9 provision modeling, albeit with significant adjustments. Not surprisingly, a Moody’s Analytics survey conducted with 28 banks found that more than 40% of respondents planned to integrate IFRS 9 requirements into their Basel infrastructure.

Arguably the biggest change brought by IFRS 9 is incorporation of credit risk data into an accounting and therefore financial reporting process. Essentially, a new kind of interaction between finance and risk functions at the organization level is needed, and these functions will in turn impact data management processes. The implementation of the IFRS 9 impairment model challenges the way risk and finance data analytics are defined, used, and governed throughout an institution.

IFRS 9 is not the only driver of this change. Basel Committee recommendations, European Banking Authority (EBA) guidelines and consultation papers, and specific supervisory exercises, such as stress testing and Internal Capital Adequacy Assessment Process (ICAAP), are forcing firms to consider a more data-driven and forward-looking approach in risk management and financial reporting.

Comparison Basel and IFRS 9 allowance models

Key risk parameter

Basel III

IFRS 9

Probability of Default (PD)

Measurement standard

Average of default within the next 12 months

Depending on the asset, the PD measures either for the next 12 months (stage 1) or for the remaining life of the financial instrument (stage 2 and 3)

Period of measurement (look-back period)

Estimates based on long-run average default rate, ranging from ‘point-in-time’ (PIT) to ‘through-the-cycle’ (TTC)

Estimates based on PIT measures, at the reporting date, of current and expected future conditions reflecting future economic cycles

Loss Given Default (LGD)

Intention of estimate

‘Downturn’ LGD to reflect adverse economic scenarios

‘Current’ or ‘forward-looking’ LGD to reflect impact of economic scenarios

Collection cost

Considers both direct and indirect costs associated with collection of the exposure

Only considers cost directly attributable to the collection of recoveries

Discount rate

Based on weighted average costs of capital or risk-free rate

Depends on the type of financial instrument but is broadly based on effective interest rate

Period of observation

Minimum five years for retail exposures, seven years for sovereign, corporate and bank exposures

No specific requirements about observation period or collection of historical data used

Exposure at Default (EAD)

Intention of estimate

‘Downturn’ EAD to reflect what would be expected during a period of economic downturn

Consider all the contractual terms over the lifetime of the instrument

Period of observation

Minimum five years for retail exposures, seven years for sovereign, corporate and bank exposures

No specific requirements about observation period or collection of historical data used

Expected Loss/Expected Credit Losses (ECL)

Calculation

PD x LGD (loss rate) is applied to EAD

PD x PV of cash shortfalls represents a probability-weighted estimate of credit losses

Economic assumptions

Reflects downturn LGD and EAD (factoring in macroeconomic stress conditions)

Reflects an unbiased probability-weighted amount, determined by evaluating a range of possible outcomes

As the above table highlights, the Basel III models can be used for IFRS 9 under the condition that significant adjustments are made, such as:

  • Removal of the regulatory-driven components (e.g., regulator floors and observation periods)
  • Correction for the point in the economic cycle for the TTC measures
  • Adjustment of the model to the expected life of the financial instruments

The modelling approach for the key risk parameters will be affected by the incorporation of forward-looking, credible, and robust economic scenarios into accounting models. Additionally, banks will need to compensate for a lack of historical data by using expert overlays, vendor models, or external data pools.

Overcoming the challenge of insufficient historical data, common in small and medium banks, increases the cost of implementing an IFRS 9 solution.

Under the current Basel framework, the following two approaches can be used for credit measurement to calculate regulatory capital:

  • The standardized approach (SA) allows the bank to measure credit risk in a standardized manner, assigning risk weights supported by external credit assessments.
  • The internal ratings-based approach (IRB), which is subject to the explicit approval of the bank’s supervisor, would allow banks to use internal rating systems for risk-weighted asset (RWA) calculation for credit risk. This includes measures for PD, LGD, EAD, and effective maturity (M). In some cases, banks may be required to use a supervisory value as opposed to an internal estimate for one or more of the risk parameters.

Depending on whether the standardized or advanced Basel approach is used, the bank will be able to leverage some of the data used by the Basel models to model IFRS 9 expected credit loss and encourage easier reconciliation of inputs for capital requirement and impairment calculations. The table below presents some clarification.

Mode of risk computation

IFRS 9 usability

Standardised Approach

Measurement of credit risk in a standardised manner, supported by external credit assessment informing asset’s risk weights for regulatory capital calculations

Data is not complete or substantial enough to meet IFRS 9 modelling requirements

Foundation IRB

Own PD estimation and rely on supervisory estimates for other risk components for regulatory capital calculations

Data can be leveraged, under the condition that significant adjustments are made

Advanced IRB

Own PD, LGD, EAD estimates, and calculation of maturity (M) for regulatory capital calculations

Data can be leveraged, under the condition that significant adjustments are made

Food for thought – Business implications

Impact on KPIs and volatility in profit or loss

Transition to the expected credit loss model for measuring impairment is likely to have a significant impact on key performance indicators (KPIs) for many entities, but especially banks and other lenders. The new model may make equity and profit or loss more volatile because:

  • credit losses will be recognised for all financial assets in the scope of the model – rather than only for those assets for which losses have been incurred;
  • external data used as inputs may be volatile – e.g. ratings, credit spreads and predictions about future conditions; and
  • any move from a 12-month expected credit losses measurement to a lifetime expected credit losses measurement – and vice versa – (see Significant increase in credit risk) may result in a large change in the corresponding loss allowance.

The IASB fieldwork discussed above indicated that the results of the proposed model were more sensitive to changing economic conditions – e.g. forward-looking macro-economic data – than the IAS 39 incurred loss model.

Implementation of the new methodology

Implementation of the new IFRS 9 impairment methodology may be challenging. The methodology is likely to have a particularly significant impact on the systems and processes of banks, insurers and other financial services entities. Extended data and calculation requirements will include:

Banks with less sophisticated approaches to credit risk management may currently lack the data or systems to carry out the expected credit losses calculations. Also, they may have little expertise in developing expected credit loss models.

3.2 12-month expected credit losses and lifetime expected credit losses

Under IFRS 9, impairment is measured as either:

  • 12-month expected credit losses; or
  • lifetime expected credit losses. (IFRS 9.5.5.3-5)

The circumstances under which expected credit losses are measured as 12-month or lifetime expected credit losses are explained in Significant increase in credit risk, Credit impaired financial assets and Simplified approach.

3.2.1 12-month expected credit losses

’12-month expected credit losses’ are defined as: ‘the portion of lifetime expected credit losses that represents the expected credit losses that result from default events on the financial instrument that are possible within the 12 months after the reporting date.’

This means that 12-month expected credit losses are all cash shortfalls (see 4.2) that will result if a default occurs in the 12 months after the reporting date (or a shorter period if the expected life of a financial instrument is less than 12 months).

Food for thought – The concept of 12-month expected credit losses

(IFRS 9.BC5.195, IFRS 9.BC5.198-199, IFRS 9.BC5.203)

The IASB acknowledges that there is no conceptual basis for selecting 12 months of expected credit losses rather than any other period. Instead, this period has been selected because the IASB considers it to represent an appropriate balance between the benefits of a faithful representation of expected credit losses, and operational costs and complexity.

The Board notes that selecting a period longer than 12 months would lead to the recognition of a larger proportion of expected credit losses, and therefore increase the overstatement of expected credit losses at initial recognition.

The Board also observes that in many jurisdictions, regulated financial institutions already calculate a 12-month credit loss rate that is similar to the requirement under IFRS 9, and so implementing the model would be less costly for them.

Financial institutions that already apply a 12-month expected credit losses concept for regulatory purposes will have to identify and quantify the effect of any differences in definition between the regulatory requirements and those of IFRS 9 (see Food for thought – Impact on equity on initial adoption and in future periods above).

Food for thought – Losses that result from default events that are possible in the next 12 months

Banks often gather information on the past performance of their assets to calculate the relevant loss statistics. For example, they may track a cohort of retail loans that have become 30 days past due, to determine what proportion of these loans does not pay in full and so results in a loss.

When using this information to estimate 12-month expected credit losses, entities will have to ensure that they:

  • include only losses that result from a default in the next 12 months; and
  • exclude losses that result from any subsequent defaults outside the 12-month period relating to the same loan.

This may be challenging.

See also ‘Food for thought – Relationship between an actual default event and a significant increase in credit risk‘ in 3.4.1.2.

3.2.2 Lifetime expected credit losses

‘Lifetime expected credit losses’ are defined as: ‘the expected credit losses that result from all possible default events over the expected life of the financial instrument.’

3.2.3 Definition of default

IFRS 9 does not define the term ‘default’, but instead requires each entity to do so. The definition has to be consistent with that used for internal credit risk management purposes for the relevant financial instrument, and has to consider qualitative indicators – e.g. breaches of covenants – when appropriate.

The standard contains a rebuttable presumption that default does not occur later than 90 days past due unless an entity has reasonable and supportable information to corroborate a more lagging default criterion. The definition of default should be applied consistently, unless information that becomes available indicates that another default definition is more appropriate for a particular financial instrument. (IFRS 9.B5.5.37)

Food for thought – Definition of ‘default’ and its impact on applying the model

(IFRS 9.BC5.248, IFRS 9.BC5.251-252)

The IASB notes that entities can use their own definitions of default, including, where applicable, a regulatory definition – as long as the definitions are consistent with the entities’ credit risk management practices (see Food for thought – Impact on equity on initial adoption and in future periods above) and consider qualitative indicators.

