Purchased and originated credit-impaired financial assets – IFRS 9 Best Read

Purchased and originated credit-impaired financial assets

Purchased and originated credit-impaired financial assets are those for which one or more events that have a detrimental impact on the estimated future cash flows have already occurred. If these financial assets had been originated or purchased before becoming credit impaired, they would be in Stage 3 and lifetime expected losses would be recognised.

Purchased and originated credit-impaired financial assetsIndicators that an asset is credit-impaired would include observable data about the following events:

  • Significant financial difficulty of the issuer or the borrower
  • Breach of contract,
  • The lender has granted concessions as a result of the borrower’s financial difficulty which the lender would not otherwise consider,
  • It is becoming probable that the borrower will enter bankruptcy or other financial reorganisation,
  • The disappearance of an active market for that financial asset because of financial difficulties,
  • The financial asset is purchased or originated at a deep discount that reflects the incurred credit losses.

It may not be possible to identify a single discrete event. It could be the combined effect of several events may have caused financial assets to become credit-impaired.

Food for thought – Interaction between definitions of ‘credit-impaired’ and ‘default’
The definition of ‘credit-impaired’ under IFRS 9 may differ from the entity’s definition of ‘default’ (see explanation here). However, an entity’s definition of default should be consistent with its credit risk management, and should consider qualitative factors. For example, many financial institutions apply regulatory definitions of default for accounting and regulatory purposes – e.g. those issued by the Basel Committee on Banking Supervision under which a default is considered to have occurred when it is unlikely that the obligor will be able to repay its obligation. The assessment of whether such a definition is met may be based on similar criteria to those used for assessing whether an asset is credit-impaired. In these cases, the asset would be considered to be in default when it is credit-impaired. (IFRS 9.5.5.37)

Food for thought – Objective evidence of impairment vs credit-impaired financial assets

Under IAS 39, an entity determines whether there is ‘objective evidence of impairment’ to identify incurred losses. The criteria and examples used for this assessment under IAS 39 are similar to those used in defining ‘credit-impaired’ under IFRS 9. The definition of credit-impaired is relevant in IFRS 9 when determining when an asset:

  • is credit-impaired on initial recognition (a special expected credit loss approach and special interest recognition rules apply to these assets); and
  • becomes credit-impaired after initial recognition (special interest recognition rules apply to these assets).

For further discussion of the calculation of credit-adjusted EIR (look here)and the recognition of interest revenue for credit-impaired assets look here.

Initial measurement credit-impaired financial assets

 At initial recognition, purchased or originated credit-impaired financial assets do not carry an impairment allowance. Instead, lifetime expected credit losses are incorporated into the calculation of the EIR (see credit-adjusted EIR). (IFRS 9.5.5.13, IFRS 9.B5.4.7)

Case – Initial recognition of purchased or originated credit-impaired financial assets

Company Y buys a portfolio of amortising loans with a remaining life of four years for 800, which is the fair value at that date. The remaining contractual cash flows at the time of purchase are 1,000 and the expected cash flows are as follows. Assume that all cash flows are expected to be paid at the year end.

Year 1 2 3 4
Expected cash flows 220 220 220 220

The EIR of 3.925% p.a. is calculated as the IRR of the initial purchase price – i.e. 800 – and the cash flows expected to be collected.

On initial recognition, the following journal entries arise.

Loan asset 800
Cash 800

Purchased credit-impaired financial assets are recorded on initial recognition at the transaction price without presentation of an allowance for expected contractual cash shortfalls that are implicit in the purchase price, but disclosures are required of contractual cash shortfalls that are implicit in the purchase price.

It is only in unusual circumstances that originated financial assets would be regarded as being credit impaired. Simply because originated assets might be of high credit risk does not mean that they are credit impaired. Purchased and originated credit-impaired financial assets

Subsequent measurement credit-impaired financial assets

The expected credit losses for purchased or originated credit-impaired financial assets are always measured at an amount equal to lifetime expected credit losses. However, the amount recognised as a loss allowance for such assets is not the total amount of lifetime expected credit losses, but instead the changes in lifetime expected credit losses since initial recognition of the asset. (IFRS 9.5.5.13-14)

Favorable changes in lifetime expected credit losses are recognised as an impairment gain, even if the favorable changes are more than the amount previously recognised in profit or loss as impairment losses. This is a different presentation from IAS 39, under which reversals of impairment relate only to amounts previously recognised in profit or loss as impairment losses. (IFRS 9.5.5.14 )

Case – Subsequent measurement of purchased or originated credit-impaired financial assets – No changes in expectations

Continuing the case above on Initial recognition of purchased or originated credit-impaired financial assets, assume that Y’s expectation about future cash flows from the portfolio at the end of Year 1 has not changed since initial recognition.

