The best 1 in overview – IFRS 9 Impairment requirements

IFRS 9 Impairment requirements

forward-looking information to recognise expected credit losses for all debt-type financial assets

 

Under IFRS 9 Impairment requirements, recognition of impairment no longer depends on a reporting entity first identifying a credit loss event.

IFRS 9 instead uses more forward-looking information to recognise expected credit losses for all debt-type financial assets that are not measured at fair value through profit or loss.

IFRS 9 requires an entity to recognise a loss allowance for expected credit losses on:

IFRS 9 requires an expected loss allowance to be estimated for each of these types of asset or exposure. However, the Standard specifies three different approaches depending on the type of asset or exposure:

IFRS 9 Impairment requirements

* optional application to trade receivables and contract assets with a significant financing component, and to lease receivables

Food for thought

Loan commitments

Similar to IAS 39, IFRS 9 requires some loan commitments to be measured at fair value through profit or loss (those that can be net cash-settled or which oblige the issuer to lend at a below-market rate). Unlike, IAS 39, however, other loan commitments are subject to IFRS 9’s impairment model. This is an important change compared to IAS 39.

Financial guarantees

Financial guarantee contracts are also within the scope of IFRS 9’s expected loss requirements for the issuer, unless they have previously been accounted for as insurance contracts under IFRS 17 ‘Insurance Contracts’ and the entity elects to continue to account for them as such. This election is irrevocable and cannot be applied to an embedded derivative where the derivative is not itself a contract within the scope of IFRS 17.

Implications

For financial institutions that manage off-balance sheet loan commitments and financial guarantee contracts using the same credit risk management approach and information systems as loans and other on-balance sheet items, this might prove to be a simplification.

For other institutions that issue these types of instruments, the new requirements could be a significant change, necessitating adjustments to systems and monitoring processes for financial reporting purposes.

Equity instruments

Under IFRS 9, investments in equity instruments are measured either at fair value through profit or loss or at fair value through other comprehensive income. Impairment of such assets is unnecessary as they are measured at fair value, and they are therefore outside the scope of IFRS 9’s impairment requirements.

Unlike IAS 39, it is not possible under IFRS 9 to measure investments in equity instruments at cost where they do not have a quoted market price and their fair value cannot be reliably measured.

Investments in equity instruments are measured either at fair value through profit or loss or at fair value through other comprehensive income. Impairment of such assets is therefore unnecessary.

The general (or three stage) impairment approach

IFRS 9’s general approach to recognising impairment is based on a three-stage process which is intended to reflect the deterioration in credit quality of a financial instrument.

  • Stage 1 covers instruments that have not deteriorated significantly in credit quality since initial recognition or (where the optional low credit risk simplification is applied) that have low credit risk
  • Stage 2 covers financial instruments that have deteriorated significantly in credit quality since initial recognition (unless the low credit risk simplification has been applied and is relevant) but that do not have objective evidence of a credit loss event
  • Stage 3 covers financial assets that have objective evidence of impairment at the reporting date.

12-month expected credit losses are recognised in stage 1, while lifetime expected credit losses are recognised in stages 2 and 3.

IFRS 9 draws a distinction between financial instruments that have not deteriorated significantly in credit quality since initial recognition and those that have.

’12-month expected credit losses’ are recognised for the first of these two categories. ‘Lifetime expected credit losses’ are recognised for the second category. Measurement of the expected credit losses is determined by a probability-weighted estimate of credit losses over the expected life of the financial instrument.

An asset moves from 12-month expected credit losses to lifetime expected credit losses when there has been a significant deterioration in credit quality since initial recognition. Hence the ‘boundary’ between 12-month and lifetime losses is based on the change in credit risk not the absolute level of risk at the reporting date.

There is also an important operational simplification (one of several in IFRS 9) that permits companies to stay in ’12-month expected credit losses’ if the absolute level of credit risk is ‘low’. This applies even if the level of credit risk has increased significantly.

What are credit losses?

Credit losses are defined as the difference between all the contractual cash flows that are due to an entity and the cash flows that it actually expects to receive (‘cash shortfalls’). This difference is discounted at the original effective interest rate (or credit-adjusted effective interest rate for purchased or originated credit-impaired financial assets).

What are ’12-month expected credit losses’?

  • 12-month expected credit losses are a portion of the lifetime expected credit losses
  • they are calculated by multiplying the probability of a default occurring on the instrument in the next 12 months by the total (lifetime) expected credit losses that would result from that default
  • they are not the expected cash shortfalls over the next 12 months.

