IFRS 9 ECL Model best read – Impairment of investments and loans

Impairment of investments and loans

is about impairment in a ‘normal’ business not complicated accounting but straightforward accounting calculations.

Normal operations

Although the focus for IFRS 9 Financial Instruments is on financial institutions such as banks and insurance companies, ‘normal’ operating entities are also affected by IFRS 9. Maybe their investment and loan portfolios are less complex but in operating a business and as part of the internal credit risk management practice policy making it is still important to implement the impairment model under IFRS 9 Financial Instruments.

The objective of these approaches to expected credit losses or timely recording of impairments/loss allowances is to provide approaches that result in a situation in which very different reporting entities all can record estimates as objectively as possible. And in general record more prudent loss allowances than under IAS 39.

Impairment not in IFRS 9 Financial instruments

Impairment in IFRS 9

Impairment not in IFRS 9

Debt instruments measured at amortised cost or at fair value through other comprehensive income – includes inter-company loans, trade receivables, contract assets and debt securities.

Financial guarantee contracts – including intra-group financial guarantee contracts

Lease receivables

Equity investments

Other financial instruments measured at fair value through profit or loss, such as derivatives

New impairment model

IFRS 9 introduced a new impairment model based on expected credit losses, resulting in the recognition of a loss allowance before the credit loss is incurred. Under this approach, entities need to consider current conditions and reasonable and supportable forward-looking information that is available without undue cost or effort when estimating expected credit losses. IFRS 9 sets out a ‘general approach’ to impairment. However, in some cases this ‘general approach’ is overly complicated and some simplifications were introduced.

The 7 Steps for impairment

Take the following steps to administrate your policy for accounting for impairments of financial assets. Impairment of investments and loans

Impairment of investments and loans

The decision tree starts with Step 1 Define default, see below.

Step 1 Define Default

You have to do it, there is no definition of ‘Default’ in IFRS. That provides entities the room to tailor the definition to their internal credit risk management practices and consider qualitative indicators of default in addition to days past due.

IFRS 9 includes a rebuttable presumption that default does not occur later than 90 days past due date of the asset unless the reporting entity has reasonable and supportable information to corroborate a more lagging default criterion.

Logical examples of qualitative indicators of default include:

  • credit worthiness of the counterparty and more importantly negative changes therein,
  • initiation of bankruptcy proceedings, although you might consider this to be recognised too late, the good or service has already been transferred,
  • breaches of covenants.

Be aware defining ‘Default’ is not science, it is a judgmental and subjective assessment of the financial fitness of an investment and loan portfolio, a single investment or a single loan.

Use a multi-criteria model for default risk assessment of counterparties, that incorporates value judgments and dealing with qualitative aspects. And it is more about the change in indicators over time than in just the current status of an indicator, is is getting worse, are only a few indicators getting worse and what is the answer you are receiving on questions after new orders are boarded.

Default assessment decisions are usually based on four types of information:FXX

  • information of a commercial nature, related to the supplier-customer’s relationship history;
  • information of a financial nature, quantitatively assessed through some indicators;
  • information related to the customer’s management; and
  • information which mitigates the default risk (collateral and other guarantees).

Example:

On December 31, 2018, Entity A determines the credit risk of the loan has not increased significantly since initial recognition.

Entity A estimates that the loan has a 10% probability of default in the next 12 months.

Entity A calculates that $50 will be lost if the loan defaults. The $50 is calculated as the present value of the cash shortfalls expected over the life of the instrument if the default occurs in the next 12 months. The expectation is based on past experience updated for current conditions and forward-looking information.

12-month ECLs = $5 ($50 × 10%) which are the ECLs that result from default events on a financial instrument that are possible within the next 12 months. Impairment of investments and loans

2018 interest revenue = $30 (3% × $1,000) which is based on the effective interest rate applied to the gross carrying amount (which is the amortized cost before adjusting for any loss allowance). Impairment of investments and loans

Step 1 a Indicators of a possible default

Descriptions of indicators of a possible default are classified in three groups: Impairment of investments and loans

  • the usual financial ratios derived from financial statements,
  • market criteria, such as market conditions, the customer’s positioning and adaptability, and
  • management criteria, such as management’s experience and its behavior towards stakeholders and the society in general.

