This article was first published in the July/August 2015 international edition of Accounting and Business magazine.

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In July 2014, the International Accounting Standards Board (IASB) issued the final version of IFRS 9, Financial Instruments. IFRS 9 consolidates the classification and measurement, impairment and hedge accounting requirements of the project to replace IAS 39, Financial Instruments: Recognition and Measurement. 

By introducing a forward-looking expected credit loss (ECL) model, the impairment requirements in the standard address the concerns raised over the incurred loss model in IAS 39, which resulted in a delayed recognition of credit losses. To provide support to stakeholders and inform the IASB on implementation issues arising from the standard, the IASB has also set up an IFRS Transition Resource Group for Impairment of Financial Instruments (ITG). 

The ECL model applies to debt instruments recorded at amortised cost or at fair value through other comprehensive income, lease receivables, contract assets and loan commitments, and financial guarantee contracts that are not measured at fair value through profit or loss. The purpose of the model is to reflect the general pattern of deterioration or improvement in the credit quality of financial instruments.

The loss allowance or provision recognised is based upon the credit deterioration since initial recognition. Lifetime ECL is an expected present value measure of losses that arise on default throughout the life of the instrument. It is the weighted average credit losses with the probability of default as the weighting.

Three approaches

The entity is required to follow one of three approaches outlined in the standard.

If an entity uses the general approach, a loss allowance should be recognised at each reporting date, based on either 12 month ECLs or lifetime ECLs. The approach taken depends upon whether or not there has been a significant increase in credit risk on the financial instrument since initial recognition. Any changes in the loss allowance balance are recognised in profit or loss.

At each reporting date, an entity must make the following assessment: where there has not been a significant increase in the credit risk since initial recognition, it should provide for 12-month ECLs; where there has been a significant increase in credit risk since initial recognition, it should calculate a loss allowance based upon lifetime ECLs.

If the credit quality of the financial instrument improves in future periods and there is no longer a significant increase in credit risk since initial recognition, then the loss allowance is based again on 12-month ECLs. Entities can assess ECLs on a collective basis.

When assessing whether credit risk has increased » significantly since initial recognition, management looks at the change in the risk of a default occurring over the expected life of the financial instrument rather than the change in the ECLs. 

A comparison should be made between the risk of default at the date of the financial statements with that at the date of initial recognition. The standard allows a 12-month period to be used to assess the risk of default if it is not expected to give a different result to that of assessing the lifetime default risk. In assessing whether or not the credit risk has increased significantly, reasonable and supportable best information should be used, such as actual and expected changes in external market indicators, internal factors and borrower-specific information.

Normally, a financial instrument would have a significant increase in credit risk before there is objective evidence of impairment or before a default occurs. It is expected that lifetime ECL should be recognised before a financial asset is regarded as credit-impaired or in default.

The entity should always consider forward-looking information. But if this is not available, there is a rebuttable presumption that credit risk has increased significantly since initial recognition where contractual payments are more than 30 days overdue.

Where the financial asset is not a purchased or originated credit-impaired asset or has not become credit impaired since initial recognition, interest revenue is calculated on the gross carrying amount. This is therefore the case for financial instruments that have and have not had a significant increase in credit risk since initial recognition.

If a financial asset subsequently becomes credit-impaired, the interest revenue is calculated by applying the effective interest rate (EIR) to the amortised cost of the financial asset that is the gross carrying amount net of loss allowance, rather than the gross carrying amount. If the financial asset is no longer credit-impaired and the improvement in credit quality can be related objectively to a certain event, such as an improvement in the credit rating of a loan creditor, then the interest revenue can again be calculated by applying the EIR to the gross carrying amount. If there is no reasonable expectation of recovering the financial asset, then the gross carrying amount of the financial asset should be written off.

Simplified approach

A second approach has been termed the ‘simplified approach’. Here the entity does not have to track the changes in credit risk, but on recognition it recognises a loss allowance based on lifetime ECLs at each reporting date. This approach is used when accounting for trade receivables or contract assets that fall within the scope of IFRS 15, Revenue from Contracts with Customers, and that do not contain a significant financing component. It should also be used when the entity applies the practical expedient for contracts that have a maturity date of one year or less, in accordance with IFRS 15. The loss allowance should be probability-weighted, allow for the time value of money and utilise the best available forward-looking information. 

It seems obvious that a considerable amount of judgment will be required when assessing ECLs under this approach. However, entities are required to disclose the basis behind their estimation of lifetime ECLs. In addition, the entity may choose to apply either the simplified approach or the general approach to trade receivables or contract assets within the scope of IFRS 15 and finance or operating lease receivables. This choice of policy should assist those entities that do not have sophisticated credit risk management systems. For those trade receivables and contract assets that are due within 12 months, the 12-month ECLs will be the same as the lifetime ECLs.

When a financial asset is first recognised, there is a requirement to determine whether or not the asset is credit-impaired. Credit-impairment occurs when events have occurred that have a detrimental impact on the asset’s estimated future cashflows. These events include breach of contract, the financial difficulty or bankruptcy of the borrower, or the lack of an active market for the financial asset due to financial issues.

If the entity purchases a credit-impaired asset, it is likely that the acquisition will be deeply discounted. For such assets, the effective interest rate is calculated after accounting for the initial lifetime ECLs. This treatment is unchanged from IAS 39.

Subsequently, the entity recognises any changes in lifetime ECLs as a loss allowance, with any impairment gain recognised in profit or loss. This gain would occur where favourable changes result in the estimate of lifetime ECLs becoming lower than originally calculated. Interest revenue is calculated by applying the credit-adjusted EIR to the amortised cost of these financial assets from initial recognition. The ECL model relies on a relative assessment of credit risk, which means that a loan with the same characteristics could be treated differently by entities, as could different loans with the same counterparty, depending on the credit risk of each at recognition.

ITG Group

The first meeting of the ITG Group took place in April 2015. The discussion focused on the implementation of the impairment requirements of IFRS 9. There were several items on the agenda. Here are a few examples of the items discussed.

  • The group was asked whether there was a requirement to measure ECLs at the date of de-recognition of a financial asset measured at amortised cost or FVTOCI (fair value through other comprehensive income). The conclusion was that this measurement should occur as a gain or loss on de-recognition and should be calculated.
  • It was noted that a recent measure of the loss allowance could serve as a proxy depending upon how frequently the loss allowances were calculated. 
  • The group was also asked whether a financial guarantee contract should be taken into account when assessing whether there has been a significant increase in the credit risk of the guaranteed debt instrument. The group felt that expected recoveries from integrated guarantee contracts should not be taken into account, but that the behaviour of the guarantor may influence the probability of default.
  • On a similar note, the ITG Group was asked whether premiums received from the holder of a guarantee contract should be taken into account when assessing the ECLs of the guarantee contract itself. The group felt that the premiums should not be included in the measurement of ECLs, but the entity should bear in mind that the non-payment of premiums may cause the guarantee to lapse.
  • The group was asked to comment on an example where a bank granted a mortgage to a client that had a six-month maturity date, but that was automatically extended unless the borrower or lender terminated the loan. The question posed was surrounding the length of the maximum period that the bank should consider when assessing expected credit losses. The group felt that the maximum period was six months as the lender was not contractually required to lend beyond six months.

Financial institutions will find the standard very challenging. Most entities do not collect the credit information required to apply the standard. New models will need to be built to determine both 12-month and lifetime ECLs, and significant judgment will be required. 

Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School