They are also not the credit losses on financial instruments that are forecast to actually default in the next 12 months.

What are ‘lifetime expected credit losses’?

Lifetime expected credit losses are the expected shortfalls in contractual cash flows, taking into account the potential for default at any point during the life of the financial instrument.

An asset moves from 12-month expected credit losses to lifetime expected credit losses when there has been a significant deterioration in credit quality since initial recognition.

There is also a third stage. This applies to assets for which there is objective evidence of impairment (essentially the same as objective evidence of an incurred loss in IAS 39). In Stage 3 the credit loss allowance is still based on lifetime expected losses but the calculation of interest income is different.

In the periods subsequent to initial recognition, interest is calculated based on the amortised cost net of the loss provision, whereas the calculation is based on the gross carrying value in Stages 1 and 2.

IFRS 9 Impairment requirements

Finally, it is possible for an instrument for which lifetime expected credit losses have been recognised to revert to 12-month expected credit losses should the credit risk of the instrument subsequently improve so that the requirement for recognising lifetime expected credit losses is no longer met.

There are two exceptions to this general approach:

  • a simplified approach for trade receivables, contract assets and lease receivables, and
  • an approach for purchased or originated credit-impaired financial assets.

Impact of a significant increase in credit risk

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.

As noted above, 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 (see below); 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.

IFRS 9 Impairment requirements

It is possible for an instrument for which lifetime expected credit losses have been recognised to revert to 12-month expected credit losses should the credit risk of the instrument subsequently improve.

Worked example – 12 month versus lifetime expected credit losses

Entity B has a reporting date of 31 December. On 1 July 20X1 Entity B advanced a 3-year interest-bearing loan of CU2,000,000 to Entity A. Management estimates the following risks of defaults and losses that would result from default at 1 July 20X1 and at 31 December 20X1 and 20X2:

IFRS 9 Impairment requirements

Note that the probability that there will be no default is implicit in the percentages above. Note also that the loss that will transpire should a loss occur in the event of default in the next 12 months does not correspond to the expected cash shortfalls in the next 12 months.

What credit loss provision should Entity B book at:

  1. 1 July 20X1
  2. 31 December 20X1
  3. 31 December 20X2

Solution
At 1 July 20X1:

On initial recognition Entity B should recognise a credit loss provision equivalent to 12-month expected losses.

12-month expected loss = (2.5% * CU800,000] = CU20,000

At 31 December 20X1:

Entity B first evaluates whether credit risk has increased significantly since the loan was initially recognised (on 1 July 20X1). If Entity B has chosen to use the practical expedient for low credit risk, it also evaluates whether the absolute level of credit risk is low. The evaluations are as follows:

  • credit risk relative to initial recognition? The total risk of default has increased from 7.5% to 13.0% which is clearly significant
  • is absolute level of credit risk ‘low’? Although ‘low’ is not quantified, a 13.0% risk of default certainly appears to not be low. IFRS 9 B.5.5.23 refers to an example of low credit risk being an external rating of ‘investment grade’. The lowest rating generally considered investment grade is ‘BBB’ meaning adequate capacity to meet financial commitments.

The credit loss provision should therefore be based on lifetime expected losses.

Lifetime expected loss = (3.0%+10%) * CU700,000 = CU91,000

At 31 December 20X2:

Entity B again evaluates whether credit risk has increased significantly since 1 July 20X1. If Entity A has chosen to use the practical expedient for low credit risk, it also evaluates whether the absolute level of credit risk is low. The evaluations are as follows:

  • credit risk relative to initial recognition? The total risk of default has now decreased to 3.0% and is therefore lower than the risk at initial recognition of 7.5%
  • is absolute level of credit risk ‘low’? This evaluation is not relevant given there has not been a significant increase in the instrument’s credit risk compared to the level at initial recognition.

The credit loss provision should therefore return to being based on 12-month expected losses.

12-month expected loss = (1.0% * CU500,000) = CU5,000

Identifying a significant increase in credit risk

Subject to the ‘low credit risk’ operational simplification, IFRS 9 requires that the credit losses estimate switches from 12-month expected credit losses to lifetime expected credit losses when credit risk has increased significantly since initial recognition.

If the level of credit risk reduces in a later period, such that the level of credit risk is no longer significantly higher, the credit losses estimate switches back to 12-month expected credit losses. The assessment of whether there has been a significant deterioration in the credit risk of a financial instrument is therefore key.

