The credit adjusted approach

The credit adjusted approach applies only rarely when an entity acquires or originates a loan or receivable that is “credit impaired” at the date of its initial recognition (e.g., when a loan is acquired at a deep discount due to credit concerns via a business combination). The credit adjusted approach

This is part of the impairment of financial instruments in IFRS 9 Impairment of Financial Instruments.

An asset is credit impaired when one or more events that have a detrimental effect on the estimated future cash flows of the asset have occurred. The credit adjusted approach is one of three IFRS 9 approaches for measuring and recognising expected credit losses, the other two are the general approach and the simplified approach.

The IASB retained the credit adjusted approach for loans and receivables that are credit impaired at the date of initial recognition (e.g., loans acquired at a deep discount due to credit quality) because neither the general nor the simplified approach can appropriately portray the economics of these arrangements. The credit adjusted approach

Credit impairment indications

Examples in IFRS 9 of evidence that an asset is credit-impaired The credit adjusted approachThe credit adjusted approach

  • Significant financial difficulty of the issuer or borrower The credit adjusted approach
  • A breach of contract, such as a default or past due event (i.e., a borrower has failed to make a payment when contractually due)
  • The lender, for economic or contractual reasons relating to the borrower’s financial difficulty, has granted a concession that the lender would not otherwise consider The credit adjusted approach
  • It is becoming probable that the borrower will enter bankruptcy or other financial reorganization The credit adjusted approach
  • The disappearance of an active market for that financial asset because of financial difficulties The credit adjusted approach
  • The purchase or origination of a financial asset at a deep discount that reflects incurred credit losses The credit adjusted approach

When a financial asset is credit-impaired, IFRS 9 5.4.1(b) requires an entity to calculate (a lower) interest revenue by applying the credit adjusted effective interest rate to the amortised cost of the financial asset, i.e. the (original) gross amount less expected credit losses. This results in a difference between:

  1. the interest that would be calculated by applying the effective interest rate to the gross carrying amount of the credit-impaired financial asset, and
  2. the interest revenue recognised for that asset. The credit adjusted approach

The (original) effective interest rate is the rate that discounts the estimated future cash flows from the asset to the asset’s Amortized Cost before any allowance for expected credit losses. The credit adjusted effective interest rate differs from the effective interest rate in that estimates of future cash flows includes an adjustment for expected credit losses.

If a financial asset ‘cures’, so that it is transferred back to stage 2 or stage 1, interest revenue would once again be recognised based on the gross carrying amount.

As a result, an entity recognises the adjustment required to bring the loss allowance to the amount required to be recognised in accordance with IFRS 9 as a reversal of expected credit losses ECLs in profit or loss [IFRS 9 5.5.8]. The credit adjusted approach

Purchased or Originated Credit-Impaired Financial Assets

A purchased or originated credit-impaired financial asset is a financial asset that is credit impaired on initial recognition. At the reporting date, an entity shall only recognise the cumulative changes in lifetime expected credit losses since initial recognition as a loss allowance for purchased or originated credit-impaired financial assets. The lifetime expected credit loss is recognised by determining the credit-adjusted effective interest rate of the instrument at initial recognition and over the expected life of the instrument through the amortisation process.

An entity recognises in profit or loss the amount of the any change in lifetime expected credit losses as an impairment gain or loss. This means that an entity must recognise favourable changes in lifetime expected credit losses as an impairment gain, even if the lifetime expected credit losses are less than the amount of the expected credit losses that were included in the estimated cash flows on initial recognition. The credit adjusted approach

Effective interest methodEffective interest rate

Interest revenue shall be calculated by using the effective interest method. This shall be calculated by applying the effective interest rate to the gross carrying amount of a financial asset except for (IFRS 9 5.4.1):

