# Step 2 Decide to use the general or simplified approach

Step 2 Decide to use the general or simplified approach – 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. This is step 3 which started with an introduction in Impairment of investments and loans.

Under IFRS 9 entities apply one of the following two approaches in recognising and measuring ECL: Step 2 Use the general or simplified approach

• the general approach, mainly for debt securities, intercompany loans and financial guarantee contracts, or
• the simplified approach, mainly for certain trade receivables and contract assets recognised in accordance with IFRS 15 and lease receivables.

In summary the two approaches applied look like this.  Step 2 Use the general or simplified approach

Topics

### ‘General approach’ to impairment

Under the ‘general approach’, a loss allowance for lifetime expected credit losses is recognised for a financial instrument if there has been a significant increase in credit risk (measured using the lifetime probability of default) since initial recognition of the financial asset. If, at the reporting date, the credit risk on a financial instrument has not increased significantly since initial recognition, a loss allowance for 12-month expected credit losses is recognised. In other words, the ‘general approach’ has two bases on which to measure expected credit losses; 12-month expected credit losses and lifetime expected credit losses. Step 2 Decide to use the general or simplified approach

Putting the theory into practice, expected credit losses under the ‘general approach’ can best be described using the following formula:

Probability of Default (PD) x Loss given Default (LGD) x Exposure at Default (EAD)

=

Expected Credit Losses.

For each forward looking scenario an entity will effectively develop an expected credit loss using this formula and probability weight the outcomes.

Probability of Default (PD) is an estimate of the likelihood of a default over a given time horizon. For example, a 20% PD implies that there is a 20% probability that the loan will default. (IFRS 9 makes a distinction between 12-month PD and a lifetime PD as described above).

Loss given Default (LGD) is the amount that would be lost in the event of a default. For example, a 70% LGD implies that if a default happens only 70% of the balance at the point of default will be lost and the remaining 30% may be recovered (be that through recovery of security or cash collection). Step 2 Decide to use the general or simplified approach

Exposure at Default (EAD) is the expected outstanding balance of the receivable at the point of default. Step 2 Decide to use the general or simplified approach

### ‘Simplified approach’ to impairment

IFRS 9 establishes a simplified impairment approach for qualifying trade receivables, contract assets within the scope of IFRS 15 and lease receivables. For these assets an entity can, or in one case must, recognize a loss allowance based on Lifetime ECLs rather than the two step process under the general approach. The simplified approach does not apply to intercompany loans.

Lifetime expected credit loss is the expected credit losses that result from all possible default events over the expected life of a financial instrument. 12-month expected credit loss is the portion of the lifetime expected credit losses that represent the expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date.

Provision matrix in the simplified approach

A provision matrix is nothing more than applying the relevant loss rates to the trade receivable balances outstanding (i.e. a trade receivable aged analysis). For example, an entity would apply different loss rates depending on the number of days that a trade receivable is past due. Depending on the diversity of its customer base, the entity would use appropriate groupings if its historical credit loss experience shows significantly different loss patterns for different customer segments.

Continue to go to either use the General Approach or use the Simplified Approach.

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