To make this assessment an entity compares the risk of a default occurring on the financial instrument as at the reporting date with the same risk as at the date of initial recognition, considering reasonable and supportable information that is indicative of significant increases in credit risk since initial recognition.

Definition of default

IFRS 9 explains that changes in credit risk are assessed based on changes in the risk of a default occurring over the expected life of the financial instrument (the assessment is not based on the amount of expected losses). ‘Default’ is not itself actually defined in IFRS 9 however. Companies must instead reach their own definition and IFRS 9 provides guidance on how to do this.

The Standard states that when defining default, an entity shall apply a default definition that is consistent with the definition used for internal credit risk management purposes for the relevant financial instrument and consider qualitative indicators (for example, financial covenants) when appropriate.

However, there is a ‘rebuttable presumption’ that default does not occur later than when a financial asset is 90 days past due unless an entity has reasonable and supportable information to demonstrate that a more lagging default criterion is more appropriate.

Food for thought – Defining default

Not every entity needs to define ‘default’. For example, an entity whose credit exposures are limited to trade receivables and contract assets (with no significant financing component) would apply the simplified model.

However, ‘default’ is a key building block when applying the general (three-stage) model because:

  • movement between the three stages is driven by changes in the risk of default
  • some entities estimate credit losses as the product of the probabilities of various defaults (PDs) and the losses that would arise if those defaults occur (‘loss given default’ or LGD)

Definitions of default used in practice fall into two very broad categories:

  • definitions based on contractual breaches such as failure to make a payment when due or breaches of a covenant
  • more judgemental definitions based on qualitative factors.

The most important point is that the definition should be appropriate to the instrument. This is best explained by examples:

Example 1 – instalment loan

Lender A makes a 5 year amortising loan with payments of principal and interest payable in regular monthly instalments. The borrower is also subject to six-month financial covenants.

For this loan a definition of default based on missed payments and covenant breaches could be suitable.

Example 2 – term loan

Lender B makes a 5 year loan with interest payable monthly and principal all due on maturity.

In this case it is unlikely that a definition of default that is based solely on missed payments will be sufficient. This is because the main repayment is not due until maturity and hence a definition based on late payment would not capture the possibility that events take place before maturity that result in the borrower becoming unlikely to repay.

Once determined, the definition has to be applied consistently to all financial instruments unless information becomes available that shows another definition is more appropriate for a particular financial instrument.

Food for thought – interaction with regulatory definitions of default

Some entities such as financial institutions may be the subject of regulation which is designed to gauge their solvency. The regulations affecting such entities will often contain a definition of default. This leads to the question of whether the regulatory definition can be used for IFRS 9 purposes.

The simple answer to this question is that regulatory definitions of default can be used in so far as they do not conflict with the principles set out in IFRS 9.

Worked example

An entity might wish to use a local regulator’s definition of ‘non-performing loans’ for determining when it needs to transfer assets into and out of Stage 3 of IFRS 9’s impairment model. Under the local regulator’s rules, a loan cannot be transferred back to the portfolio of performing loans until at least 12 months have elapsed from the point it was categorised as non-performing. Can the regulator’s definition of non-performing loans be used as the basis for making transfers into and out of Stage 3 of IFRS 9’s impairment model?

The regulator’s definition of non-performing loans may not be appropriate for IFRS 9 purposes. IFRS 9 would require the asset to be transferred out of stage 3 if the credit risk on the financial instrument improves so that the financial asset is no longer credit-impaired. There is nothing in IFRS 9 to prohibit the transfer out of stage 3 occurring sooner than 12 months after the transfer into stage 3.

The regulatory definition of non-performing loans may be a useful starting point in arriving at a definition of default, but will probably need to be amended to comply with IFRS 9.

Interaction with the level of credit

Applying the three-stage model requires calibrating the level of credit risk of financial assets at initial recognition. This becomes the reference point at each future reporting date. If the credit risk has increased, the next key assessment is to determine whether or not the increase is significant.

A given increase in credit risk is more likely to be significant for a financial instrument with a lower credit risk at initial recognition.

Food for thought – Effect of business combinations

When financial assets are acquired in a business combination, the reference point for measuring the initial level of credit risk of those assets is reset to the date of the business combination.

Worked example

Entity C acquired Entity D in a business combination in June 2014. Entity D holds a loan from an associate that was considered low credit risk when first advanced in 2012. In June 2014, the risk of default on this loan was considered to be significant. At the reporting date of December 2014, the risk of default remains the same as at June 2014.

Has there been a significant increase in credit risk at the reporting date of December 2014?