Such indicators need to be rated by management for customers according to an usual categorical scale of the type: poor, fair, good, very good and excellent (poor default risk being the worst rating). Impairment of investments and loans

In reviewing a chosen set of indicators the changes in the indicator and its trend (favorable or unfavorable change) over time is paramount, not only its current status. Using the trend can facilitate a forward looking approach. Impairment of investments and loans

Examples of financial criteria used in assessing default risks are: Impairment of investments and loans

Financial criteria

Descriptions/IndicatorsTime

Cash

Operating sources of cash, operating uses of cash

Quick ratio

(Current assets -/- Inventories) / (Current liabilities -/- short term portion of long term financing)

Required financing period

Days Trade receivables outstanding +/+ Days inventory held -/- Days Trade payables outstanding

Times interest earned ratio

EBIT / Interest payments

Examples of market criteria used in assessing default risks are: Impairment of investments and loans

Market criteria

Descriptions/IndicatorsCosts

Dependence on portfolio of customers and suppliers

Concentration of customers and suppliers

Placement

Dependence on distribution channel and cunsumer choices

Production flexibility

Capacity of production progress to face market changes

Technology and innovation

Technological sophistication

Examples of management criteria used in assessing default risks are: Impairment of investments and loans

Management criteria

Descriptions/Indicators

Timely and reliable reporting

Existence of regular and reliable information

Performing behavior with respect to investments and loans granted

Historical loan credit records

Experience and past performance

Historical information on managers’ previous successes and failures (or lack thereof)

Commitment and skills of the management team

Stability and appropriateness of management skills and choices for the specific businesses

After defining ‘Default’ go to Step 2 Decide to apply the general or simplified approach, see below. Impairment of investments and loans

Step 2 Decide to apply the general or simplified approach

Under IFRS 9 entities apply one of the following two approaches in recognising and measuring ECL:

  • the general approach, mainly for debt securities, intercompany loans and financial guarantee contracts, or
  • the simplified approach, mainly for lease receivables and certain trade receivables and contract assets (with or without a significant financing component) recognised in accordance with IFRS 15. Impairment of investments and loans

In summary the two approaches applied look like this. Impairment of investments and loans

Impairment of investments and loans

Continue to go to either use the IFRS 9 General Approach ECL or use the IFRS 9 Simplified Approach ECL. Impairment of investments and loans

IFRS 9 General approach ECL
IFRS 9 Simplified approach ECL

Step 3 Define ‘Significant increase in Credit Risk’

The assessment of a significant increase in credit risk is paramount in determining when to switch between 12-month Expected Credit Losses (ECL) and the lifetime ECL basis.

This assessment is conducted each reporting date and entails consideration of changes in the risk of default occurring over the expected life of the financial instrument, rather than changes in the amount of ECL (ie the magnitude of loss) if the default were to occur.

Significant increase in credit risk not defined

Because of the judgmental and subjective process of measuring expected credit losses, IFRS 9 does not define ‘significant increase in credit risk’ and the reporting entity has to define this criterion in the context of its specific types of instruments and business environment.

Assessment of significant increase in credit risk

Various approaches may be applied in assessing whether there has been a significant increase in credit risk for investments or loans.

In general significant increase in credit risk, in the context of IFRS 9, is a significant change in the estimated Default Risk (over the remaining expected life of the financial instrument).

Use a multi-criteria model for default risk assessment of counterparties, that incorporates value judgments and dealing with qualitative aspects. And it is more about the change in indicators over time than in just the current status of an indicator, is is getting worse, are only a few indicators getting worse and what is the answer you are receiving on questions after new orders are boarded.

Ultimately the approach may vary according to the level of sophistication of the entity, the financial instrument and the availability of data. In many cases, qualitative and non-statistical quantitative information may be sufficient for the impairment assessment. In other cases a statistical model or credit rating process may be used. Alternatively a mixture of quantitative and qualitative information may also be relevant, see Step 1 on the identified examples of financial, market and management criteria. Consider developing an indicator-based approach to timely assess significant increase in credit risk of customers as part of the entity’s internal credit risk management practices.

