Step 4 Define low credit risk

Step 4 Define low credit risk – 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 4 which started with an introduction in Impairment of investments and loans. Step 4 Define low credit risk

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. Step 4 Define low credit risk

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. Step 4 Define low credit risk

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: Step 4 Define low credit risk

  1. the financial instrument has a low risk of default; Step 4 Define low credit risk
  2. the borrower has a strong capacity to meet its contractual cash flow obligations in the near term; and
  3. 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. Step 4 Define low credit risk

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. Step 4 Define low credit risk

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-). Step 4 Define low credit risk

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. Step 4 Define low credit risk

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. Step 4 Define low credit risk

After defining ‘Low credit risk’ go to Step 5 Allocate receivables to high and low credit risk

Or jump to:

Step 1 Define DefaultStep 2 Decide to use the general or simplified approachStep 3 Define significant increase in credit risk, Step 6 Apply the provision matrixStep 7 Measure expected credit losses

Step 4 Define low credit risk

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