No. The date of the business combination is the reference date for the acquirer’s financial statements, not the acquiree’s date of initial recognition.

Interaction with the length to maturity of an instrument

The risk of a default occurring on financial instruments that have comparable credit risk is higher the longer the expected life of the instrument. For example, the risk of a default occurring on an asset with an expected life of 20 years is higher than that on an otherwise identical asset that has an expected life of 10 years.

The change in credit risk cannot be assessed simply by comparing the change in the absolute risk of a default occurring over time. For example, if the risk of a default occurring for a financial instrument with an expected life of 20 years at initial recognition is identical to the risk of a default occurring on that financial instrument when its expected life in a subsequent period is only five years, that may indicate an increase in credit risk.

This is because the risk of a default occurring generally decreases as time passes if the credit risk is unchanged and the financial instrument is closer to maturity. This may not be the case however for financial assets that only have significant payment obligations close to the maturity of the asset. For such assets, the risk of a default occurring may not necessarily decrease as time passes.

Reasonable and supportable information

An entity should use ‘reasonable and supportable information that is available without undue cost or effort’ to determine whether credit risk has increased significantly. This should typically include forward-looking information as well as historical data such as past due status.

This reflects the fact that typically, credit risk increases significantly before a financial instrument becomes past due (NB this holds true for other borrower specific factors such as modifications or restructurings).

However when forward-looking information is not available without undue cost or effort, an entity may use past due information to determine whether there have been significant increases in credit risk since initial recognition.

Rebuttable presumption for payments more than 30 days past due

Regardless of the way in which an entity assesses significant increases in credit risk, there is a rebuttable presumption that the credit risk of a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due.

The presumption can be rebutted only when the reporting entity has reasonable and supportable information available that demonstrates that 30 days past due does not represent a significant increase in the credit risk of a financial instrument.

For example historical evidence might demonstrate that there is no significant correlation between the risk of a default occurring and financial assets becoming more than 30 days past due. Instead, a correlation might be observable only once payments are say more than 45 days past due.

The presumption does not apply when an entity determines that there have been significant increases in credit risk before contractual payments are more than 30 days past due.

An entity should use ‘reasonable and supportable information that is available without undue cost or effort’ to determine whether credit risk has increased significantly. This should typically include forward-looking information as well as historical data.

Multi-factor analysis

IFRS 9 states that the analysis of credit risk is a multi-factor and holistic analysis. This means that determining whether a specific factor is relevant, and the weight it should be given compared to other factors in the overall assessment, will depend on the type of product, characteristics of the financial instruments and the borrower as well as the geographical region.

Individual or collective assessment

Depending on the nature of the financial instrument and the information available about its credit risk, it may not be possible (without undue cost or effort) to identify significant changes in credit risk at individual instrument level before the financial instrument becomes past due. It may therefore be necessary to assess significant increases in credit risk on a collective or portfolio basis.

Food for thought – Shared credit risk characteristics

This is particularly relevant to financial institutions with a large number of relatively small exposures such as retail loans. In practice, the lender may not obtain or monitor forward-looking credit information about each customer.

In such cases the lender would assess changes in credit risk for appropriate portfolios, groups of portfolios or portions of a portfolio of financial instruments.

Any instruments that are assessed collectively must possess shared credit risk characteristics. This is to prevent significant increases in credit risk being obscured by aggregating instruments that have different risks.

The Standard gives the following, non-exhaustive list of examples of possible shared credit risk characteristics:

  • instrument type
  • credit risk ratings
  • collateral type
  • date of initial recognition
  • remaining term to maturity
  • industry
  • geographical location of the borrower
  • the value of collateral relative to the financial asset if it has an impact on the probability of a default occurring.

When instruments are assessed collectively, it is important to remember that the aggregation may need to change over time as new information becomes available.

Food for thought – Information that may be relevant in assessing changes in credit risk

You may wish to consider the following in assessing changes in credit risk. The list is not intended to be exhaustive.

  • significant changes in internal price indicators of credit risk
  • changes in the terms of an instrument that reflect changes in credit risk (eg more stringent covenants)
  • significant changes in external market indicators of credit risk (eg the length of time or extent to which a financial asset has been below amortised cost)
  • existing or expected adverse changes in the regulatory, economic, or technological environment that significantly affect, or are expected to affect, the borrower’s ability to meet its debt obligations
  • an actual or expected significant change in the operating results of the borrower
  • significant changes in the value of the collateral supporting the obligation or in the quality of guarantees or credit enhancements
  • reductions in financial support from a parent entity that are expected to reduce the borrower’s incentive to make scheduled contractual payments
  • expected breaches of contract that may, for example, lead to covenant waivers or amendments, or interest payment holidays
  • significant changes in the expected performance and behaviour of the borrower
  • past due information.