At the end of Year 1, Y calculates interest revenue of 31 by applying the EIR – i.e. 3.925% p.a. –  to the amortised cost of the loan of 800. In addition, Y receives a cash payment of 220. Y records the following entries in Year 1.

Loan asset 31
Interest revenue 31
Cash 220
Loan asset 220

This example illustrates that no impairment expense or allowance is recognised if, in subsequent periods, experience and expectations about the collectibility of cash flows are unchanged from expectations at initial recognition.

Case – Subsequent measurement of purchased or originated credit-impaired financial assets – Positive changes in expectations
Alternatively, assume that the creditworthiness of the borrowers in the portfolio has improved and at the end of Year 1, Y expects the following cash flows to be collected.
Year 1 2 3 4
Expected cash flows 220 250 250 250

At the end of Year 1, Y calculates interest income of 31 by applying the EIR – i.e. 3.925% p.a. – to the amortised cost of the loan of 800, and records the following entries, as above, to recognise interest revenue and cash received.

Loan asset 31
Interest revenue 31
Cash 220
Loan asset 220

In addition, the revised expected cash flows are discounted using the original EIR, and the resulting favorable change in lifetime expected credit losses of 83a is recognised as an impairment gain at the end of Year 1, as follows.

Loss allowance 83
Impairment gain 83

At the end of Year 1, the following balances are therefore recognised for the loan portfolio in the statement of financial position:

  • a gross carrying amount of 611 (being 800 plus interest of 31 less cash received of 220); and
  • a loss allowance, being a debit balance of 83.

Note – (a) Calculated as (30 / 1.03925) + (30 / 1.039252) + (30 / 1.039253).

Modified contractual cash flows

When the contractual cash flows of a POCI asset are modified and the modification does not result in derecognition, the calculation of the modification gain or loss (see modified financial assets) is the difference between:

  • the gross carrying amount of the asset before the modification; and
  • the recalculated gross carrying amount.

The recalculated gross carrying amount is the present value of the modified contractual cash flows using the credit-adjusted EIR before the modification, which also considers the initial expected credit losses that were considered when calculating the credit-adjusted EIR (see Credit-adjusted EIR).

Food for thought – Modification of a POCI asset

IFRS 9 does not explain how the initial expected credit losses that were considered when calculating the credit-adjusted EIR should be taken into account when calculating the modification gain or loss.

Therefore, application issues may arise in practice, requiring further analysis and the exercise of judgement.

Day 1 loss

For purchased and originated credit-impaired financial assets, a ‘day 1 loss’ is not recognised. Instead:

  • Lifetime expected credit losses would be included in the estimated cash flows for the purposes of calculating the effective interest rate – resulting in a credit-adjusted effective interest rate,
  • Interest revenue would be calculated on the net carrying amount at the credit-adjusted effective interest rate i.e. including expected credit losses,
  • Expected credit losses would be discounted using the credit-adjusted effective interest rate,
  • Any subsequent changes (favorable or unfavorable) from the initial expected credit losses would be recognised immediately in profit or loss.

Credit-adjusted EIR

The EIR for purchased or originated credit-impaired financial assets is calculated slightly differently than under the general approach (see initial measurement above). For purchased or originated credit-impaired financial assets, the EIR is calculated using expected cash flows inclusive of future lifetime expected credit losses – i.e. the estimated contractual cash flows are reduced by lifetime expected credit losses. (IFRS 9.B.5.4.7)

The resulting EIR is defined as the credit-adjusted EIR.

 Food for thought – Calculation of EIR  for purchased or originated credit-impaired financial assets

The requirements of the new standard for calculating the credit-adjusted EIR are very similar to the requirements of IAS 39 for assets that are acquired at a deep discount that reflects incurred credit losses. However, under IAS 39 the EIR calculation for these assets includes only credit losses that have been incurred, while under IFRS 9 the EIR includes all expected future credit losses.