In this context, the staff noted11 that some definitions of default that are used in practice for other purposes – e.g. by ratings agencies – are narrow and focus only on failure to make contractual payments. Others – e.g. those used by some regulators, such as the Basel Committee on Banking Supervision or the European Banking Authority – are broader, and also:

  • capture failure to uphold some other aspects of the contractual terms – e.g. breaches of covenants or failure to submit audited financial statements; and
  • consider the obligor’s likeliness to pay future contractual payments in full before the payment is actually past due.

Entities will have to define the term ‘default’ in the context of their specific types of assets and in a way that is consistent with their credit risk management practices. In some cases, it may be appropriate to consider assets to be in default if a contractual payment is not made when it is due. In other cases, default may occur earlier – e.g. when a borrower breaches loan covenants, which may occur before any contractual payment is missed.

The definition of default may affect the amount of expected credit losses recognised (see 4), because the earlier an asset is considered to be in default, the more likely it is that the default event would be possible within the 12 months after the reporting date.

However, the IASB has noted that expected credit losses are not expected to change as a result of differences in the definition of default, because of the counterbalancing interaction between the way the entity defines default and the credit losses that arise as a result of that definition of default.

3.3 When is it appropriate to recognise 12-month expected credit losses or lifetime expected credit losses?

Expected credit losses are measured as 12-month expected credit losses unless:

3.4 Significant increase in credit risk

3.4.1 General requirements

3.4.1.1 Definition of significant increase in credit risk

Expected credit losses are measured as lifetime expected credit losses if, at the reporting date, the credit risk on the financial instrument has increased significantly since its initial recognition. (IFRS 9.5.5.3, IFRS 9.5.5.5)

IFRS 9 clarifies that an entity cannot align the timing of its recognition of lifetime expected credit losses to the date on which a financial asset becomes credit-impaired (see Credit impaired financial assets), or to its internal definition of default (see 3.2.3). (IFRS 9.B5.5.21)

Food for thought – No definition of ‘significant increase in credit risk

The term ‘significant increase’ is not defined in IFRS 9. Determining whether there has been a significant increase in credit risk is one of the most critical and difficult judgement areas in the model.

Entities will need to decide how they will define this key term in the context of their instruments.

3.4.1.2 Assessing whether credit risk has increased significantly

In assessing whether credit risk has increased significantly, an entity uses the change in the risk of default occurring over the expected life of the financial instrument, rather than changes in the magnitude of loss if the default were to occur. Therefore, changes in loss given default (LGD) are not considered for this purpose, although they are incorporated in the resulting measurement of expected credit losses (see 4). (IFRS 9.5.5.9)

To determine whether the risk of default of a financial instrument has increased significantly since initial recognition, an entity compares the current risk of default at the reporting date with the risk of default at initial recognition.(IFRS 9.5.5.9)

An entity assesses whether there has been a significant increase in credit risk at each reporting date. The impairment model in IFRS 9 is symmetrical, and assets can move into and out of the lifetime expected credit losses category, as illustrated below.(IFRS 9.5.5.7)

Impairment of financial assets

To be ‘significant’, a larger absolute increase in the risk of default will be required for an asset with a higher risk of default at initial recognition than for an asset with a low risk of default at initial recognition. (IFRS 9.5.5.9, IFRS 9.BC5.173-174)

For example, an absolute change of 2 percent in the probability of default occurring (PD) will be more significant for an asset with an initial PD of 5 percent than for an asset with an initial PD of 20 percent. The basis for conclusions also indicates that to be significant, a larger absolute increase in the risk of default will be required for a longer-term financial asset than for a short-term financial asset.

Food for thought – Significant increase in credit risk – a relative concept

(IFRS 9.BC5.160)

IFRS 9 explains that, in evaluating whether an increase in credit risk is significant, an entity compares the risk of default at initial recognition of an instrument with the risk of default at the reporting date.

Accordingly, there may be situations in which loans with a higher credit risk will carry a loss allowance equal to 12-month expected credit losses, whereas other loans with a lower credit risk will carry a loss allowance equal to lifetime expected credit losses.

During its deliberations, the IASB considered whether lifetime expected credit losses should be recognised on the basis of:

  • an absolute assessment of the credit quality – i.e. whether the credit risk of the instrument is above a specified threshold that applies to all assets; or
  • a relative assessment – i.e. whether the credit risk of the instrument has deteriorated relative to expectations at its initial recognition.

It concluded that although the absolute approach would be easier to apply because it is more closely aligned with the risk management process, it would provide very different information to users. This is because it would not approximate the economic effect of initial credit expectations and subsequent changes in expectations. In addition, it would be difficult to define an absolute level of deterioration at which lifetime recognition of losses would be appropriate for all instruments.

Accordingly, an entity will not be able to apply the significant increase concept by simply selecting a single absolute PD threshold and concluding that any instrument whose PD increases above that threshold has undergone a significant increase in credit risk. However, an approach similar to this may be appropriate for particular portfolios if all assets in the portfolio have a similar credit-risk at initial recognition (see 3.4.2.2).

Case – Significant increase in credit risk – a relative concept

Bank W uses an internal credit rating system of 1 to 10, with 1 denoting the lowest credit risk and 10 denoting the highest credit risk.

W considers an increase of two rating grades to represent a significant increase in credit risk. It considers Grades 3 and lower to be a ‘low credit risk’ (see 3.4.3).

At the reporting date W has two loans to Company X outstanding, as follows.

Impairment of financial assets

W assesses whether there has been a significant increase in credit risk in respect of the loans and reaches the following conclusions.

Impairment of financial assets

The loans each attract a loss allowance measured on a different basis because only the credit risk of Loan A has increased significantly since initial recognition. The measurement basis for the loss allowance is different irrespective of the fact that both loans have the same grade at the reporting date.

Food for thought – Relationship between an actual default event and a significant increase in credit risk

In defining ‘default’ for the purpose of assessing a significant increase in credit risk, entities will need to consider how this definition relates to the occurrence of a contractual default – i.e. payments not made when due under the contract (see 3.2.3, including ‘Food for thought – Definition of ‘default’ and its impact on applying the model‘). It may be that there is an actual contractual default – e.g. a missed interest payment – without there being a significant increase in credit risk.

For example, this could be the case when:

  • the 30-day presumption is rebutted (see 3.4.4); or
  • the 30-day presumption is not rebutted, but a payment is less than 30 days past due.

Food for thought – Instruments with credit spreads that reset when the credit rating changes

(IFRS 9.B5.5.7)

Certain debt instruments include features under which the credit spread resets when their credit rating changes. IFRS 9 explains that the assessment of whether there has been a significant increase in credit risk is made relative to expectations at initial recognition, irrespective of whether a financial instrument has been repriced to reflect an increase in credit risk after initial recognition.

3.4.1.3 Loan commitments and financial guarantee contracts

The assessment of a significant increase in credit risk requires an entity to identify the date on which it initially recognised a financial instrument, because any increase in credit risk is measured from that date. (IFRS 9.5.5.6, IFRS 9.B5.5.47)

For loan commitments and financial guarantee contracts, the date of initial recognition is considered to be the date on which the entity becomes a party to the irrevocable commitment. This applies to both the drawn and undrawn amounts. This is because, for the purpose of applying the impairment requirements, a financial asset that is recognised as a result of the draw-down of a loan commitment is treated as a continuation of the loan commitment.

Food for thought – Loans drawn down under loan commitments

(IFRS 9.B5.5.47)

It appears that the requirement of IFRS 9 that the date of initial recognition for loan commitments should be the date on which an entity becomes a party to the contract means that, for loans drawn down under loan commitments – e.g. revolving credit facilities – the assessment is made relative to the credit risk when the contract was signed, rather than the credit risk when each balance is drawn.

Certain loan agreements – e.g. credit cards or bank overdrafts – can have a life of many years, with balances being drawn daily and repaid (fully or partially) at short intervals – e.g. monthly.

If the date of initial recognition for these instruments is considered to be the date on which the agreement with the customer was initially signed, then to assess whether credit risk has increased significantly since initial recognition entities may have to compare the current level of credit risk to a level that existed many years before.

This would require entities to continue to track historical information about credit assessments dating back to the time when facilities were granted.

3.4.1.4 Approaches used for assessing whether credit risk has increased significantly

IFRS 9 explains that an entity may apply various approaches when assessing whether there has been a significant increase in credit risk – including using different approaches for different financial instruments.

An approach that does not include an explicit PD as an input, such as a credit loss rate approach, can be used provided that the entity is able to separate the changes in the risk of default occurring from other changes in expected credit losses – e.g. due to collateral. Any approach used considers:

  • the change in the risk of default occurring since initial recognition;
  • the expected life of the financial instrument; and
  • reasonable and supportable information that is available without undue cost or effort that may affect credit risk. (IFRS 9.B5.5.12)

Food for thought – Counterparty assessment

(IFRS 9.BC5.166-168)

Generally, the assessment of whether there has been a significant increase in credit risk is made for a specific instrument rather than for a counterparty, because:

  • the magnitude of changes in credit risk may be different for different instruments transacted with the same party; and
  • different instruments issued by the same counterparty may have had a different credit risk at initial recognition – e.g. they may have been acquired at different points in time.

However, the IASB noted that assessing credit risk on a basis that considers a counterparty’s credit risk more holistically may be consistent with the impairment requirements – e.g. to make an initial assessment of whether credit risk has increased significantly as part of an overall assessment, as long as this assessment satisfies the requirements of IFRS 9 on when to recognise lifetime expected credit losses, and the outcome would not be different to the outcome if the financial instruments had been assessed individually.

Using the 12-month risk of default for the assessment

The method used to identify a significant increase in credit risk should consider the characteristics of the financial instrument and historical default patterns for comparable financial instruments.