IFRS 9 Impairment requirements

Measuring expected credit losses

IFRS 9 defines expected credit losses as ‘the weighted average of credit losses with the respective risks of a default occurring as the weights’. In other words, expected credit losses are a probability-weighted estimate of credit losses (ie the present value of all cash shortfalls) over the expected life of the financial instrument.

General principles

IFRS 9 does not prescribe a particular method of measuring expected credit losses. The Standard instead acknowledges that measurement might vary based on the type of instrument in concern and the information that is available. It does however require that any method that an entity uses to measure credit losses should take into account three ‘building blocks’.

Three key building blocks:

  1. an unbiased and probability weighted amount that is determined by evaluating a range of possible outcomes
  2. the time value of money
  3. reasonable and supportable information about past events, current conditions and forecasts of future economic conditions.

Probability-weighted amount

IFRS 9 requires the estimate of expected credit losses to reflect an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes.

In doing this, the purpose is neither to estimate a worst-case scenario nor to estimate the best-case scenario. An estimate of expected credit losses shall however always reflect the possibility that a credit loss occurs and the possibility that no credit loss occurs even if the most likely outcome is no credit loss.

The Standard notes that in practice, a complex analysis may not be needed in order to arrive at the probability-weighted outcome. In some cases, relatively simple modelling may be sufficient, without the need for a large number of detailed simulations of scenarios.

For example, the average credit losses of a large group of financial instruments with shared risk characteristics may be a reasonable estimate of the probability weighted amount. In other situations, the identification of scenarios that specify the amount and timing of the cash flows for particular outcomes and the estimated probability of those outcomes will probably be needed. If this is the case, then the analysis must reflect at least the possibility that a credit loss occurs and the possibility that no credit loss occurs.

Time value of money

IFRS 9 requires expected credit losses to be discounted to the reporting date using the effective interest rate determined at initial recognition or an approximation of it. The table sets out the discount rates to be used for different types of financial instrument.

Instrument

Discount rate to be used

Fixed rate assets

effective interest rate determined at initial recognition

Variable rate assets

current effective interest rate

Purchased or originated credit impaired financial assets

credit-adjusted effective interest rate determined at initial recognition

Lease receivables

same discount rate as used in the measurement of the lease receivable

Loan commitments

effective interest rate, or an approximation of it, that will be applied when recognising the financial asset resulting from the loan commitment

Loan commitments for which the effective interest rate cannot be determined

a rate that reflects the current market assessment of the time value of money and the risks specific to the cash flows (unless adjustment has instead been made to the cash shortfalls)

Financial guarantee contracts

a rate that reflects the current market assessment of the time value of money and the risks specific to the cash flows (unless adjustment has instead been made to the cash shortfalls)

Reasonable and supportable information

Reasonable and supportable information is that which is reasonably available at the reporting date without undue cost or effort, including information about past events, current conditions and forecasts of future economic conditions.

The information used is required to reflect factors that are specific to the borrower, general economic conditions and an assessment of both the current as well as the forecast direction of conditions at the reporting date. Information that is available for financial reporting purposes is always considered to be available without undue cost or effort.

An entity is not required to incorporate forecasts of future conditions over the entire expected life of a financial instrument. Neither is a detailed estimate of expected credit losses needed for periods that are far in the future. Instead an entity may extrapolate projections from available, detailed information for such periods.

Possible data sources

  • internal historical credit loss experience
  • internal ratings
  • credit loss experience of other entities
  • external ratings, reports and statistics.

Where an entity does not have sufficient sources of entity-specific data of its own, it may use peer group experience for comparable financial instruments.

Historical information is a useful base from which to measure expected credit losses but may need to be adjusted to reflect current conditions. For example, estimates of changes in expected credit losses should reflect and be directionally consistent with changes in related observable data from period to period and in the magnitude of those changes. Examples include changes in:

  • unemployment rates
  • property prices
  • commodity prices
  • payment status or
  • other factors indicative of credit
  • losses on the instrument.

As discussed in earlier sections, an entity is required to recognise either lifetime expected credit losses or 12-month expected credit losses depending on the particular circumstances of the instrument in concern.