30 days past due

IFRS 9 includes a rebuttable presumption that the condition for recognising lifetime ECL is met when payments are more than 30 days past due unless the reporting entity has information that is more forward-looking than data about past due payments (available without undue cost or effort), then that information needs to be considered and the entity cannot solely rely on past-due data.

Risk increase indicators

Risk Indicators the can establish whether there has been a significant increase in credit risk vary considerably depending on the nature of the borrower, the product type, internal management methods and external market resources.

Elements to Consider

The following lists provide some examples:

Internal (Management) Indicators
  • Significant changes in internal price indicators of credit risk (the credit spread / premium that would be charged currently for similar risk)
  • Other changes in the rates of terms of an existing financial instrument that would be significantly different if the instrument was newly originated
  • Significant changes in external market indicators of credit risk for a particular financial instrument or similar financial instruments with the same expected life
  • Changes in the entity’s credit management approach in relation to the financial instrument; ie based on emerging indicators of changes in the credit risk of the financial instrument, the entity’s credit risk management practice is expected to become more active or to be focused on managing the instrument, including the instrument becoming more closely monitored or controlled, or the entity specifically intervening with the borrower

Step 6 Apply provision matrix?

For trade receivables, a reporting entity can use a provision matrix as a practical expedient for measuring Expected Credit Losses (ECL).

An example is as follows:

Company T has a portfolio of trade receivables of EUR 30,000 at the reporting date. None of the receivables includes a significant financing component (otherwise these would have to be excluded from the matrix calculation, since there is a reward included in such instruments). T operates in one geographic region and has a large number of small customers. This immediately leads to possibilities to sophisticate the provision matrix, different provision matrices may be used for different countries, geographic regions, thresholds in the size of the outstanding amount, turnover days of each receivable, etcetera. Impairment of investments and loans

T uses a provision matrix to determine the lifetime ECL for the portfolio. It is based on T’s historical observed default rates, and is adjusted by a forward-looking estimate that includes the probability of a worsening economic environment within the next year. At each reporting date, T updates the observed default history and forward-looking estimates. Impairment of investments and loans

Aging of receivables

Expected credit loss

Trade receivable (EUR)

Impairment allowance (EUR)

Current

0,5%

15.000

75

1- 30 days past due

2,2%

7.500

165

31 – 60 days past due

2,7%

4.000

108

61 – 90 days past overdue

4,5%

2.500

112

Over 90 days past due

10,0%

1.000

100

Total

30.000

560

Ways to improve the provision matrix approach (in addition to ones mentioned above) are: Impairment of investments and loans

  • consider to segment trade receivables based on common risk categories, for example:
    • geographical region,
    • product type sold,
    • internal customer rating,
    • collateral or trade credit insurance,
    • type of customer, such as wholesale or retail,
  • Gather historical loss information by age band for an acceptable period for each segment (for example 3 – 5 years),
  • Adjust any historical losses that are not representative of future credit losses, for example write offs due to billing system errors, discounts or rebates,
  • Compute preliminary average historical loss rate by age band,
  • Adjust the preliminary average historical loss rate:
    • to incorporate all reasonable and supportable information about current conditions of the debtors and the general economic conditions, and
    • for reasonable and supportable forecasts of future macro-economic indicators that the (group of) financial instruments are sensitive to for example:
      • unemployment rates,
      • GDP Impairment of investments and loans
      • property prices,
      • commodity prices,
      • payment status, or
      • other factors that are indicative of credit losses.
    • Consider if specific allowance on an individual basis should be made for any receivables where specific information is available. Apply the adjusted loss rate to the remaining balances (excluding low credit rated receivables and specifically impaired receivables) on a collective basis in each segment.