  1. purchased or originated credit-impaired financial assets. For those financial assets, the entity shall apply the credit-adjusted effective interest rate to the amortised cost of the financial asset from initial recognition.
  2. financial assets that are not purchased or originated credit-impaired financial assets but subsequently have become credit-impaired financial assets. For those financial assets, the entity shall apply the effective interest rate to the amortisd cost of the financial asset in subsequent reporting periods.
Something else -   IFRS 7 Credit risk disclosures

Credit-adjusted effective interest rate

The rate that exactly discounts the estimated future cash payments or receipts through the expected life of the financial asset to the amortised cost of a financial asset that is a purchased or originated credit-impaired financial asset. When calculating the credit-adjusted effective interest rate, an entity shall estimate the expected cash flows by considering all contractual terms of the financial asset (for example, prepayment, extension, call and similar options) and expected credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate, transaction costs, and all other premiums or discounts.

There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be estimated reliably. However, in those rare cases when it is not possible to reliably estimate the cash flows or the remaining life of a financial instrument (or group of financial instruments), the entity shall use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments).

Credit-impaired (stage 3)

Example of application of the credit adjusted approach from HSBC

HSBC determines that a financial instrument is credit-impaired and in stage 3 by considering relevant objective evidence, primarily whether:

  • contractual payments of either principal or interest are past due for more than 90 days; The credit adjusted approach
  • there are other indications that the borrower is unlikely to pay such as that a concession has been granted to the borrower for economic or legal reasons relating to the borrower’s financial condition; and The credit adjusted approach
  • the loan is otherwise considered to be in default. The credit adjusted approach

If such unlikeliness to pay is not identified at an earlier stage, it is deemed to occur when an exposure is 90 days past due, even where regulatory rules permit default to be defined based on 180 days past due. Therefore the definitions of credit-impaired and default are aligned as far as possible so that stage 3 represents all loans which are considered defaulted or otherwise credit-impaired. The credit adjusted approach

Interest income is recognised by applying the effective interest rate to the amortised cost amount, i.e. gross carrying amount less ECL allowance.

Example – Purchased credit impaired loanInter-company loans

IFRS References: IFRS 9 5.4.1(a), IFRS 9 5.4.4, IFRS 9 5.5.13 and IFRS 9 B5.4.7

On 1 January 2014 InvestCollect has purchased a loan owing to Great Bank & Co. The principle amount of the loan is CU100,000 and the interest rate charged is 15% p.a. The loan falls due on 31 December 2017.

Great Bank & Co had been struggling to recover the interest payments on the loan and therefore sold the loan to InvestCollect (who is known for their effective debt collection strategies). InvestCollect purchased this loan for its fair value of CU80,000 on 1 January 2014 (being the gross carrying amount of CU100,000 less expected credit losses of CU20,000).

At 1 January 2014 InvestCollect expected to recover CU10 000 of the annual interest and 70% of the principle amount when it falls due. At 31 December, InvestCollect did in fact receive an interest payment of CU10 000 on the loan.

On 31 December 2014, InvestCollect re-assessed the credit risk of the loan and estimated that only CU8,000 of interest would be received annually and only 65% of the principle will be recovered on due date.

Journal entries in 2014

1. Purchase of the loan

Date

Accounts The credit adjusted approach

DT

CR

01/04/14

Financial asset The credit adjusted approach

80,000

01/04/14

Cash at bank The credit adjusted approach

80,000

2. Recording interest income

The credit-adjusted effective interest rate has to be calculated based on the expected cash flows as at 31 December 2014:

Expected repayment of principal in Year +4: CU100,000 * 70% = CU70,000

Expected recovery of interest: CU10,000 year +1 to +4

Expected cash flows in CU inflow(outflow)

The credit adjusted approach The credit adjusted approach

Nominal

Discounted at 9.80%

01/01/14 Purchase of the loan The credit adjusted approach

-80,000

-80,000

31/12/14 Expected interest The credit adjusted approach

10,000

9,108

31/12/15 Expected interest The credit adjusted approach

10,000

8,296

31/12/16 Expected interest The credit adjusted approach

10,000

7,555

31/12/17 Expected interest plus redemption (70,000)