An entity may use practical expedients when measuring expected credit losses if they are consistent with IFRS 9’s principles. An example of a practical expedient is the calculation of the expected credit losses on trade receivables using a provision matrix (see simplified model).

IFRS 9 explains that a credit loss arises even if the entity expects to be paid in full but at a later time than when contractually due. This follows from the fact that expected credit losses consider the timing of payments as well as the cash shortfalls.

Measurement of expected credit losses for different types of asset/exposure

The table below illustrates how the principles for the measurement of credit losses apply to various different types of asset/exposure.

IFRS 9 Impairment requirements* purchased or originated credit-impaired financial assets are excluded as the general approach to impairment is not applied to them (impairment is always based on lifetime expected credit losses and the estimate of such losses on initial recognition is reflected in a credit-adjusted effective interest rate).

Application issues

Period to consider when measuring expected credit losses

Entities are required to estimate cash flows by considering all contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) through the expected life of that financial instrument.

There is a presumption that the expected life of a financial instrument can be estimated reliably. However, in those rare cases when it is not possible to reliably estimate the expected life of a financial instrument, the entity shall use the remaining contractual term of the financial instrument.

For the purpose of measuring expected credit losses, IFRS 9 states that the maximum period to consider is the maximum contractual period (including borrower extension options) over which the entity is exposed to credit risk. In some cases an entity might expect to be exposed to credit risk over a longer period than the contractual period – for example if it expects to extend the loan term even though it has no obligation to do so.

However, subject to the limited exception for credit card and similar facilities (see food for thought box below), the measurement period is limited to the contractual period even though a longer period may be consistent with business practice.

Food for thought – Credit card and similar facilities

Some financial instruments include both a loan and an undrawn commitment component, with the effect that the entity’s contractual ability to demand repayment and cancel the undrawn commitment does not limit the entity’s exposure to credit losses to the contractual notice period. Examples are revolving credit facilities, such as credit cards and overdraft facilities, which can be contractually withdrawn by the lender with as little as one day’s notice.

In practice lenders continue to extend credit for a longer period in such situations. The consequence of this is that the lender may frequently withdraw the facility only after the credit risk of the borrower increases, which could be too late to prevent some or all of the expected credit losses.

IFRS 9 contains specific guidance for such arrangements stating that the entity shall measure expected credit losses over the period that the entity is exposed to credit risk and expected credit losses would not be mitigated by credit risk management actions, even though the period may extend beyond the maximum contractual period.

The Standard notes that when determining the period over which the entity is exposed to credit risk, the entity should consider factors such as relevant historical information and experience on similar financial instruments. This guidance, which is narrowly scoped, should not be applied by analogy to other instruments.

Worked example – measurement period

Entity E makes a 12-month loan to Entity F. The contract states that the loan can be extended for a further 6 months at the sole option of Entity E (the lender). Entity E’s management considers that it is probable that the loan will be extended. It is assumed that the loan meets IFRS 9’s ‘solely payments of principal and interest’ condition to be measured at amortised cost.

In this example, the expected losses would be measured based on the 12-month contractual term. The measurement would not take into account possible future losses arising from management’s decision to extend the loan for the additional 6 month period, unless or until the extension option is actually exercised. This is because the extension is at the sole option of the lender, so 12 months is the maximum contractual period over which the lender is exposed to credit risk.

If Entity F (the borrower) has the right to extend the loan however, the maximum contractual credit risk period would be 18 months.

For loan commitments and financial guarantee contracts, the maximum contractual period is the period over which an entity has a present contractual obligation to extend credit.

Collateral

While the existence of collateral plays a limited role in the assessment of whether there has been a significant increase in credit risk, it is very relevant to the measurement of expected credit losses.

IFRS 9 states that the estimate of expected cash shortfalls reflects the cash flows expected from collateral and other credit enhancements that are integral to the instrument’s contractual terms.

The estimate of expected cash shortfalls on a collateralised financial instrument reflects

  • the amount and timing of cash flows that are expected from foreclosure on the collateral
  • less the costs of obtaining and selling the collateral.

This is irrespective of whether or not foreclosure is probable. In other words, the estimate of expected cash flows considers both the probability of a foreclosure and the cash flows that would result from it. A consequence of this is that any cash flows that are expected from the realisation of the collateral beyond the contractual maturity of the contract are included in the analysis.

This is not to say that the entity is required to assume that recovery will be through foreclosure only however. Instead the entity should calculate the cash flows arising from the various ways in which the asset might be recovered and assign probability-weightings to those outcomes (see also probability weighted amount).