After ‘Applying the provision matrix’ you can go to Step 7 Measure Expected credit losses or go back to Step 3 Define ‘significant increase in credit risk’ to use the General approach to other financial assets. Impairment of investments and loans Impairment of investments and loans

  • Expected changes in the loan documentation including an expected breach of contract that may lead to covenant waivers or amendments, interest payment holidays, interest rate step-ups, requiring additional collateral or guarantees, or other changes to the contractual framework of the instrument
  • Past due information Step 3 Define significant increase in credit risk
  • Significant increases in credit risk on other financial instruments of the same borrower. Step 3 Define significant increase in credit risk
  • Significant changes in the expected performance and behaviour of the borrower, including changes in the payment status of borrowers in the group (for example, an increase in the expected number or extent of delayed contractual payments or significant increases in the expected number of credit card borrowers who are expected to approach or exceed their credit limit or who are expected to be paying the minimum monthly amount)
  • A significant change in the quality of the guarantee provided by a shareholder (or an individual’s parents) if the shareholder (or parents) have an incentive and financial ability to prevent default by capital or cash infusion.
  • Significant changes, such as reductions in financial support from a parent entity or other affiliate or an actual or expected significant change in the quality of credit enhancement, that are expected to reduce the borrower’s economic incentive to make scheduled contractual payments. Credit quality enhancements or support include the consideration of the financial condition of the guarantor and/or, for interests issued in securitisations, whether subordinated interests are expected to be capable of absorbing expected credit losses (for example, on the loans underlying the security).
External (Market) Indicators
  • Credit spreads Step 3 Define significant increase in credit risk
  • Credit default swap prices for the borrower
  • Length of time (duration) or the extent (degree) to which the fair value of a financial asset is less then the amortized cost
  • Other market information related to the borrower
  • Significant change in the value of the collateral supporting the obligation or in the quality of third-party guarantees or credit enhancements, which are expected to reduce the borrower’s economic incentive to make scheduled contractual payments or to otherwise have an effect on the probability of a default occurring. For example, if the value of collateral declines because house prices decline, borrowers in some jurisdictions have a greater incentive to default on their mortgages.
  • Actual or expected significant downgrade in an external credit rating
  • Existing or forecast adverse changes in business, financial or economic conditions that are expected to cause a significant change in the borrower’s ability to meet its debt obligations, such as an actual or expected increase in interest rates or an actual or expected significant increase in unemployment rates
  • An actual or expected significant adverse change in the regulatory, economic, or technological environment of the borrower that results in a significant change in the borrower’s ability to meet its debt obligations, such as a decline in the demand for the borrower’s sales product because of a shift in technology.
  • Actual or expected significant internal credit rating downgrade or decrease (worsening) in behavioral scoring used to assess credit risk internally
  • Actual or expected significant change in the operating results of the borrower. Examples include actual or expected declining revenues or margins, increasing operating risks, working capital deficiencies, decreasing asset quality, increased Balance Sheet leverage, liquidity, management problems or changes in the scope of business or organisational structure (such as the discontinuance of a segment of the business) that results in a significant change in the borrower’s ability to meet its debt obligations.

Next step 4: Define low credit risk, see below

Step 4: Define ‘low credit risk’

An entity may assume that credit risk has not increased significantly if a loan or receivable is determined to have a ‘low credit risk’ profile at the reporting date; e.g., the risk of default is low (i.e. not a poor default risk rating), 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 ability of the borrower to fulfill its contractual cash flow obligations.

IFRS 9 introduces an exception to the general model in that, for “low credit risk” exposures, entities have the option not to assess whether credit risk has increased significantly since initial recognition. It was included to reduce operational costs for recognising lifetime expected credit losses on financial instruments with low credit risk at the reporting date.

Although use of the low-credit-risk exemption is provided as an option in IFRS 9, the IASB Committee expects that use of this exemption should be limited. In particular, it expects banks to conduct timely assessment of significant increases in credit risk for all lending exposures. In the Committee’s judgment, use of this exemption by banks for the purpose of omitting the timely assessment and tracking of credit risk would reflect a low-quality implementation of the ECL model and IFRS 9.

In order to achieve a high-quality implementation of IFRS 9, any use of the low-credit-risk exemption must be accompanied by clear evidence that credit risk as of the reporting date is sufficiently low that a significant increase in credit risk since initial recognition could not have occurred.

According to IFRS 9 B5.5.22, the credit risk on a financial instrument is considered low if:Step 4 Define low credit risk

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

An example of a loan that has a low credit risk is one that has an external “investment grade” rating. An entity may use internal credit ratings or other methodologies to identify whether an instrument has a low credit risk, subject to certain criteria.

