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
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:
- 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/Indicators |
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/Indicators |
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
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 |
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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 definedBecause 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 riskVarious 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 dueIFRS 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 indicatorsRisk 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
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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
Ways to improve the provision matrix approach (in addition to ones mentioned above) are: Impairment of investments and loans
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 |
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External (Market) Indicators
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:
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:
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. |
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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
The measurement model should reflect the following considerations:
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See also: ECL
Impairment of investments and loans
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