For financial instruments whose default patterns are not concentrated at a specific point during their expected life, changes in the 12-month risk of default may be a reasonable approximation of changes in the lifetime risk of default, unless circumstances indicate that a lifetime assessment is necessary.

IFRS 9 includes the following examples of situations in which using the 12-month risk of default is not appropriate: (IFRS 9.B5.5.13-14)

  • for loans whose significant payment obligations are only after the next 12 months – e.g. bullet loans or financial instruments that are non-amortising in the first few years;
  • when changes in macro-economic or other credit-related factors occur that are not adequately reflected in the 12-month risk of default; or
  • when changes in credit-related factors occur that have an impact on credit risk that is more pronounced beyond 12 months.

Food for thought – Identifying a significant increase in credit risk using the 12-month risk of default

(IFRS 9.BC5.176-179)

The 2013 impairment ED proposed that, generally, the lifetime risk of default would be used to evaluate whether an increase in credit risk is significant, and that using the 12-month risk of default would be permitted only if the information considered did not suggest that the outcome would differ.

However, during its redeliberations the IASB noted that it did not intend to require entities in the latter case to make the assessment based on both the 12-month and the lifetime risk of default to prove that the outcome would not differ, because this would not result in a simplification.

The Board explained that the 12-month risk of default should generally be a reasonable approximation of the lifetime risk of default, and would therefore not be inconsistent with the requirements of the standard. However, it also noted that there may be circumstances in which the use of the 12-month risk of default would not be appropriate.

The IASB also noted that some entities already calculate a 12-month PD measure for regulatory requirements. Therefore, these entities could use their existing systems and methodologies as a starting point for assessing significant increases in credit risk, which would reduce the costs of implementation.

However, they would have to identify the effect of any differences in definition between the regulatory requirements and those of IFRS 9 (see Food for thought – Impact on equity on initial adoption and in future periods above), as well as situations in which using a 12-month risk of default would be inappropriate.

3.4.1.5 Assessing changes in the risk of default over time

IFRS 9 explains that, because of the relationship between the remaining life and the risk of default, the change in credit risk cannot be assessed simply by comparing the change in the absolute risk of default over time. For example, the risk of default over the remaining life of a loan will tend to reduce over time, as the remaining life becomes shorter.

Therefore, if the actual risk of default of a particular loan has not reduced over time, this may indicate an increase in the credit risk of that loan. However, the standard states that this may not be the case for financial instruments that have significant payment obligations only close to maturity. In such cases, an entity should also consider other qualitative factors to determine a significant increase in credit risk. (IFRS 9.B5.5.11, IFRS 9.BC5.174)

Food for thought – Assessing changes in the risk of default on a comparable basis

(IFRS 9.BC5.173-174)

IFRS 9 does not specify how an entity could assess the change in credit risk other than simply comparing the change in the absolute risk of default over time, beyond noting that if the absolute risk of default does not decline over time, then this may indicate an increase in credit risk.

One possible approach might be to adjust the absolute risk of default for different points in time to a comparable basis – e.g. an annualised average risk of default – or to estimate at initial recognition a default curve (with different PDs for different future periods) for the purposes of subsequent comparison.

However, IFRS 9 does not provide detailed guidance as to whether such approaches would be acceptable.

Also, in making the assessment over time, a smaller absolute increase in the risk of default might be considered significant as the term of the financial asset becomes shorter (see 3.4.1.2).

Food for thought – Instruments with significant payment obligations only close to maturity

(IFRS 9.B5.5.11, IFRS 9.B5.5.37)

IFRS 9 explains that, for instruments that have significant payment obligations only close to maturity, the risk of default may not necessarily decrease over time.

To the extent that the entity’s definition of default relates to non-payment in accordance with the terms of the contract, a default cannot occur until a payment obligation arises. However, in defining ‘default’ an entity should also consider qualitative factors – e.g. non-compliance with contractual covenants – which means that a default can arise during a particular period even if there are no contractual payments due in that period.

3.4.2 Individual or collective basis of evaluation

The objective of the impairment requirements in IFRS 9 is to recognise lifetime expected credit losses for all financial instruments for which there has been a significant increase in credit risk since initial recognition – whether assessed on an individual or collective basis.

The standard explains that, for some instruments, a significant increase in credit risk may not be evident on an individual instrument basis before the financial instrument becomes past due. For example, this could be the case when there is little or no updated information that is routinely obtained and monitored on an individual instrument until a customer breaches the contractual terms – e.g. for many retail loans. (IFRS 9.5.5.4, IFRS 9.B5.5.3)

In these cases, an assessment of whether there has been a significant increase in credit risk on an individual basis would not faithfully represent changes in credit risk since initial recognition, and so if more forward-looking information (see 3.4.5) is available on a collective basis, an entity makes the assessment on a collective basis. (IFRS 9.5.5.11, IFRS 9.B5.5.1, IFRS 9.B5.5.3)

3.4.2.1 Grouping financial instruments for collective assessment

To assess significant increases in credit risk on a collective basis, an entity can group financial instruments on the basis of shared credit risk characteristics. (IFRS 9.B5.5.5)

The standard gives the following examples of shared credit risk characteristics: (IFRS 9.B5.5.5)

  • instrument type;
  • credit risk ratings;
  • collateral type;
  • date of origination;
  • remaining term to maturity;
  • industry;
  • geographical location of the borrower; and
  • the value of collateral relative to the financial asset if it has an impact on the PD – e.g. loan-to-value ratios for non-recourse loans in some jurisdictions.

The aggregation of financial instruments may change over time as new information becomes available. (IFRS 9.B5.5.6)

IFRS 9 provides the following illustrative example on assessing a significant increase in credit risk on a portfolio basis by grouping the instruments on the basis of shared credit risk characteristics.

Case – Assessing a significant increase in credit risk on a portfolio basis

(IFRS 9.IE38)

Bank F has a portfolio of mortgages that were provided to finance residential real estate in a specific region.

This region includes a mining community that is largely dependent on the export of coal and related products. F becomes aware of a significant decline in coal exports and anticipates the closure of several coal mines.

F anticipates an increase in the unemployment rate in this community and determines that the credit risk and the risk of default of borrowers in the region who rely on the coal mines have significantly increased, even if those borrowers are not past due at the reporting date.

Accordingly, F segments its mortgage portfolio on the basis of industries – i.e. a shared credit risk characteristic – to identify borrowers that rely on the coal mines. For these mortgages, F recognises a loss allowance equal to lifetime expected credit losses.

However, F continues to recognise a loss allowance equal to 12-month expected credit losses for newly originated loans to borrowers who rely on the coal mines, because these have not experienced a significant increase in credit risk since initial recognition.

If an entity is not able to form, on the basis of shared credit risk characteristics, a group of financial instruments for which credit risk is considered to have increased significantly, but is able to identify a significant increase in credit risk for a portion of a group, then it recognises lifetime expected credit losses on this portion. (IFRS 9.B5.5.6)

The following case demonstrates an assessment of a significant increase in credit risk on a collective basis when an entity is not able to group financial instruments for which the credit risk has increased significantly based on shared risk characteristics, but is able to estimate a portion of a portfolio on which credit risk has increased significantly.

Case – Significant increases in credit risk for a portion of a portfolio

(IFRS 9.IE39)

Bank G originates a homogeneous portfolio of 100 variable interest rate mortgage loans. Historically, an increase in interest rates has been a lead indicator of future defaults on similar mortgages. G does not have information on individual mortgages (except for past-due information) that would indicate a significant increase in credit risk, and is not able to group them on the basis of shared risk characteristics for this purpose.

Therefore, G assesses whether there is a significant increase in the credit risk of mortgages in the portfolio on a collective basis using information on expected increases in interest rates during the expected life of the mortgages.

Based on historical information, G estimates that an increase in interest rates of 1% will cause a significant increase in credit risk on 10% of the portfolio. None of the mortgage loans are past due.

Therefore, as a result of an anticipated increase in interest rates of 1%, G determines that there has been a significant increase in credit risk on 10% of the portfolio. Accordingly, G recognises lifetime expected credit losses on 10% of the portfolio and 12-month expected credit losses on 90% of the portfolio.

3.4.2.2 Assessment by comparison with the maximum initial credit risk in a portfolio

The basis for conclusions indicates that the assessment of significant increases in credit risk could be implemented more simply for some groups of financial instruments by: (IFRS 9.BC5.161)

  • establishing the maximum credit risk for the particular portfolio on initial recognition – e.g. by product type and/or region – that will not require the recognition of lifetime expected credit losses; and then
  • comparing the credit risk of financial instruments in that portfolio at the reporting date with that maximum credit risk.

However, this approach would only be possible if all of the financial instruments in the portfolio have a similar credit risk at initial recognition – e.g. a credit rating within a relatively narrow band. If this were not the case, it would not be possible to identify a single credit rating that would reflect a significant increase in credit risk for all assets. (IFRS 9.BC5.161)

IFRS 9 provides the following case to illustrate this point.

Case – Assessment by comparison with the maximum initial credit risk

(IFRS 9.IE40-IE42)

Bank N has a portfolio of automobile loans. N assigns an internal credit risk rating from 1 to 10 to each loan on origination, with 1 denoting the lowest credit risk and 10 denoting the highest credit risk. The risk of default occurring increases exponentially – meaning that the difference between Grades 1 and 2 is smaller than that between Grades 2 and 3, etc.

Loans in the portfolio are offered only to existing customers with an internal credit rating of 3 or 4 at initial recognition. Therefore, 4 is the maximum internal credit rating grade that N will accept for this portfolio of loans. N determines that all loans in the portfolio have a similar initial credit risk at initial recognition because they are graded either 3 or 4.