Practical expedients

‘Low credit risk’ exception

As a practical measure, IFRS 9 states that an entity may assume that the credit risk on a financial instrument has not increased significantly since initial recognition if the financial instrument is determined to have low credit risk at the reporting date. This is an optional simplification. It is designed to relieve entities from tracking changes in the credit risk of high quality assets. This election can be made on an instrument by instrument basis.

Food for thought – What is ‘low’ credit risk?

IFRS 9 does not define ‘low’ credit risk. It does state that the credit risk on a financial instrument is considered low for the purpose of IFRS 9, if:

  • the financial instrument has a low risk of default
  • 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 fulfil its contractual cash flow obligations.

To determine whether a financial instrument has low credit risk, an entity may use its internal credit risk ratings or other methodologies that are consistent with a globally understood definition of low credit risk and that consider the risks and the type of financial instruments that are being assessed. An external rating of ‘investment grade’ is an example of a financial instrument that may be considered as having low credit risk.

Food for thought – impact on corporates

Corporate entities that hold externally rated debt instruments are likely to rely on external rating agencies data when using the low credit risk simplification. It is important to realise however that in some situations adjustments may be needed to these ratings. For example during the financial crisis, it was evident that some ratings were lagging behind the times and did not reflect current market conditions.

In order to conclude that an instrument with an external rating equivalent to ‘investment grade’ has low credit risk, IFRS 9 therefore requires an entity to consider whether an external rating is determined using methodologies that are consistent with a globally understood definition of low credit risk and whether there is evidence of an increase in credit risk that is not yet reflected in the rating.

An asset is not considered to have low credit risk simply because it has

  • a low risk of loss
  • a lower risk of default than other assets that the entity holds
  • a lower risk of default relative to the credit risk of the jurisdiction in which the entity operates.

Where an entity opts to use the simplification and an instrument is deemed to have low credit risk, a loss allowance is recognised based on 12-month expected credit losses. When an instrument is no longer considered to have low credit risk then the general requirements for assessing whether there has been a significant increase in credit risk apply.

Other practical expedients

In addition to the low credit risk exception described above, IFRS 9 contains a number of other practical expedients and simplifications:

IFRS 9 expedients and simplifications

Link

Rebuttable presumption that default does not occur later than when a financial asset is 90 days past due

Definition of default

Rebuttable presumption that the credit risk on a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due

Rebuttable presumption 30 days past due

Simplified approach for trade receivables and contract assets of one year or less or ones that do not contain a significant financing component

See below

Option of applying the simplified approach for lease receivables

See below

Use of provision matrices when applying the simplified model for trade receivables

See below

Simplified model for trade receivables, contract assets and lease receivables

In developing IFRS 9’s impairment requirements, there was concern that the process of determining whether to recognise 12-month or lifetime expected credit losses was not justifiable for instruments such as trade receivables and lease receivables. IFRS 9 includes the following simplifications:

Situation

Simplification

Trade receivables and contract assets of one year or less or ones which do not contain a significant financing component

Always recognise a loss allowance at an amount equal to lifetime expected credit losses

Trade receivables and contract assets which do contain a significant financing component (in accordance with IFRS 15)

Entities are allowed to choose to always recognise a loss allowance at an amount equal to lifetime expected credit losses

Lease receivables within the scope of IAS 17

An entity is similarly allowed to choose as its accounting policy to measure the loss allowance at an amount equal to lifetime expected credit losses.

The accounting policy choice applies independently for trade receivables with a significant financing component, lease receivables and contract assets with a significant financing component.

A key advantage of the simplified approach is that an entity is not required to determine whether credit risk has increased significantly since initial recognition. Instead a loss allowance is recognised based on lifetime expected credit losses at each reporting date.

Food for thought – Determining whether there is a significant financing component under IFRS 15

To determine whether a financing component is significant under IFRS 15, an entity considers several factors, including, but not limited to, the following:

  • the difference, if any, between the promised consideration and the cash price
  • the combined effect of:
    • the expected length of time between delivery of the goods or services and receipt of payment
    • the prevailing interest rates in the relevant market.

A contract may not have a significant financing component if:

  • advance payments have been made but the transfer of the good or service is at the customer’s discretion
  • the consideration is variable based on factors outside the vendor’s and customer’s control (eg a sales-based royalty)
  • a difference between the promised consideration and the cash price relates to something other than financing such as protecting one of the parties from non-performance by the other.

As a practical expedient, an entity can ignore the impact of the time value of money on a contract if it expects, at contract inception, that the period between the delivery of goods or services and customer payment will be one year or less.