The low credit risk exemption will be a useful simplification for debt securities that are rated externally because entities can apply investment ratings provided by Moody’s (equivalent to or better than Baa3) or Standard & Poor’s or Fitch (equivalent to or better than BBB-).

The instrument must be considered to have low credit risk from a market participant’s perspective.

For low risk credit instruments, it is assumed that credit risk has not increased significantly at each reporting date.

This means that only 12-month expected credit losses will be recorded for these financial instruments.

The low credit risk simplification is not meant to be a bright-line trigger for the recognition of lifetime ECL. Instead, when credit risk is no longer low, management should assess whether there has been a significant increase in credit risk to determine whether lifetime ECL should be recognized.

This means that just because an instrument’s credit risk has increased such that it no longer qualifies as low credit risk, it is not automatically included in Stage 2, Management needs to assess if a significant increase in credit risk has occurred before calculating lifetime ECL for the instrument.

After defining ‘Low credit risk’ go to Step 5 Allocate receivables to high and low credit risk, see below

Step 5 Allocate receivables to high and low credit risk

Low credit risk receivables are not going to be individually assessed for impairment,

only the higher than low credit risk receivables will be included individually in the measurement of Expected Credit Losses.

In making a multi-criteria model for default risk assessment of counterparties more credit risks rates could be used, providing a possibly more accurate measurement of the Expected Credit Losses, however such a model can easily become too complicated to understand and as a result become susceptible to manipulation. The model could be improved for example by using an usual categorical scale of the type of credit risk: poor, fair, good, very good and excellent (poor credit risk being the worst rating).

However keep in mind this is an estimation process, inherently judgmental and subjective. Step 5 Allocate receivables to high and low credit risk

Use established credit limits for higher risk receivables

Credit-granting companies establish their credit limits based on factors that represent their own set of unique circumstances, policies, conditions, etc. No two companies are the same and no two sets of policy are the same. Some factors to be considered are:

  • Competition. In this method, the amount of the credit limit is determined by matching the amount (or average amount) granted by like or similar competitors. Outside reports and other credit information sources are used to identify competitive limits. If the creditor is not the same size as comparable competitors or plays a distinctly different supply role (much larger or smaller), it will be difficult to establish reasonable credit limits using this method.
  • By Formula. In this method, several calculations are made and averaged to determine the credit limit to be assigned to the customer. Key financial data, such as net worth, inventory, current assets and/or net working capital are used, assuming the customer accommodates the credit grantor’s request for information. These data items are divided by the number of creditors to determine the amount per creditor. Amounts are then averaged to set the credit limit. It may be difficult to obtain an accurate estimate of the number of creditors. This method is often used to calculate a preliminary estimate and is then further developed by one or more of the other methods.
  • Payment Record. The credit limit can fluctuate depending on the customer’s ability to pay on terms. This has the advantage of making credit decisions more routine, unless the customer does not pay on time, when a more detailed credit review process would be triggered. This type of limit encourages additional sales and is popular with sales staff.
  • Payment Performance. This popular method adopts a conservative risk management approach and rewards new customers as they continue to do business with the company. This is often used when little payment history is available. While limiting the company’s exposure, it does limit the speed at which sales can grow.
  • Period of Time. Purchases made over a specific period of time, such as a week or month, cannot exceed the credit limit. This is useful in cases where many shipments may be made to a customer from various company locations. Orders can be approved in a more routine manner using this method, as long as the overall credit provided does not exceed the credit limit.
  • Expectation of Use. Sometimes referred to as requirements, this method sets a credit limit based on the expected dollar volume of credit sales over a period of time (i.e., a year). This figure is then divided by the number of orders expected throughout the year to estimate the credit limit. This method, like the formula method, is often used to obtain a preliminary estimate that can be defined further by one or more of the other methods.
  • Agency Scoring and Ratings. This method may be used for new or existing customers to assess risk and determine credit limits. Here are details of NTCR and D&B rating guidelines.

Example

See an excerpt from the financial statements of Vodafone for 2018.

Vodafone FS 2018 Judgments and estimations

After ‘Allocating receivables to high and low credit risk’ go to Step 7 Measure Expected credit losses, below.