N deems that a change from Grade 3 to Grade 4 does not represent a significant increase in credit risk, but a change from Grade 4 to Grade 5 does represent a significant increase in credit risk. Therefore, a significant increase in credit risk occurs for each loan in the portfolio when its internal credit rating deteriorates beyond Grade 4 after initial recognition.

This means that N does not have to know the initial credit risk rating of each loan in the portfolio to assess the change in credit risk since initial recognition, but needs only to determine whether the credit risk rating of each loan in the portfolio is worse than Grade 4 at the reporting date.

However, N could not apply this approach with respect to a maximum initial credit risk of 7 for another portfolio in which loans are originated with an initial credit risk rating between 4 and 7, because this range of initial credit risk ratings is too wide.

3.4.3 Exception for assets with low credit risk

As an exception from the general requirements, an entity may assume that the criterion for recognising lifetime expected credit losses is not met if the credit risk on the financial instrument is low at the reporting date. The IASB notes in the basis for conclusions that an entity can choose to apply this simplification on an instrument-by-instrument basis. (IFRS 9.5.5.10, IFRS 9.BC5.183-184)

IFRS 9 states that the credit risk is low if: (IFRS 9.B5.5.22)

  • the instrument has a low risk of default;
  • the borrower has a strong capacity to meet its contractual cash flow obligations in the near term; and
  • adverse changes in economic and business conditions in the longer term may, but will not necessarily, reduce the borrower’s ability to fulfil its obligations.

IFRS 9 states that a financial instrument with an external rating of ‘investment grade’ is an example of an instrument that may be considered to have low credit risk. However, a financial instrument does not have to be externally rated for the exception to apply.

When an internal grade is used to determine whether the credit risk of an instrument is low, the internal assessment of low credit risk should equate to a globally understood definition of low credit risk for the risks and type of financial instrument being assessed. The assessment should be consistent with the perspective of a market participant, and should take into account all of the terms and conditions of the financial instruments. (IFRS 9.B5.5.23)

A financial instrument is not considered to have a low credit risk simply because: (IFRS 9.B5.5.22)

  • the value of collateral results in a low risk of loss – this is because collateral usually affects the magnitude of the loss when default occurs, rather than the risk of default; or
  • it has a lower risk of default than the entity’s other financial instruments or relative to the credit risk of the jurisdiction in which the entity operates.

The low credit risk exception does not mean that there is a bright-line trigger for the recognition of lifetime expected credit losses when an instrument’s credit risk ceases to be low. Instead, when an instrument no longer has low credit risk, the general requirements to assess whether there has been a significant increase in credit risk apply (see 3.4.1). (IFRS 9.B5.5.24)

Food for thought – Low credit risk

(IFRS 9.B5.5.23, IFRS 9.IE27)

Using external ratings to determine whether credit risk is low

IFRS 9 states that a financial instrument with an external rating of ‘investment grade’ is an example of an instrument that may be considered to have low credit risk.

However, an external rating is a lagging indicator, as it does not reflect events that occur or other relevant information that becomes available after the ratings agency last updated its rating. In addition, the definition of default used by a ratings agency may not be consistent with the definition used by the entity (see ‘Observation – Definition of ‘default’ and its impact on applying the model‘ in 3.2.3).

Therefore, in order to conclude that an instrument with an external rating equivalent to ‘investment grade’ has low credit risk, the entity will need to consider whether there is evidence of an increase in credit risk that is not yet reflected in the rating.

Application of the low credit risk exception for different assets

Entities will have to decide whether and how to apply the low credit risk exception to the specific assets that they hold, taking into account the internal credit ratings that they use. For example, banks will have to decide whether and how to apply it to corporate loans and other loans that are not externally rated.

Application of the low credit risk exception to retail loans may be very challenging in practice. For example, after initial recognition of such loans, the lender does not usually have up-to-date, detailed information on the credit risk and prospects of each borrower, so it may not be possible to demonstrate that the low credit risk definition is satisfied for each borrower.

Conversely, the low credit risk exemption will be a useful simplification in applying the new impairment model to debt securities that are rated externally.

3.4.4 Payments that are more than 30 days past due

IFRS 9 contains a rebuttable presumption that the condition for recognising lifetime expected credit losses is met when payments are more than 30 days past due. However, it also clarifies that delinquency is a lagging indicator, and that a significant increase in credit risk typically occurs before an asset is past due.

Therefore, when information that is more forward-looking than data about past-due payments is available without undue cost or effort, it should be considered in determining whether there has been a significant increase in credit risk, and the entity cannot rely solely on past-due data. For example, this information could be available at a portfolio level (see 3.4.2). (IFRS 9.5.5.11, IFRS 9.B5.5.2)

IFRS 9 clarifies that this presumption is not an absolute indicator, but is presumed to be the latest point at which lifetime expected credit losses should be recognised, even when using forward-looking information. (IFRS 9.B5.5.19)

The presumption can be rebutted only if an entity has reasonable and supportable information demonstrating that even if contractual payments are more than 30 days past due, this does not represent a significant increase in credit risk. This might be the case if: (IFRS 9.5.5.11, IFRS 9.B5.5.20)

  • non-payment was an administrative oversight instead of resulting from the borrower’s financial difficulty; or
  • historical evidence demonstrates that there is no correlation between a significant increase in the risk of default on financial assets and payments on them being more than 30 days past due; however, it does identify such a correlation for financial assets on which payments are more than 60 days past due.

3.4.5 Information used for the assessment

To assess whether there has been a significant increase in credit risk, an entity considers reasonable and supportable information that is available without undue cost or effort (see 4.6), and is relevant for the particular financial instrument being assessed. IFRS 9 sets out many examples of different sources of information and indicators that could be used. (IFRS 9.5.5.4, IFRS 9.B5.5.15-17)

IFRS 9 states that credit risk analysis is a multi-factor and holistic analysis. Whether a specific factor is relevant, and its weight compared with other factors, will depend on: (IFRS 9.B5.5.16)

  • the type of financial instrument;
  • the characteristics of the financial instrument; and
  • the geographical region.

Some of these factors or indicators may not be identifiable at an individual financial instrument level, but can and should be assessed for portfolios (or groups or portions of portfolios) (see 3.4.2). (IFRS 9.B5.5.16)

IFRS 9 states that in some cases the qualitative and non-statistical quantitative information available may be sufficient for the assessment. In other cases, a statistical model or credit ratings process may be used. Alternatively, an entity may base the assessment on both of the following types of information if both types of information are relevant: (IFRS 9.B5.5.18)

  • a specific internal rating category; and
  • qualitative factors that are not captured through the internal credit ratings process.

Food for thought – Information used in identifying a significant increase in credit risk

(IFRS 9.B5.5.17)

IFRS 9 allows a variety of information to be used in assessing whether there has been a significant increase in credit risk. It appears that this flexibility allows entities with sophisticated credit risk systems to use the sophisticated information available to them, and entities with simpler systems and processes to use simpler information.

As a result, the timing of the transfer of a financial instrument to a lifetime expected credit losses measurement may depend not only on the entity’s definition of the increase in credit risk that it considers significant, but also on the sophistication of its systems and processes.

However, any systems or processes used to generate the required information will have to meet the overall requirement to use reasonable and supportable information that is available without undue cost or effort.

Food for thought – Information available without undue cost or effort

(IFRS 9.IE26)

The information that is available without undue cost or effort may vary, depending on the type of financial instrument. If a lender has a direct relationship with a borrower, and the borrower prepares regular financial information that is made available to the lender, then it will be appropriate for the lender to use this information to make the estimates required by IFRS 9.

In other cases, an entity may be an investor in a quoted bond and may not have a one-to-one relationship with the borrower. In these circumstances, the lender could use only information that is publicly available – e.g. public announcements by the issuer of the bond, or reports by credit agencies.

3.4.6 Modified financial assets

IFRS 9 provides guidance on estimating expected credit losses for financial assets that have been modified. If the contractual cash flows of a financial asset are modified, then the entity is required to distinguish between: (IFRS 9.5.5.12)

  • a modification that results in derecognition; and
  • a modification that does not result in derecognition (see Modified financial assets).

If the modification does not result in derecognition, then the subsequent assessment of whether there is a significant increase in credit risk is made by comparing: (IFRS 9.5.5.12)

  • the risk of default at the reporting date based on the modified contractual terms of the financial asset; with
  • the risk of default at initial recognition based on the original, unmodified contractual terms of the financial asset.

If the modification of a financial asset results in derecognition, then the modified asset is considered to be a new asset. Accordingly, the date of modification is treated as the date of initial recognition for the purposes of the impairment requirements. (IFRS 9.B5.5.25-26)

The following diagram illustrates the assessment of whether the credit risk on a modified financial asset has increased significantly.

Impairment of financial assets

If the modification of a financial asset does not result in derecognition, then the modified asset should not be considered automatically to have lower credit risk merely because its cash flows have been modified.

IFRS 9 states that, for an asset that is modified while having an allowance equal to lifetime expected credit losses, an example of evidence that the criteria for recognising lifetime expected credit losses are no longer met includes a history of up-to-date and timely payment performance against the modified contractual terms.

Typically, a customer would need to demonstrate consistently good payment behaviour over a period of time before the credit risk is considered to be improved – e.g. a history of missed or incomplete payments would not typically be ignored if the customer made one payment on time following the modification. (IFRS 9.B5.5.27)

Case – Modified financial assets evaluated on the basis of past-due information

A lender cannot automatically assume that a modified asset has lower credit risk than the original unmodified asset, just because the loan is no longer past due. This is illustrated in the following example.

