Loss allowance is an approach for the prudence or conservatism principle. Assets should not be overstated, liabilities not understated. Better save, than sorry!
The term ‘Loss allowance’ covers allowances recorded against the following financial assets:
- The allowance for expected credit losses on financial assets measured at amortised costs (in accordance with IFRS 9 paragraph 4.1.2), lease receivables and contract assets,
- the accumulated impairment amount for financial assets measured at fair value through other comprehensive income (in accordance with IFRS 9 paragraph 4.1.2A) and
- the provision for expected credit losses on loan commitments and financial guarantee contracts.
However, there are more assets in the balance sheet than only financial assets. An other asset subject to assessment of the need for a loss allowance is inventory (see below). But be aware: every asset needs to be assessed against the question whether the carrying amount in the balance sheet will be recovered by the receipt of cash or other ways of settlement or the question whether an asset arises from applying the accrual accounting concept, such as prepaid expenses. These are cleared by expensing them to profit or loss to the period they relate to.
Trade receivables without financing component
For trade receivables or contract assets that do not contain a significant financing component, the loss allowance should be measured at initial recognition and throughout the life of the receivable at an amount equal to lifetime ECL. As a practical expedient, a provision matrix may be used to estimate ECL for these financial instruments.
Trade receivables with financing component
For trade receivables or contract assets which contain a significant financing component in accordance with IFRS 15 and lease receivables, an entity has an accounting policy choice: either it can apply the simplified approach (that is, to measure the loss allowance at an amount equal to lifetime ECL at initial recognition and throughout its life), or it can apply the general model.
Debt instruments and other non-equity financial assets under IFRS 9 that are not measured at FVPL are assessed for impairment using an expected credit loss model. The expected credit loss model is intended to reflect the pattern of deterioration or improvement in the credit quality of the financial instrument. Expected credit losses are measured through a loss allowance equal to credit losses expected in the upcoming 12-month period plus the expected credit losses for the full lifetime if the credit risk has significantly increased since initial recognition.
IFRS 9 General model
Under IFRS 9’s general impairment model, the way in which the allowance for expected credit losses is calculated changes as the credit risk of a financial instrument deteriorates significantly.
The loss allowance is generally measured at 12-month expected credit losses if, at the reporting date, its credit risk has not increased significantly since initial recognition. This also applies if credit risk has increased significantly but:
- the company has chosen to apply the ‘low credit risk’ operational simplification; and
- the absolute level of credit risk is low.
Otherwise, if credit risk has increased significantly since initial recognition, the credit loss allowance is measured at lifetime expected credit losses.
Inventory loss allowance
Like many other assets, inventory is recorded and reported at cost in accounting books following historical cost principle following a certain cost flow assumption either first-in-first-out (FIFO), last-in-first-out (LIFO), average costs (AVCO) or other methods. Under IFRS ONLY FIFO is allowed. LIFO and AVCO are either allowed under some local GAAP for smaller business and/or used for fiscal returns (to facilitate a prudent leverage of corporate income taxes.
Another way of measuring inventory value is based on net realizable value (NRV).
Under normal circumstances, cost of inventory is always lesser than the net amount business can earn by selling the inventory, called net realizable value (NRV). Common sense dictates that cost has to be lesser than NRV to make profit. But following a concept of conservatism, even if NRV is higher than cost, value of inventory is kept at cost and gain is not recognized until the inventory actually sells.
However, if NRV of inventory falls below the cost of inventory, following the same concept of conservatism, entity must write down the value of inventory to the amount that can be realized. Hence the recognition of loss to the extent expenditure on inventory are not expected to be recovered. It does not make sense to report an asset at any value higher than the amount it can recover and may overstate the assets materially. Therefore, entity must switch to NRV basis from historical cost basis of measurement if recoverable amount falls below cost of asset.
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