Loan commitments are firm commitments to provide credit under pre-specified terms and conditions. One major tool to finance corporations is via credit line commitments. These are short term credit lines that firms can withdraw from their banks, up to a certain, predetermined ceiling, at a certain cost, usually above the interest rate on long term credit. The credit lines serve corporations to finance, usually, short term financial needs, when cash outflows are greater than cash inflows. Also, credit lines are used as a buffer against unexpected short term gaps as well as to take advantage of unexpected investment opportunities. Thus, loan commitments can be employed defensively as well as offensively by the corporations.
Most companies keep cash, or liquid reserves to serve their immediate needs and provide a buffer for future potential uses. The two common forms to safeguard liquidity is first, by keeping enough liquid reserves, or, second, by signing a credit line, or loan commitment agreement.
The following loan commitments are within the scope of IFRS 9: [IFRS 9 2.3]
- loan commitments that the entity designates as financial liabilities at fair value through profit or loss (see Fair value option for financial liabilities). An entity that has a past practice of selling the assets resulting from its loan commitments shortly after origination shall apply IFRS 9 to all its loan commitments in the same class.
- loan commitments that can be settled net in cash or by delivering or issuing another financial instrument. These loan commitments are derivatives. A loan commitment is not regarded as settled net merely because the loan is paid out in installments (for example, a mortgage construction loan that is paid out in installments in line with the progress of construction).
- commitments to provide a loan at a below-market interest rate. [IFRS 9 4.2.1 (d)] An issuer of such a commitment shall (unless the recognised liability will be measured at fair value [IFRS 9 4.2.1 (a)]) subsequently measure it at the higher of:
Loan commitments that are not otherwise in the scope of IFRS 9
IAS 37 Provisions, Contingent Liabilities and Contingent Assets fully applies to all loan commitments that were not in the scope of IAS 39, because loan commitments were taken into the scope of IFRS 9. Conversely, the IFRS 9 impairment requirements apply to loan commitments that are not measured at fair value through profit or loss (FVPL). This is because commitments to provide a loan at a below market interest rate and loan commitments that are derivatives (hence, classified as measured at FVPL) or designated at FVPL are already otherwise included in the scope of IFRS 9 and being valued at FVPL already ensures valuation at market, including impairments. (IFRS 9 2.3)
Present contractual obligation
The IASB believe that expected credit losses of obligations to extend credit (off balance sheet exposures) are similar to those of loans and other on balance sheet exposures. The only difference is that, in the latter case, the borrower has already drawn down the loan whereas in the former case it has not. The recognition of a liability for expected credit losses was limited to loan commitments and financial guarantee contracts with a present contractual obligation to extend credit. Without a present contractual obligation to extend credit, an entity may withdraw its loan commitment before it extends credit.
Consequently, the IASB concluded that a liability does not exist for loan commitments or financial guarantee contracts when there is no present contractual obligation to extend credit.
- The three-stage expected credit loss model also applies to these off-balance sheet financial commitments
- An entity considers the expected portion of a loan commitment that will be drawn down within the next 12 months when estimating 12 month expected credit losses (stage 1), and the expected portion of the loan commitment that will be drawn down over the remaining life the loan commitment (stage 2)
- For loan commitments that are managed on a collective basis, an entity estimates expected credit losses over the period until the entity has the practical ability to withdraw the loan commitment.
Because loan commitments and financial guarantee contracts are unfunded, the effective interest method and, hence, an effective interest rate, would not be applicable. This is because the IASB considered that those financial instruments by themselves, before they are drawn down, do not give rise to the notion of interest and that, instead, their cash flow profiles are akin to that of derivatives.
The fact that interest revenue does not apply is reflected in the accounting for loan commitments and financial guarantee contracts within the scope of IFRS 9. For those loan commitments and financial guarantee contracts, revenue recognition of the related fee income does not use the effective interest method. Consequently, the IASB did not consider it appropriate to simply extend the requirements for the discount rate for measuring expected credit losses that arise from financial assets to the requirements for the discount rate for measuring expected credit losses that arise from loan commitments and financial guarantee contracts.
Comparision table – Expected credit losses measurement
|Financial assets measured at amortised cost or at fair value through other comprehensive income||Loan commitments||Financial guarantee contracts|
|Date of initial recognition in applying the
|Trade date||Date that an entity becomes a party to the irrevocable commitment||Date that an entity becomes a party to the irrevocable commitment|
|Period over which to estimate ECLs||The maximum contractual period (including extension options) over which the entity is exposed to credit risk and not a longer period.||The maximum contractual period over which an entity has a present contractual obligation
to extend credit However, for revolving credit
facilities, this period extends beyond the contractual period over which the entity is exposed to credit risk and the ECLs would not be mitigated by credit risk management actions
|The maximum contractual period over which an entity has a present contractual obligation to extend credit|
|Cash shortfalls in measuring ECLs||Cash shortfalls between the cash flows that are due to an entity in accordance with the contract and the cash flows that the entity expects to receive.||Cash shortfalls between the contractual cash
flows that are due to the 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
|Cash shortfalls are the expected payments to
reimburse the holder for a credit loss that it incurs less any amounts that the entity (issuer) expects to receive from the holder, the debtor or any other party
|EIR used in discounting ECLs||The EIR is determined or approximated at initial recognition of the financial instrument||The EIR of the resulting asset will be applied and if this is not determinable, then the current rate representing the risk of the cash flows is used||The current rate representing the risk of the cash flows is used|
|Assessment of significant increases in credit risk||An entity considers changes in the risk of a default occurring on the financial asset||An entity considers changes in the risk of a default occurring on the loan to which a loan commitment relates||An entity considers the changes in the risk that the specified debtor will default on the contract|
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