Lender L has a portfolio of retail loans for which it applies the presumption that the credit risk increases significantly if the loan is more than 30 days past due (see 3.4.4). One of the borrowers (Borrower B) is experiencing some difficulty in meeting the contractual payments, and so L modifies the contract by extending the maturity of the loan and reducing the monthly payments.

The modification does not result in derecognition. At the time of the modification, the loan is 60 days in arrears. Following the modification, B is meeting the new contractual payments. L will have to exercise judgement – taking into account all reasonable and supportable information (e.g. historical experience on forbearance activities) – to determine whether the modified loan continues to meet the ‘significant increase in credit risk’ criterion.

IFRS 9 notes that in some unusual circumstances following a modification that results in derecognition, there could be evidence that the modified financial asset is credit-impaired at initial recognition – e.g. when there is a substantial modification of a distressed asset. For the accounting for such assets, see Credit-impaired at initial recognition. (IFRS 9.B5.5.26)

3.4.7 Financial assets that have been reclassified

If a financial asset has been reclassified out of the FVTPL measurement category into the amortised cost or FVOCI measurement category (see Measurement of reclassified financial assets), then, for the purpose of assessing whether there has been a significant increase in credit risk, the reclassification date is treated as the date of initial recognition. Therefore, only changes in the asset’s credit risk following the reclassification date are considered. (IFRS 9.B5.6.2)

Impairment of financial assets

However, when a financial asset is reclassified between the amortised cost and FVOCI measurement categories (in either direction), then the credit risk at the asset’s original date of initial recognition (rather than the reclassification date) will continue to be used for assessing changes in credit risk. This is because both categories are subject to the same impairment model under IFRS 9 (see ‘Food for thought – FVOCI category’ in 1.1).

Impairment of financial assets

If a financial asset is reclassified from the amortised cost or FVOCI measurement category into the FVTPL measurement category, then an impairment assessment no longer has to be performed. (IFRS 9.B5.6.2)

Impairment of financial assets

Food for thought – Reclassifications into and out of the FVTPL measurement category

At the reclassification date, the fair value of a financial asset reclassified from FVTPL into the amortised cost or FVOCI measurement category becomes its new gross carrying amount (see Debt instruments at FVOCI). At the next reporting date, an impairment loss is initially recognised for the asset.

Therefore, similar to the origination or acquisition of a new financial asset that is initially classified as measured at amortised cost or FVOCI, a day one loss will result from this type of reclassification if the asset is not credit-impaired at the reclassification date (see Credit-impaired financial assets). For further discussion of day one losses, see ‘Food for thought – Day one loss‘ in 3.1.

By contrast, if an asset is reclassified from amortised cost or FVOCI to FVTPL, the fair value at the reclassification date will become the new carrying amount, but an impairment allowance will no longer be necessary. Therefore, a credit to profit or loss will arise relating to the reversal of the loss allowance previously associated with the reclassified asset.

Case – Reclassifications out of FVTPL and into the amortised cost measurement category

(IFRS 9.IE104-IE107, IFRS 9.IE110)

Company C purchases a portfolio of bonds for 500 and classifies them as measured at FVTPL. In the next reporting period, C changes its business model such that the bonds are held in order to collect the contractual cash flows; accordingly, C reclassifies the portfolio into the amortised cost measurement category.

Assume that at the reclassification date:

  • the fair value of the bonds is 490;
  • the 12-month expected credit losses of the portfolio are estimated to be 4; and
  • the bonds are not credit-impaired (see Credit-impaired financial assets).

C records the following entries at the reclassification date.

Bonds (at amortised cost)

490

Bonds (at FVTPL)

490

Impairment expense (profit or loss)

4

Loss allowance

4

The day one loss on the reclassification date is equal to the amount of 12-month expected credit losses at that date.

4 Measurement of expected credit losses

4.1 Overview

Expected credit losses are a probability-weighted estimate of credit losses over the expected life of the financial instrument (see 4.3). Credit losses are the present value of expected cash shortfalls (see 4.2). (IFRS 9.B5.5.28)

The measurement of expected credit losses should reflect: (IFRS 9.5.5.17)

IFRS 9 does not prescribe a single method to measure expected credit losses. Rather, it acknowledges that the methods used to measure expected credit losses may vary based on the type of financial asset and the information available. (IFRS 9.B5.5.12)

The standard allows entities to use practical expedients when estimating expected credit losses, provided that they are consistent with the principles above. It gives an example of such an expedient – i.e. a provision matrix to measure expected credit losses for trade receivables. (IFRS 9.B5.5.35)

Food for thought – No practical expedient to measure impairment at fair value

(IAS 39.AG84, IFRS 9.B5.5.54)

IFRS 9 does not retain the practical expedient available in IAS 39 to measure impairment on the basis of an instrument’s fair value using an observable market price. However, it requires that, as part of considering all reasonable and supportable information in measuring expected credit losses, an entity also considers observable market information about credit risk (see 4.6).

The impairment loss (or reversal) recognised in profit or loss is the amount required to adjust the loss allowance to the appropriate amount at the reporting date. (IFRS 9.5.5.8)

The following topics are covered in the remainder of this section.

  • Expected credit losses
    • Cash shortfalls (4.2, see below)
    • Estimation period (4.3)
  • Measurement reflects….
    • Probability-weighted outcome (4.4)
    • Time value of money (4.5)
    • Reasonable and supportable information (4.6)
  • Other considerations
    • Collateral (4.7)
    • Individual or collective basis (4.8)
  • Financial guarantee contracts and loan commitments (4.9)
  • Example of expected credit losses measurement (4.10)

4.2 Definition of ‘cash shortfall’

4.2.1 Overview

A cash shortfall is the difference between: (IFRS 9.B5.5.28)

  • the cash flows due to the entity in accordance with the contract; and
  • the cash flows that the entity expects to receive.

Because estimation of credit losses considers the amount and timing of payments, a cash shortfall would arise even if the entity expects to be paid in full but later than the date on which payment is contractually due. This delay would give rise to an expected credit loss – except to the extent that the entity expects to receive additional interest in respect of the late payment that compensates it for the delay at a rate at least equal to the EIR.

For measuring 12-month and lifetime expected credit losses (see 3.2), cash shortfalls are identified as follows. (IFRS 9.B5.5.43)

Type of loss allowance

Cash shortfalls

12-month expected credit losses

Those resulting from default events that are possible in the next 12 months (or a shorter period if the expected life is less than 12 months), weighted by the probability of that default occurring

Lifetime expected credit losses

Those resulting from default events that are possible over the expected life of the financial instrument, weighted by the probability of that default occurring

The term ‘cash shortfall’ refers to overall shortfalls against contractual terms, and not just shortfalls on particular dates when cash is received or due. Therefore, cash shortfalls consider later recoveries of missed payments as shown in the following example. (IFRS 9.B5.5.28)

Case – Definition of ‘cash shortfall’

On 31 January 2015, Company V originates a two-year loan with a principal of 100 and a 5% coupon payable annually. On 31 December 2015, V estimates that, if the borrower were to default, the estimated future cash flows would be as follows.

Date

Contractual cash flows

Expected cash flows

Shortfall

31/01/16

5

3

2

15/02/16

2

-2

31/01/17

105

70

35

31/03/17

20

-20

All shortfalls – i.e. both positive and negative amounts – are included in the measurement of the expected credit losses for the loan.

Food for thought – Negative cash shortfalls

The standard does not provide specific guidance for cases in which the net present value of all cash shortfalls is expected to be negative – e.g. if the entity expects to recover additional interest as a penalty due to late payment.

4.2.2 Loan commitments

For undrawn loan commitments, a cash shortfall is the difference between: (IFRS 9.B5.5.30)

  • the contractual cash flows that are due to an entity if the holder of the loan commitment draws down the loan; and
  • the cash flows that the entity expects to receive if the loan is drawn down.

When estimating the drawn-down cash flows, the relevant amounts for each type of loss allowance are as follows. (IFRS 9.B5.5.31)

Type of loss allowance

Drawn-down cash flows

12-month expected credit losses

Those that are expected to be drawn down in the next 12 months

Lifetime expected credit losses

Those that are expected to be drawn down during the life of the loan commitment

Food for thought – Estimating future draw-downs

(IFRS 9.BC5.243-247)

The IASB acknowledges that the requirement to estimate future draw-downs for loan commitments would cause additional complexity, due to the uncertainty involved in estimating the behaviour of customers, especially over a long period. However, it notes that removing the requirement would cause an arbitrage between on- and off-balance sheet instruments.

The IASB notes that many financial institutions already provide similar information to regulators, and use it for internal credit risk management purposes. However, the existing information – and related processes and systems – may have to be adjusted to reflect the potentially different requirements in the new standard.

For example, the new standard requires that draw-downs of loan commitments other than certain revolving credit facilities be determined over a period not longer than that for which the entity has a contractual obligation to extend credit, and not the period over which the entity expects to extend credit (see 4.3).

Banks’ credit risk management systems often consider the full credit limit when estimating credit losses. This is because experience often indicates that when the receivable – e.g. a credit card loan – becomes problematic, the full amount of the credit limit has often been used.

4.2.3 Financial guarantee contracts

For financial guarantee contracts, a cash shortfall is the difference between: (IFRS 9.B5.5.32)

  • the expected payments to reimburse the holder for a credit loss that it incurs; and
  • any amount that an entity expects to receive from the holder, the debtor or any other party.

If the asset is fully guaranteed, then the estimation of cash shortfalls will be consistent with the estimation of cash shortfalls for the asset subject to the guarantee.

4.3 The estimation period – the expected life of the financial instrument

4.3.1 General requirements

The maximum period over which expected credit losses are measured is the contractual period, or a shorter period – e.g. as a result of prepayments – over which there is exposure to credit risk on the financial instrument. This is the case even if a longer period is consistent with business practice.

