Step 5 Allocate receivables to high and low credit risk

Step 5 Allocate receivables to high and 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 5 which started with an introduction in Impairment of investments and loans.

Step 5 Allocate receivables to high and low credit risk

Low credit risk receivables are not going to be individually assessed for impairment,

only the higher than low credit risk receivables will be included individually in the measurement of Expected Credit Losses.

In making a multi-criteria model for default risk assessment of counterparties more credit risks rates could be used, providing a possibly more accurate measurement of the Expected Credit Losses, however such a model can easily become too complicated to understand and as a result become susceptible to manipulation. The model could be improved for example by using an usual categorical scale of the type of credit risk: poor, fair, good, very good and excellent (poor credit risk being the worst rating).

However keep in mind this is an estimation process, inherently judgmental and subjective. Step 5 Allocate receivables to high and low credit risk

Use established credit limits for higher risk receivables

Credit-granting companies establish their credit limits based on factors that represent their own set of unique circumstances, policies, conditions, etc. No two companies are the same and no two sets of policy are the same. Some factors to be considered are: Step 5 Allocate receivables to high and low credit risk

  • Competition. In this method, the amount of the credit limit is determined by matching the amount (or average amount) granted by like or similar competitors. Outside reports and other credit information sources are used to identify competitive limits. If the creditor is not the same size as comparable competitors or plays a distinctly different supply role (much larger or smaller), it will be difficult to establish reasonable credit limits using this method. Step 5 Allocate receivables to high and low credit risk
  • By Formula. In this method, several calculations are made and averaged to determine the credit limit to be assigned to the customer. Key financial data, such as net worth, inventory, current assets and/or net working capital are used, assuming the customer accommodates the credit grantor’s request for information. These data items are divided by the number of creditors to determine the amount per creditor. Amounts are then averaged to set the credit limit. It may be difficult to obtain an accurate estimate of the number of creditors. This method is often used to calculate a preliminary estimate and is then further developed by one or more of the other methods. Step 5 Allocate receivables to high and low credit risk
  • Payment Record. The credit limit can fluctuate depending on the customer’s ability to pay on terms. This has the advantage of making credit decisions more routine, unless the customer does not pay on time, when a more detailed credit review process would be triggered. This type of limit encourages additional sales and is popular with sales staff.
  • Payment Performance. This popular method adopts a conservative risk management approach and rewards new customers as they continue to do business with the company. This is often used when little payment history is available. While limiting the company’s exposure, it does limit the speed at which sales can grow.
  • Period of Time. Purchases made over a specific period of time, such as a week or month, cannot exceed the credit limit. This is useful in cases where many shipments may be made to a customer from various company locations. Orders can be approved in a more routine manner using this method, as long as the overall credit provided does not exceed the credit limit.
  • Expectation of Use. Sometimes referred to as requirements, this method sets a credit limit based on the expected dollar volume of credit sales over a period of time (i.e., a year). This figure is then divided by the number of orders expected throughout the year to estimate the credit limit. This method, like the formula method, is often used to obtain a preliminary estimate that can be defined further by one or more of the other methods. Step 5 Allocate receivables to high and low credit risk
  • Agency Scoring and Ratings. This method may be used for new or existing customers to assess risk and determine credit limits. Here are details of NTCR and D&B rating guidelines.

 

Example

See an excerpt from the financial statements of Vodafone for 2018. Step 5 Allocate receivables to high and low credit risk

Vodafone FS 2018 Judgments and estimations

After ‘Allocating receivables to high and low credit risk’ go to Step 7 Measure Expected credit losses

Or jump to: Step 5 Allocate receivables to high and low credit risk

Step 1 Define DefaultStep 2 Decide to use the general or simplified approachStep 3 Define significant increase in credit riskStep 4 Define low credit risk, Step 6 Apply the provision matrix

Step 5 Allocate receivables to high and low credit risk

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