Food for thought – Contract assets

Contract asset’ is a term introduced by IFRS 15 ‘Revenue from Contracts with Customers’. IFRS 15 provides a detailed definition but contract assets are broadly equivalent to unbilled revenue.

Even though contract assets are not financial assets, and are accounted for mainly under IFRS 15, IFRS 9’s impairment requirements apply to them. This means that when entities recognise revenue in advance of being paid or recording a receivable, they also need to recognise an expected credit loss.

Applying the simplified model

IFRS 9 does not prescribe how an entity should estimate lifetime expected credit losses when applying the simplified model. The Standard does however permit the use of practical expedients and refers to the example of a ‘provision matrix’. This approach is widely applied.

In devising such a provision matrix, an entity would use its historical credit loss experience (adjusted as necessary to reflect current conditions) for trade receivables to estimate the 12-month expected credit losses or the lifetime expected credit losses on the financial assets as relevant. This might be done, for example, by specifying fixed provision rates depending on the number of days that a trade receivable is past due.

Depending on the diversity of its customer base, it might also be necessary for the entity to segregate the trade receivables. This would be the case for example if the entity’s historical credit loss experience shows significantly different loss patterns for different customer segments.

Segregating trade receivables

The following are some examples of criteria that might be used to group assets:

  • geographical region
  • product type
  • customer rating
  • collateral or trade credit insurance
  • type of customer.

Worked example

Company E, a manufacturer, has trade receivables of CU100 million in 20X1 representing balances from a large number of small clients.

The trade receivables do not have a significant financing component and are accordingly measured for impairment purposes at an amount equal to lifetime expected credit losses. Company E operates in only one geographical region.

Company E uses a provision matrix to determine expected credit losses on the receivables. The provision matrix is based on historical observed default rates over the expected life of the trade receivables, adjusted for forward-looking estimates such as the deterioration in economic conditions expected by Company E in the coming year. This process results in the following provision rates which are based on the number of days that a trade receivable is past due:

IFRS 9 Impairment requirements

These percentages are then applied in the provision matrix as follows:

IFRS 9 Impairment requirements

With reference to the disclosure requirements added by IFRS 9 to IFRS 7 ‘Financial Instruments: Disclosures’ (see section 7), such a provision matrix could also form the basis of a risk profile disclosure.

Food for thought – Building a provision matrix

As noted, IFRS 9 permits entities to use ‘practical expedients’. A provision matrix is one example. However, there is no

further guidance on other possible expedients or on how to implement a provision matrix in practice.

There is no ‘one size fits all’ approach to this: each entity will need to consider its own circumstances, including the materiality of expected losses and the data available (without undue cost or effort).

Single loss-rate approach

Fortunately, many businesses experience low levels of bad debts. In practice, however, few companies will be able to demonstrate that ECLs are so immaterial that no calculations or loss reserves are required at all. Nonetheless, for some companies applying a single loss-rate to receivables or groups of receivables might be appropriate.

For example, an entity might determine an average historical loss rate by comparing the total balance of trade receivables at various past dates and determining the amounts collected/not collected. This would then be adjusted as necessary to reflect changes in circumstances.

Provision matrix

In other cases a provision matrix or other more sophisticated approach will be necessary. The idea behind a provision matrix is to estimate expected credit losses (ECLs) based on the ‘age’ of receivables. Accordingly, the operational challenge is to determine the relationship between the age of your receivables and the risk of non-payment. In order to ‘build’ a provision matrix the typical steps will be:

  1. segregate receivables into appropriate groups
  2. within each group, determine:
    1. age-bands
    2. historical back-testing dates (data points)
  3. for each age-band, at each back-testing date determine:
    1. the gross receivables
    2. the amounts ultimately collected/written-off. If material, adjustments should be made to exclude the effect of non-collections for reasons other than credit loss (eg credit notes issued for returns, short-deliveries or as a commercial price concession)
  4. compute average historical loss rate by age-band
  5. adjust historical loss rates if necessary, eg to take account of changes in:
    1. economic conditions
    2. types of customer
    3. credit management practices
  6. consider whether ECLs should be estimated individually for any period-end receivables, eg because specific information is available about those debtors
  7. apply loss rate estimates to each age-band for the other receivables in this group.

Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.

Something else -   Excellent Study IFRS 9 Eligible Hedged items

Something else -   IAS 38 Non-contractual customer relationships

IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements

IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements

IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements IFRS 9 Impairment requirements

Leave a comment