For loan commitments and financial guarantee contracts, this is the maximum contractual period over which an entity has a present contractual obligation to extend credit. (IFRS 9.5.5.19, IFRS 9.B5.5.38)

Food for thought – Maximum contractual period over which the entity is exposed to credit risk

Banks make different types of commitments to extend credit with different terms and conditions. Sometimes, the contractual period over which the entity is exposed to credit risk from those commitments may not be clear.

A lender may have a contingent right to withdraw a facility – e.g. when there has been a deterioration in the credit condition of the potential borrower. Careful analysis may be needed to determine the contractual period over which the entity is exposed to credit risk from those facilities.

4.3.2 Certain financial instruments that include both a loan and an undrawn commitment component

Certain financial instruments include both a loan and an undrawn commitment component, and the entity’s contractual ability to demand repayment and cancel the undrawn commitment does not limit its exposure to credit losses to the contractual notice period. (IFRS 9.5.5.20, IFRS 9.B5.5.3)

An example of such an instrument is a revolving credit facility, such as a credit card or an overdraft facility. These facilities can be contractually withdrawn by the lender with little notice – e.g. one day; however, in practice lenders continue to extend credit for a longer period and may only withdraw the facility after the credit risk of the borrower increases – i.e. when they become aware of adverse changes in the credit risk of the borrower – which could be too late to prevent some or all of the expected credit losses. (IFRS 9.B5.5.39)

For such instruments (and only for such instruments), an entity measures expected credit losses over the period for which it is exposed to credit risk – and for which expected credit losses would not be mitigated by credit risk management actions – even if that period extends beyond the maximum contractual period. (IFRS 9.5.5.20)

IFRS 9 explains that such instruments generally have the following characteristics: (IFRS 9.B5.5.39)

  • they do not have a fixed term or repayment structure, and usually have a short contractual cancellation period – e.g. one day;
  • the contractual ability to cancel the contract is not enforced in the entity’s normal day-to-day management activities, but only when the entity becomes aware of an increase in the credit risk at the facility level; and
  • they are managed on a collective basis.

When determining the period over which to estimate expected credit losses for such instruments, an entity should consider factors such as historical information and experience about: (IFRS 9.B5.5.40)

  • the period over which the entity was exposed to credit risk on similar financial instruments;
  • the length of time for related defaults to occur on similar financial instruments following a significant increase in credit risk; and
  • the credit risk management actions that the entity expects to take once the credit risk on the financial instrument has increased – e.g. the reduction or removal of undrawn limits.

Foods for thought – Period of estimation of expected credit losses for revolving facilities

IFRS 9.5.5.20, IFRS 9.B5.5.39, IFRS 9.BC5.257-258

The 2013 impairment ED proposed that the estimation of expected credit losses for all facilities should consider only the contractual period over which the entity is committed to provide credit.

However, for certain types of facilities, although contractually the lender may withdraw the credit line on demand or ask for an immediate repayment of the drawn balance, the lender would not normally have information on when it would be advisable to do so.

Often, the key monitoring tool for such financial instruments is an ‘overdue status’, and by the time the loan is overdue, impairment losses may already have occurred. In addition, the contractual maturities are often set for protective reasons and are not actively enforced as part of the entity’s normal credit risk management processes.

During redeliberations, the IASB noted that – for such facilities – the contractual ability to demand repayment and cancel the undrawn commitment would not necessarily limit an entity’s exposure to credit losses to the contractual notice period.

This is because the entity’s exposure to credit losses during only the contractual notice period would not reflect the actual expectation of losses and the way in which those facilities are managed for credit risk purposes.

Therefore, the IASB decided that, as an exception to the general guidance, for facilities that meet certain conditions, the period over which expected credit losses are determined should not be limited to the contractual period over which the entity is committed to provide credit.

However, application of some of the conditions is not clear and may require judgement. IFRS 9.5.5.20 introduces the exception, states that: ‘some financial instruments include both a loan and an undrawn commitment’. This seems to indicate that in order for the exception to apply, a facility has to have both the drawn and undrawn component.

However, in many cases, at a particular point in time a facility may only have an undrawn component but meet all of the conditions in IFRS 9.B5.5.39. This would often be the case for a credit card facility, which is an example of an instrument to which the exception appears to be intended to apply.

IFRS 9.B5.5.39 explains that financial instruments qualifying for the exception generally possess certain characteristics, but does not state that these are necessary qualifying characteristics that have to be present in all cases.

One of the characteristics in paragraph B5.5.39 is that the instruments are managed on a collective basis. However, the standard does not explain what the term ‘managed on a collective basis’ means.

Case – Measurement of expected credit losses for a period longer than the contractual maximum period of the commitment

(IFRS 9.IE58-IE64)

Bank T provides credit cards to its customers. For credit risk management purposes, T does not distinguish between the drawn and undrawn balances. The credit cards have a one-day notice period, after which T has a contractual right to cancel the credit card; however, T does not enforce this right in its day-to-day management activities, but only cancels facilities when it becomes aware of an increase in credit risk and starts to monitor customers on an individual basis. Therefore, T does not consider its exposure to credit losses to be limited to the notice period.

On the basis of historical information and experience with similar portfolios, T determines that the expected period over which it is exposed to credit losses is 30 months.

At the reporting date, the outstanding balance on the credit card portfolio is 60, and the available undrawn balance is 40. In measuring the expected credit losses, T considers its expectations about future draw-downs over the expected life of the portfolio (or over the next 12 months if there has not been a significant increase in credit risk) using its credit risk models.

T determines that the exposure at default would be 70 (comprising the drawn balance of 60 and an additional 10 from the available undrawn balance), and T uses this exposure to measure the expected credit losses on the credit card portfolio.

This example does not consider the impact on the measurement of whether there has been a significant increase in credit risk in the portfolio or part of it. For discussion of identifying significant increases in credit risk at a portfolio level, see 3.4.2.

4.4 Probability-weighted outcome

The estimate of expected credit losses reflects an unbiased and probability-weighted amount, determined by evaluating a range of possible outcomes rather than based on a best- or worst-case scenario. (IFRS 9.5.5.17(a), IFRS 9.5.5.18, IFRS 9.B5.5.41)

An entity is not required to identify every possible scenario, but the estimate should always reflect at least two scenarios:

  • the probability that a credit loss occurs, even if this probability is very low; and
  • the probability that no credit loss occurs.

IFRS 9 explains that, in practice, the requirement to consider at least two scenarios may not necessitate a complex analysis. In some cases, relatively simple modelling will be sufficient, without the need for a large number of detailed simulations of scenarios. The standard gives an example of a large group of financial instruments with shared risk characteristics, for which the average credit losses may be a reasonable estimate of the probability-weighted amount. (IFRS 9.B5.5.42)

Food for thought – Probability-weighted outcome

(IAS 39.AG86, IFRS 9.BC5.263)

IAS 39 allows the estimation process for impairment losses to result either in a single amount or in a range of possible amounts. In the latter case, the entity is required to recognise the best estimate within the range. By contrast, IFRS 9 does not allow expected credit losses to be measured using the most likely outcome or as the entity’s best estimate of the ultimate outcome; rather, it requires the measurement to reflect the probability-weighted outcome.

Food for thought – Explicit scenarios in calculating expected credit losses

(IFRS 9.B5.5.42)

IFRS 9 acknowledges that in some cases it will not be necessary to develop explicit scenarios. However, in each case, an entity will have to evaluate whether its proposed approach meets the general requirement that the loss estimate reflects an unbiased and probability-weighted amount.

4.5 Time value of money

The estimate of expected credit losses has to reflect the time value of money. The following discount rates are used to reflect the time value of money. (IFRS 9.5.5.17(b), IFRS 9.B5.5.44-48)

IFRS ref.

Type of instrument

Discount rate

IFRS 9.5.4.1(b), IFRS 9.B5.5.44

Financial assets other than POCI assets and lease receivables

The EIR determined at initial recognition or an approximation thereof (the current EIR for floating-rate financial assets)

IFRS 9.5.4.1(a), IFRS 9.B5.5.44

POCI assets

The credit-adjusted EIR determined at initial recognition (see Credit-adjusted EIR)

IFRS 9.B5.5.46

Lease receivables

The discount rate used in measuring the lease receivable in accordance with IFRS 16

IFRS 9.B5.5.47

Undrawn loan commitments

The EIR, or an approximation thereof, that will be applied to discount the financial asset resulting from the loan commitment

IFRS 9.B5.5.48

Undrawn loan commitments for which the EIR cannot be determined, and financial guarantee contracts

The discount rate that reflects the current market assessment of the time value of money and the risks that are specific to the cash flows (but only if, and to the extent that, the risks are taken into account by adjusting the discount rate instead of adjusting the cash shortfalls being discounted)

Expected credit losses are discounted to the reporting date, not to the expected default date or another date. (IFRS 9.B5.5.44)

Food for thought – Using the EIR, or an approximation thereof, for discounting

The ability under IFRS 9 to use an approximation of the EIR is a welcome simplification that will reduce the operational challenge of implementing the standard while minimising the potential effect on comparability.

Food for thought – Determining the discount rate for loan commitments

(IFRS 9.B5.5.47)

Under IFRS 9, the discount rate used to calculate the expected credit losses for a loan commitment is the EIR (or an approximation thereof) that would apply to the financial asset resulting from the loan commitment.

To calculate the EIR that would apply to the financial asset resulting from the loan commitment, an entity needs to determine what the transaction price and/or the fair value of the asset will be on initial recognition.