80,000

55,041

Total

The excel function =IR(values) provides a credit adjusted effective interest rate of 9.80%. The interest income for the period 01/01/2014 – 31/12/2014 is calculated as follows:

9.8% x CU80,000 = CU7,840

Date

Accounts The credit adjusted approach

DT

CR

31/12/14

Financial asset The credit adjusted approach

7,840

31/12/14

Interest income The credit adjusted approach

7,840

3. Receipt of interest payment

Date

Accounts The credit adjusted approach

DT

CR

31/12/14

Bank The credit adjusted approach

10,000

31/12/14

Financial asset The credit adjusted approach

10,000

4. Life-time expected credit losses

The expected change in cash flows from initial recognition is calculated as follows:

– Cash flow redemption at the end of 31/12/2017 decreases from 70% to 65%, it is also expected that interest payments will decrease from CU10,000 to CU8,000.

Something else -   Transaction costs
The credit adjusted approach

Nominal

Discounted at 9.80%

31/12/15 Change in expected interest The credit adjusted approach

-2,000

-1,821

31/12/16 Change in expected interest The credit adjusted approach

-2,000

-1,659

31/12/17 Change in expected interest plus redemption (CU5,000)

-7,000

-5,288

Total

-8,768

Date

Accounts The credit adjusted approach

DT

CR

31/12/14

Impairment loss The credit adjusted approach

8,768

31/12/14

Financial asset – Life time expected credit losses

8,768

EXAMPLE – Calculation of credit-adjusted effective interest rate and recognition of loss allowance for purchased credit-impaired financial asset

On 1 January 2009, Company D issued a bond that required it to pay an annual coupon of CU800 in arrears and to repay the principal of CU10,000 on 31 December 2018. By 2014, Company D was in significant financial difficulties and was unable to pay the coupon due on 31 December 2014. The credit adjusted approach

On 1 January 2015, Company V estimates that the holder could expect to receive a single payment of CU4,000 at the end of 2016. It acquires the bond at an arm’s length price of CU3,000. Company V determines that the debt instrument is credit-impaired on initial recognition, because of evidence of significant financial difficulty of Company D and because the debt instrument was purchased at a deep discount. The credit adjusted approach

It can be shown that using the contractual cash flows (including the CU800 overdue) gives rise to an EIR of 70.1% (the net present value of CU800 now and annually thereafter until 2018 and CU10,000 receivable at the end of 2018 is CU3,000 when discounted at 70.1%). However, because the bond is credit-impaired, V should calculate the EIR using the estimated cash flows on the instrument. In this case, the EIR is 15.5% (the net present value of CU4,000 receivable in two years is CU3,000 when discounted at 15.5%).

All things being equal, interest income of CU464 (CU3,000 × 15.5%) would be recognised on the instrument during 2015 and its carrying amount at the end of the year would be CU3,464 (CU3,000 + CU464). However, if at the end of the year, based on reasonable and supportable evidence, the cash flow expected to be received on the instrument had increased to, say, CU4,250 (still to be received at the end of 2016), an adjustment would be made to the asset’s amortised cost. Accordingly, its carrying amount would be increased to CU3,681 (CU4,250 discounted over one year at 15.5%) and an impairment gain of CU217 would be recognised in profit or loss. The credit adjusted approach

EXAMPLE – Loan from Subsidiary C to Subsidiary B (novated interest bearing bank term loan)

The loan from Subsidiary C is non-recourse in nature due to the fact that Subsidiary B only holds one asset being the investment property. Subsidiary C must therefore look through to the underlying asset (being the investment property) and determine whether this feature results in the SPPI test being failed.