Step 7 Measure Expected credit losses

The measurement of Expected Credit Losses is inherently difficult, subjective and judgmental, in particular if the receivable is not rated or no market observable information is available. The measurement of Expected credit losses has to be carefully documented in the (period) financial close, which includes working sheets on each step in this process. The content may look as follows: Impairment of investments and loans

  1. Introduction Impairment of investments and loans
    1. Measurement date and purpose (Annual Financial Statements financial close, Interim period financial close, Consolidation return financial close or ….) Impairment of investments and loans
    2. Industry characteristics, Impairment of investments and loans
    3. Relevant historical data (updated each year), Impairment of investments and loans
  2. The measurement of expected credit losses Impairment of investments and loans
    1. Definition of default, substantiated with industry and/or company data,
    2. Decision on using the general or simplified approach (or both) including data analysis of the recent history to-date and outlook for the near future, Impairment of investments and loans
      1. The simplified approachProvision matrix calculation including two or three years/periods of comparable calculations,
      2. The general approach – Definition of significant increase in credit risks including data analysis of the recent history to-date, outlook for the near future, and previous definitions (or if the same definition but only updated data, state the latest revision date),
      3. Definition of low risk receivables/financial assets including data analysis of the recent history to-date, outlook for the near future, and previous definitions (or if the same definition but only updated data, state the latest revision date),
      4. Allocation of low and higher risk receivables, data build up with comparison of latest revision (including latest revision date),
      5. Measurement of expected credit losses for the higher than low risk receivables/financial assets including data analysis of the recent history to-date and outlook for the near future, Impairment of investments and loans
  3. Review and conclude Impairment of investments and loans
    1. on the correctness of the documentation in the previous chapters and
    2. on the reflection on the below considerations. Impairment of investments and loans
  4. Sign offs and date of completion Impairment of investments and loans

The measurement model should reflect the following considerations:

Key considerations

Possible actions

An unbiased and probability-weighted amount

Estimate should 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.

Consider using average historical credit losses for a large group of similar financial assets or historical default rates implied by credit default spreads, bond spreads of the counterpart or a comparative peer group exposure as a reasonable estimate of the probability-weighted amounts.

The time value of money

Apply an appropriate discount rate:
  • Financial assets other than credit impaired financial assets and lease receivables: Apply the effective interest rate (EIR) determined on initial recognition or an approximation thereof,
  • Lease receivables: Apply discount rate used in measuring lease receivables in accordance with IFRS 16,
  • Financial guarantee contracts: Apply the discount rate that reflects the current market assessment of the time value of money and the risk that are specific to the cash flows, but only if, and to the extent that, risks are taken into account by adjusting the discount rate instead of adjusting the cash flows that are being discounted.

Consider estimating an average rate that would approximate the effective interest rate (EIR) to discount the expected losses.

Reasonable and supportable information that is available without undue costs or effort

  • The estimates of ECL are required to reflect reasonable and supportable information that is available without undue costs 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 typically considered to be available without undue costs or effort.

 

 

Loan receivable classification and measurement

  • Consider if the information on historical loss experience, current conditions, and forecasts of future economic conditions is reasonable and supportable information and is available without undue cost or effort,
  • Consider data sources such as:
    • internal historical credit loss experience,
    • internal and external ratings,
    • the credit loss experience of other companies, and
    • external reports and statistics,
  • If no information or insufficient sources of entity-specific data is available, then use experience from similar financial instruments,
  • For periods far in the future, consider availability of detailed information by for example extrapolating the information that is available from earlier periods,
  • Adjust historical information based on current observable data to reflect conditions and forecast of future conditions by considering that the (group of) financial instruments, using:
    • unemployment rates,
    • GDP
    • property prices,
    • commodity prices,
    • payment status, or
    • other factors that are indicative of credit losses.
Something else -   Fair value option

See also: ECL

Impairment of investments and loans

Impairment of investments and loans Impairment of investments and loans Impairment of investments and loans Impairment of investments and loans Impairment of investments and loans Impairment of investments and loans Impairment of investments and loans Impairment of investments and loans Impairment of investments and loans Impairment of investments and loans Impairment of investments and loans

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Something else -   Commitments in financial statements

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