Determining these amounts at initial recognition may depend on whether the loan is treated as:

  • a continuation of the commitment (in which case, fair value is measured at the time of entering into the commitment); or
  • an instrument separate from the loan commitment (in which case, fair value is measured at the time when the loan is made).

IAS 39 does not specify which of the above approaches is appropriate. IFRS 9 states that, for the purpose of applying the impairment requirements, a financial asset that is recognised following a draw-down on a loan commitment is treated as a continuation of that commitment, rather than a new financial instrument – but the new standard does not specify whether a similar logic applies for the initial measurement of the gross carrying amount of the loan.

4.6 Reasonable and supportable information

4.6.1 General requirements

IFRS 9 requires the estimates of expected credit losses to reflect reasonable and supportable information that is available without undue cost or effort – including information about past events and current conditions, and forecasts of future economic conditions. Information that is available for financial reporting purposes is considered to be available without undue cost or effort. (IFRS 9.5.5.17(c), IFRS 9.B5.5.49)

The standard acknowledges that the degree of judgement required to estimate cash shortfalls depends on the availability of detailed information. As the forecast horizon increases – i.e. as the period for which an entity needs to make its estimate becomes longer – the availability of detailed information decreases, and the judgement required to estimate expected credit losses increases.

An entity is not required to forecast future conditions over the entire expected life of the financial instrument. For periods far in the future, an entity could develop projections by extrapolating the information that is available for earlier periods. (IFRS 9.B5.5.50)

An entity is not required to undertake an exhaustive search for information but needs to consider all reasonable and supportable information that is available without undue cost or effort that is relevant for the estimation. (IFRS 9.B5.5.51)

The information used should include:

  • factors that are specific to the borrower; and
  • general economic conditions, including assessment of both the current conditions and the forecast direction of the change of conditions.

The standard gives examples of the following potential data sources:

  • internal historical credit loss experience;
  • internal and external ratings;
  • the credit loss experience of other entities; and
  • external reports and statistics.

An entity reviews the methodology and assumptions used for estimating expected credit losses regularly, to reduce any differences between estimates and actual credit losses. (IFRS 9.B5.5.52)

Food for thought – Wider and more complex judgements

The judgements required under IFRS 9 may be wider and significantly more complex than under IAS 39.

Under IAS 39’s incurred loss model, the expected cash flows from an asset are estimated only once an impairment trigger has been reached. At this point, the borrower is often in financial difficulties, so the analysis focuses on the amount that can be recovered from any available assets that the borrower may have.

Under IFRS 9’s new expected credit loss model, estimates are needed for all financial assets. For assets maturing in the medium and longer term, these estimates may involve making assumptions about changes in economic conditions relatively far into the future.

At any given time, there may be a number of conflicting and equally credible views as to future economic conditions; therefore, management will have to develop robust methodologies to ensure that their conclusions are reasonable and supportable, and that judgement is applied consistently.

4.6.2 Historical information

Historical information is an important base from which to measure expected credit losses. This base is adjusted on the basis of current observable data to reflect current conditions and an entity’s forecast of future conditions during the life of the instrument.

However, in some cases the best reasonable and supportable information could be the unadjusted historical information, depending on the nature of such information and when it was calculated, compared to circumstances at the reporting date. (IFRS 9.B5.5.52)

If expected credit losses are estimated using historical credit loss experience, then information about historical loss rates has to be applied to groups that are defined in a manner that is consistent with the groups for which the historical loss rates were observed. (IFRS 9.B5.5.53)

The standard explains that estimates of changes in expected credit losses should reflect, and be directionally consistent with, changes in related observable data from period to period. Examples of such observable data are: (IFRS 9.B5.5.52)

  • unemployment rates;
  • property prices;
  • commodity prices;
  • payment status; or
  • other factors that are indicative of credit losses.

Case – Adjusting historical data to current economic conditions

Company Z has a portfolio of similar loans. Data about unemployment in Z’s region is a key factor in estimating expected credit losses for these loans. Except for certain specific past-due exposures, Z has measured impairment in the portfolio as 12-month expected credit losses.

At the reporting date, the unemployment rate in the region is 8%. However, consensus estimates available to Z at the reporting date are that the unemployment rate will increase to 11% in the next 12 months.

Accordingly, Z uses the 11% unemployment forecast in estimating expected credit losses for these loans. (Similarly, if consensus estimates were that the unemployment rate would reduce to 6%, then Z would use this data, which might cause a reduction in the loss allowance.)

In addition, Z considers whether, as a result of this forecast, the risk of default has increased such that a lifetime expected credit losses measurement is required for all, or a portion, of the portfolio (see 3.4).

4.6.3 Externally sourced information

Expected credit losses reflect an entity’s own expectations of credit losses. However, an entity should also consider observable market information about the credit risk of the particular financial instrument or similar financial instruments. (IFRS 9.B5.5.54)

Food for thought – Observable information about credit risk

(IFRS 9.B5.5.52-54)

Even though expected credit losses are an entity-specific estimation, IFRS 9 requires an entity to consider observable market information about credit risk. This may include market prices for the same or similar financial instruments.

However, when considering market information, market prices and credit spreads on financial assets do not directly yield an estimate of expected cash flows, because they include other elements – e.g. liquidity spreads or a premium for bearing the risk that credit losses may be greater than expected – and are not always observable.

Therefore, using such information in the measurement of expected credit losses may be challenging and require judgement. In addition, IFRS 9 does not define the term ‘observable’ in this context.

Food for thought – Debt instruments measured at FVOCI

(IFRS 9.B5.5.54)

Even though IFRS 9 requires an entity to consider observable market information about the credit risk of the particular financial instrument, the expected credit losses measurement for debt instruments that are measured at FVOCI is not necessarily the same as the fair value changes attributable to changes in credit risk recognised in OCI (see 10.1).

This is because expected credit losses are measured using the EIR (or an approximation thereof), rather than the market interest rate (see 4.5). Also, as noted above, expected credit losses reflect the entity’s own expectations of credit losses informed by observable market information, rather than reflecting the views of market participants.

Entities that have no, or insufficient, sources of entity-specific data are permitted to use peer group experience for comparable financial instruments (or groups of financial instruments). (IFRS 9.B5.5.51)

4.7 Collateral

The estimate of expected credit losses reflects the cash flows expected from collateral and other credit enhancements that are part of the contractual terms of the financial instrument and are not recognised by the entity separately from the financial instrument being assessed for impairment. (IFRS 9.B5.5.55)

Under IFRS 9, irrespective of whether foreclosure is probable the estimate of expected cash shortfalls on a collateralised financial asset reflects: (IFRS 9.B5.5.55)

  • the amount and timing of cash flows that are expected from foreclosure (including cash flows that are expected beyond the asset’s contractual maturity); less
  • costs for obtaining and selling the collateral.

Food for thought – Cash flows resulting from foreclosure

(IAS 39.AG84, IAS 39.IG.E4.8)

The requirement that the estimate of expected cash flows for collateralised financial assets reflects the cash flowsImpairment of financial assets that may result from foreclosure is similar to the requirements in IAS 39.

However, under IAS 39 an entity may instead elect to measure impairment with reference to the fair value of the collateral at the reporting date – i.e. in effect, viewing any future changes in fair value as being irrelevant to determining the losses incurred at the reporting date.

Under the expected credit loss model in IFRS 9, it is clearer that the focus should be on the cash flows that the entity actually expects to receive in the future. Also, because expected cash flows are a probability-weighted estimate, they include possible scenarios in which the cash flows recoverable from collateral decrease (or, where relevant, increase).

In addition, because under IAS 39, some banks elect to measure impairment with reference to the fair value of the collateral, this may be an important change for them.

Similar to IAS 39, any collateral obtained as a result of foreclosure is not recognised as a separate asset unless it meets the recognition criteria in IFRS for the relevant asset. The following example illustrates the measurement of lifetime expected credit losses on a collateralised loan. (IFRS 9.B5.5.55)

Case – Measurement of lifetime expected credit losses of a collateralised loan

(IFRS 9.IE18-IE23)

Bank K holds a collateralised loan. K determines that the credit risk of the loan has increased significantly since initial recognition – i.e. the risk of default has increased significantly. However, as the value of the collateral is significantly higher than the amount due from the loan, the LGD is very small.

Although K does not believe that it is probable that it will suffer a credit loss if a default occurs, it recognises lifetime expected credit losses for the asset. This is because a significant increase in credit risk is assessed with reference to the risk of default rather than to the LGD.

However, the amount of the loss would be very small, because the asset is expected to be fully recoverable through the collateral held under almost all possible scenarios.

4.8 Individual or collective basis of measurement

IFRS 9 does not provide general guidance as to when expected credit losses should be measured on an individual or collective basis. However, it states that if an entity does not have reasonable and supportable information that is available without undue cost or effort to measure lifetime expected credit losses on an individual basis, then it measures lifetime expected credit losses on a collective basis, by considering comprehensive credit risk information. (IFRS 9.B5.5.4)

In addition to using past-due information, this measurement should incorporate all relevant credit information – including forward-looking macro-economic information. This is required in order to approximate the result of recognising lifetime expected credit losses on an individual instrument level. (IFRS 9.B5.5.4)

To measure expected credit losses on a collective basis, financial assets are grouped on the basis of shared credit risk characteristics. For examples of shared credit risk characteristics, see 3.4.2.1. (IFRS 9.B5.5.5)

Food for thought – Collective basis of assessment vs measurement

IFRS 9.B5.5.4-6

IFRS 9 refers to collective vs individual assessment in two separate contexts:

  • when assessing whether an increase in credit risk is significant (see 3.4.2); and
  • when measuring expected credit losses.

The standard does not state that both should be done on the same basis – i.e. individual or collective – for the same instruments.

