Under IFRS 9 expected credit losses are recognised from the point at which financial instruments are originated or purchased. There is no longer be a threshold (such as a trigger loss event of default) before expected credit losses would start to be recognised. With limited exceptions, a 12-month expected credit losses must be recognised initially for all assets subject to impairment. For example, an entity recognises a loss allowance at the initial recognition of a purchased debt instrument rather than when an event of default by the issuer occurs.
The amount of expected credit losses that are recognised depends on the change in the credit quality since initial recognition to reflect the link between expected credit losses and the pricing of the financial instrument. With limited exceptions, IFRS 9 requires that at each reporting date, an entity shall measure the loss allowance for a financial instrument at an amount equal to the lifetime expected credit losses if the credit risk on that financial instrument has increased significantly since initial recognition [IFRS 220.127.116.11]. See also Impairment – Expected credit losses on financial assets for the three-stage approach based on changes in credit risk. Lifetime expected credit losses are defined as the expected credit losses that result from all possible default events over the life of the financial instrument.
The requirements in IFRS 9 result in lifetime expected credit losses being recognised only when the credit risk of a financial instrument is worse than that anticipated when the financial instrument was first originated or purchased. If, at the reporting date, the credit risk on a financial instrument has not increased significantly since initial recognition, an entity shall measure the loss allowance for that financial instrument at an amount equal to 12-month expected credit losses [IFRS 9.5.5]. 12-month expected credit losses are defined as the expected credit losses that result from those default events on the financial instrument that are possible within the 12 months after the reporting date.
A portion of lifetime expected credit losses is recognised when financial instruments are first originated or purchased. This is a way to reflect that the yield on the instrument includes a return to cover those credit losses expected from when a financial instrument is first recognised. If this amount was not recognised the full yield would be recognised as interest income with no adjustment for credit losses that were always expected.
Example at recognition and at year-end 1
Entity B, as a lender, contracts a five-year term loan of CU1,000,000 at the beginning of Year 1. If there were no possibility of credit losses, the coupon rate that Entity B would charge the borrower is 5% per annum.
However, because of the borrower’s credit rating, Entity B estimates that there is a possibility the borrower might default on the payments and the expected credit losses are estimated at CU10,000 per year over the five-year term.
Accordingly, Entity B charges the borrower a 6% coupon rate to reflect the yield on the instrument to include a return to cover those credit losses expected when the loan is first recognised. The present value of the lifetime expected credit losses of CU10,000 per year for five years discounted at 6% is CU42,124. The present value of the 12-month expected credit losses of CU10,000 for the first year discounted at 6% is CU9,434 (10,000/1.06).
Thus, on initial recognition, Entity B records the following journal entries:
Dr Loan receivable CU1,000,000
Cr Cash CU1,000,000
to recognise loan asset at gross amount
Cr Loss allowance in financial position CU9,434
to recognise 12-month expected credit losses
If, at the end of Year 1, there is no significant deterioration of the credit quality, there would be no change to the recognition of the 12-month expected credit losses.
However, suppose, at the end of year 1, there is a significant deterioration of the credit quality and Entity B re-estimates that the present value of the lifetime expected credit losses is CU34,651 (discount CU10,000 per year for year 2 – 5). Entity B recognises the lifetime expected credit losses (calculated as CU34,651 – CU9,434 = CU25,217), as follows :
Dr Impairment loss in profit or loss CU25,217
Cr Loss allowance in financial position CU25,217
to recognise lifetime expected credit losses
The loss allowance in the statement of financial position would have a balance of CU34,651 and that is equal to the lifetime expected credit losses at the end of Year 1.