Although under IFRS 9 the calculation of EIR for purchased or originated credit-impaired financial assets reflects all expected credit losses rather than just incurred credit losses, this may not in practice result in a big change in the EIR for these assets as compared with IAS 39. This is because once an asset is impaired, it may be difficult in practice to distinguish between incurred and expected credit losses.

purchased or originated credit-impaired financial assets

Case: Purchased credit-impaired financial asset and credit adjusted effective interest rate (EIR)

On 1 January 20X1, Entity X issues a bond with a face value of $10,000 and a fixed annual coupon of $600 (i.e. 6%) payable on 31 December each year until maturity date, which is 31 December 20X6. In 20X2, Entity X run into financial difficulties and did not pay the coupon due on 31 December 20X2 which resulted in significant reduction in market prices of this bond. On 1 January 20X3, Entity A acquires this bond for $5,000 as it believes that Entity X will be able to partially repay the face value on redemption date. Entity A expects to receive $8,000 on 31 December 20X6, but it does not expect to receive any coupon payments.

On 1 January 20X3, Entity A calculates credit adjusted EIR based on expected cash flows that include initial expected credit losses (ECL):

A

B

1

20×3-01-01 purchase of credit-impaired bond of $10,000

-$5,000

2

20×3-12-31 no coupon of interest

3

20×4-12-31 no coupon of interest

4

20×5-12-31 no coupon of interest

5

20×6-12-31 redemption of credit-impaired bond of $10,000

$8,000

6

Adjusted Effective interest rate

12.5%

(put the numbers in a spreadsheet, use the function =IRR(B1:B5) in cell B6).

The purchase, interest recognition and redemption accounting for this credit-impaired bond of $10,000 are as follows:

Year

Opening 01 – 01

Interest recognition

Cash flow (out (in))

Closing 31 – 12

20×3

6231

-5,000

5,623

20×4

5,623

701

6,325

20×5

6,325

789

7,113

20×6

7,113

887

8,000

Purchased and originated credit-impaired finanacial assetsOn 1 January 20X6 Entity A revises its estimates and expects to receive $8,500 which it finally receives on 31 December 20X6. On 1 January 20X6, $8,500 to be received on 31 December 20X6 and discounted using the original credit-adjusted EIR has a present value of $7,558. Under the original accounting schedule presented above, the bond has a carrying value of $7,113 on 1 January 20X6. Therefore, Entity A recognises an impairment gain amounting to $445. The accounting schedule for this bond is updated as follows:

Year

Opening 01 – 01

Impairment gain

Interest recognition

Cash flow (out (in))

Closing 31 – 12

20×3

623

-5,000

5,623

20×4

5,623

701

6,325

20×5

6,325

789

7,113

20×6

7,113

445

942

8,500

Calculating credit-impaired interest revenue and expense

For credit-impaired financial assets (see above), interest revenue is calculated by applying the EIR (or credit-adjusted EIR if the asset was credit-impaired at initial recognition) to the amortised cost of the asset. An asset could be credit-impaired if: (IFRS 9.5.4.1(a)-(b))

  • it was credit-impaired on initial recognition (a purchased or originated credit-impaired financial asset); or
  • it became credit-impaired after initial recognition.

For an asset that became credit-impaired after initial recognition, the calculation of interest revenue reverts to the gross basis if the asset is no longer credit-impaired. However, for purchased or originated credit-impaired financial assets, the calculation of interest revenue can never revert to a gross basis, even if the credit risk of the asset improves. (IFRS 9.5.4.1(a), IFRS 9.5.4.2)

Food for thought – Applying the EIR to the gross carrying amount or amortised cost of a financial asset

The requirements of IFRS 9 to calculate interest revenue for credit-impaired assets by applying the EIR to the amortised cost of a financial asset are the same as the current IAS 39 requirements for all financial assets and financial liabilities.

However, for assets that are not credit-impaired an apparent difference arises between the requirements of IFRS 9 and IAS 39. This is because under IFRS 9, an asset attracts an impairment allowance even if it is not credit-impaired (See the general approach to impairment). Therefore, under IFRS 9 interest revenue on these assets is calculated by applying the EIR to the gross carrying amount – i.e. the amortised cost grossed up for the impairment allowance. By contrast, under IAS 39 interest revenue is always calculated by applying the EIR to amortised cost but no impairment allowance is recorded for assets that are not credit-impaired.

Purchased and originated credit-impaired financial assets

Purchased and originated credit-impaired financial assets Purchased and originated credit-impaired financial assets

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2 thoughts on “Purchased and originated credit-impaired financial assets – IFRS 9 Best Read”

  1. In the last part of the example I am trying to appreciate the importance of the revision happening in January. What, if anything, would be different in the schedule if the revised estimate in January had been $8600 and the final outcome (as above) $8500?

    Reply
    • The number would change off course and the timing and amounts over the period of interest income recognition would change

      Reply

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