Therefore, an asset might, for example, be evaluated for a significant increase in credit risk on an individual basis, but its expected credit losses be measured on a collective basis.

For example, when an individual retail loan is more than 30 days past due (see 3.4.4), it may be considered that the credit risk on it has increased significantly, and that the lifetime expected credit losses measurement basis therefore applies.

However, expected credit losses may be measured on a collective basis as part of a portfolio using information on portfolio default rates.

4.9 Financial guarantee contracts and loan commitments

4.9.1 Financial guarantee contracts

IFRS 9 requires liabilities that result from financial guarantee contracts in its scope to be measured, after initial recognition, at the higher of: (IFRS 9.4.2.1(c))

  • the amount of the provision for expected credit losses; and
  • the amount initially recognised, less the cumulative amount of income recognised in accordance with the principles of IFRS 15.

This ‘higher of’ approach is similar to that in IAS 39, except that under IAS 39 the provision for credit losses is calculated by applying IAS 37.

Food for thought – Measurement of expected credit losses for financial guarantee contracts

When an arm’s length fee or premium for a financial guarantee is paid to the issuer in full at inception of the contract, no expected credit losses might be recognised in respect of the guarantee – either at initial recognition or subsequently – unless there are adverse developments. This is because:

  • the amount initially recognised – i.e. the fair value of the financial guarantee – will reflect lifetime expected credit losses at that time; and
  • expected credit losses on a good-quality instrument will usually decrease over time, so expected credit loss provisions calculated under IFRS 9 may generally be less than the amounts initially recognised, less the cumulative amount of income recognised under IFRS 15.

However, this may not be the case if the issuer of the guarantee is paid a fee or premium in installments over the life of the guarantee, rather than in full at inception. In this case, the fair value of the financial guarantee is likely to be zero at inception.

Even though the definition of a cash shortfall for financial guarantee contracts (see 4.2.3) includes any amounts that the entity expects to receive, it is not clear whether this also includes future premium receipts.

If they are not included, then it is likely that the amount of provision determined in accordance with IFRS 9 will always be higher than the fair value at initial recognition, which will result in the recognition of expected credit losses (and an impairment loss) at initial recognition and in subsequent periods.

This would mean that the recognition of an allowance for expected credit losses would depend on the manner in which the guarantee premium is collected.

Food for thought – Applying IFRS 15 principles to a financial guarantee contract

(IFRS 15.35)

IFRS 9 requires an entity to assess the cumulative amount of income recognised on a financial guarantee contract inImpairment of financial assets accordance with the principles of IFRS 15. The general principle in IFRS 15 is that an entity recognises revenue to depict the transfer of goods and services to the customer, at an amount that reflects the consideration that it expects to be entitled to receive from the customer.

However, IFRS 15 contains no specific guidance on how to apply this principle, or the more detailed requirements of IFRS 15, to financial guarantee contracts.

In the case of a financial guarantee contract, key practical questions are likely to include identifying the nature of the entity’s obligation under the contract and assessing when that obligation is satisfied.

There are two main possibilities under IFRS 15: an obligation may be satisfied over time (e.g. over the term of the contract) or at a point in time (e.g. on completion of the contract). If an obligation is satisfied over time, an entity identifies an appropriate method of measuring progress to complete satisfaction of the obligation.

4.9.2 Loan commitments issued with a below-market interest rate

Similar to the accounting for financial guarantee contracts, IFRS 9 retains a similar approach of measuring liabilities that result from commitments to provide a loan at a below-market interest rate after initial recognition at the higher of: (IFRS 9.4.2.1(d))

  • the amount of the provision for expected credit losses; and
  • the amount initially recognised, less the cumulative amount of income recognised in accordance with the principles of IFRS 15.

Case – Loan commitment issued with a below-market interest rate

In practice, the accounting for loan commitments that are not measured at FVTPL may be different depending onImpairment of financial assets whether the loan commitment is to provide a loan at or below a market interest rate. The following example illustrates this difference.

Below-market rate loan commitment

Company D issues a commitment to provide a loan at a below-market interest rate whose fair value on initial recognition is 10. D measures expected credit losses for the commitment at an amount equal to 12-month expected credit losses and estimates these to be 2.

On initial recognition, D records the loan commitment at its fair value of 10, which is the higher of:

  • the provision for expected credit losses of 2; and
  • the amount initially recognised (fair value of 10) less the cumulative amount of income recognised under IFRS 15 (zero, as the loan commitment has just been recognised).

No expected credit losses are recognised, because the fair value of the loan commitment is higher than the 12-month expected credit losses.

At-market rate loan commitment

Assume instead that D issued a loan commitment with an at-market interest rate for its fair value of 5, with the remaining facts unchanged. D would then record the fee received of 5 as a liability (see 11.2.1.2) and, in addition, would recognise a provision for expected credit losses of 2. This is because the specific measurement requirements for loan commitments issued with a below-market interest rate do not apply to other loan commitments issued.

Summary

This means that whether a provision for expected credit losses is recognised on a loan commitment may depend on whether the commitment is to provide a loan at or below a market interest rate.

4.10 Example of measurement of expected credit losses

IFRS 9 provides a number of illustrative examples. The following example illustrates a simple method of calculating both a 12-month expected credit loss allowance and a lifetime expected credit loss allowance.

Case – Measurement of expected credit losses

(IFRS 9.IE49-IE50)

Fact pattern

Company X originates a 10-year loan for 1,000,000. The interest is paid annually. The loan’s coupon and EIR are 5%.

Scenario 1 – Assume that recognition of 12-month expected credit losses is appropriate for this loan

Using the most relevant information available, X makes the following estimates:

  • the loan has a 12-month PD of 0.5%; and
  • the LGD – which is an estimate of the amount of loss if the loan were to default – is 25%, and would occur in 12 months’ time if the loan were to default.

The 12-month expected credit loss allowance is 1,250, which is calculated by multiplying the amount of cash flows receivable (1,050,000(a)) by the PD (0.5%) and by the LGD (25%), and discounting the resulting amount using the EIR for one year (5%).

Scenario 2 – Assume that recognition of lifetime expected credit losses is appropriate for this loan

Using the most relevant information available, X makes the following estimates:

  • the loan has a lifetime PD of 20%; and
  • the LGD is 25% and would occur on average in 24 months’ time if the loan were to default.

The lifetime expected credit loss allowance is 47,619, which is calculated as (1,050,000 / 1.05²)(b) x 20% x 25%.

Summary

The difference between calculating 12-month expected credit losses and lifetime expected credit

losses in this example comprises:

  • the different PD applied – either the 12-month PD or the lifetime PD; and
  • the timing of the losses occurring.

Other potential sources of differences include:

  • different LGDs; and
  • different exposures at default (EADs).

Notes

(a) Includes the amount of principal and interest receivable in 12 months’ time.

(b) Includes the amount of principal and interest receivable in 24 months’ time, assuming that the interest for Year 1 would be paid fully.

5 Write-offs

Under IFRS 9, the gross carrying amount of a financial asset is reduced when there is no reasonable expectation of recovery. A write-off constitutes a derecognition event. Write-offs can relate to a financial asset in its entirety, or to a portion of it. (IFRS 9.5.4.4, IFRS 9.B3.2.16(r), IFRS 9.B5.4.9)

Although write-offs do not have an impact on profit or loss – because the amounts written off are reflected in the loss allowance – the standard notes that a definition of ‘write-off’ is needed to faithfully represent the gross carrying amount and for disclosure purposes. (IFRS 9.BC5.81)

Food for thought – Derecognition of financial assets when a write-off event occurs

(IAS 39.63)

IAS 39 does not prescribe when the gross carrying amount of a financial asset should be reduced, other than under the general derecognition rules. Also, IAS 39 allows entities that do not use a loss allowance account to reduce the carrying amount of the asset directly to reflect impairment.

IFRS 9 changes this by requiring the use of a loss allowance account and the derecognition of the portion of an asset when the write-off criterion is met. In our experience, many entities – in particular, banks – carry loss allowance accounts and use write-off criteria similar to those described in IFRS 9.

Accordingly, for these entities, implementing the new requirements may not lead to a significant change in existing practice. However, some banks have write-off criteria that are different from those in IFRS 9 – e.g. based on local legal requirements – and may therefore be impacted more by the new guidance on write-offs.

Food for thought – Write-off of a portion of an asset

(IFRS 9.3.2.2, IFRS 9.B3.2.16(r), IFRS 9.B5.4.9)

IFRS 9 identifies a write-off as a derecognition event. It also explains that write-offs can relate to a financial asset in its entirety, or to a portion of it. As regards derecognition of a portion of an asset, under the general derecognition provisions of the standard, a part of a financial asset (rather than the whole asset) can be derecognised only if it comprises specifically identified cash flows or a fully proportionate share of the cash flows.

The standard provides the following example, which demonstrates a write-off that relates to a portion of an asset.

Case – Write-off of a portion of an asset

(IFRS 9.B5.4.9)

Company R holds a collateralised financial asset and plans to foreclose the collateral.

R expects to recover no more than 30% of the financial asset from the collateral. R has no reasonable prospects of recovering any further cash flows from the financial asset. Therefore, it writes off the remaining 70% of the financial asset.

Food for thought – Recovery of a written-off asset

(IFRS 9.5.5.4)

IFRS 9 does not discuss:

  • whether a subsequent recovery should be accounted for as the recognition of a new financial asset;
  • when a recovery should be recognised – e.g. on a change in the lender’s expectations, or on the receipt of cash; or
  • how a recovery should be reflected in profit or loss.

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Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets

Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets

Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets

Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets

Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets Impairment of financial assets

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