In considering the SPPI test, Subsidiary C notes that if the loan was considered a basic lending arrangement which met the SPPI test, it would also meet the definition of a ‘Purchased or Originated Credit Impaired’ loan because the discount of £300k would represent incurred credit losses. This means that a credit adjusted EIR taking into account those incurred losses would be calculated. At initial recognition therefore:
–– Fair value = £500k;
–– Credit adjusted EIR = 8% (i.e. the interest rate which discounts future cash flows of £40k in 2021 and £540k 2022 back to the initial carrying amount of £500k).

Something else -   Purchased and originated credit-impaired financial assets

Under this method of accounting, any subsequent changes (gains or losses) in lifetime ECL of £300k would be taken as an impairment gain or loss in future periods and would be entirely dependent upon the value of the property. This is not consistent with a basic lending arrangement and implies that the loan is more in the nature of an indirect investment in the underlying property than the provision of finance.

Based on the above analysis, Subsidiary C concludes that the loan fails the SPPI test and would be classified at FVPL. On an ongoing basis, the loan would be measured at fair value in accordance with IFRS 13 Fair Value Measurement with all movements in fair value going through profit or loss.

EXAMPLE – Loan becomes credit impaired

An entity originates a 5-year loan of RM10,000,000 that pays fixed interest of 8% per year and is repayable at the nominal amount at the end of Year 5. Transaction costs amount to RM200,000. If the borrower defaults at the end of Year 5, the entity expects to recover only RM7,500,000 of the principal amount. Based on the credit risk of the borrower, there is a 1% chance that the borrower will default at the end of Year 5. Using a discount rate of 4% risk-free rate, the probability-weighted lifetime expected credit losses is estimated at RM20,548. An initial 12-month expected credit losses of RM4,110 is recognised as a loss allowance on the origination date of the loan.

  • Initial recognition loan receivable
Loan receivable 10,000,000
Bank account 10,000,000
  • Transaction costs
Loan receivable – transaction costs 200,000
Bank account 200,000
  • 12-month expected credit losses
Impairment in profit or loss 4,110
Loan receivable – initial loss allowance 12-month credit losses 4,110

The effective interest rate is calculated on the gross carrying amount as follows:

Determine adjusted effective interets rateWhere: “r”, the effective interest rate, is determined at 7.51%. The interest revenue is recognised at the effective interest rate of 7.51% on the gross carrying amount over the five-year term and the loss allowance is adjusted for the 12-month expected credit losses at the end of each year as follows:

Amortised costs adjusted effective interest

  • Year 1 journal entries
Loan receivable 765,571
Interest income 765,571
Bank account 800,000
Loan receivable 800,000
Impairment in profit or loss 164
Loan receivable – initial loss allowance 12-month credit losses 164

At the end of Year 5 and if there is no default, the entity records the following journals:

  • Receipt of the loan on repayment
Bank account 10,000,000
Loan receivable 10,000,000
  • Reversal of 12-month expected credit losses
Loss allowance on loan receivable 5,000
Impairment gain in profit or loss 5,000

When the Loan becomes Credit-Impaired

If, in the above example, the loan receivable subsequently becomes credit-impaired at the end of Year 2, and the entity revises the estimated future cash flows to consist of RM600,000 interest per year for the remaining three years and the recoverable amount of RM9,000,000 of the principal at the end of Year 5. Using the original effective interest rate of 7.51%, the present value of the revised future cash flows is calculated at RM8,803,671. The lifetime expected credit losses are calculated at the present value of the shortfall in the future cash flows and the amount of lifetime expected credit losses required is RM1,324,887. The entity recognises the impairment loss as follows:

Impairment loss in profit or loss (1,324,887 (required allowance) – 4,274 (recorded allowance) 1,320,613
Loss allowance on loan receivable 1,320,613

The entity subsequently applies the original effective interest rate to the revised amortised cost amount in the subsequent periods, as follows:

Credit impaired table

The credit adjusted approach

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Something else -   Low credit risk operational simplification

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