After the financial crisis of 2007-8, it became glaringly obvious that amendments were necessary to the existing accounting rules for financial instruments. The International Accounting Standards Board (IASB) issued IFRS 9, Financial Instruments on July 24, 2014. The following is a summary of the new impairment rules.
Overview of expected credit loss model
The following financial instruments fall within the scope of the expected credit loss (ECL) model:
- Financial assets measured at amortized cost;
- Financial assets mandatorily measured at fair value through other comprehensive income (FVOCI);
- Loan commitments that are not measured at fair value through profit and loss (FVPL) when there is a present obligation to extend credit;
- Financial guarantee contracts that are within the scope of IFRS 9 and that are not measured at FVPL; and
- Lease and trade receivables.
The current loss model under IAS 39 only allows impairment provisions for losses occurring at the reporting date. The new impairment rules are forward-looking, which will have major implications for preparers of financial statements.
A 12-month ECL allowance is recognized at each reporting period for financial instruments that have not seen a significant increase in credit risk. The 12-month ECL is a portion of the lifetime ECL and represents the amount of expected credit losses resulting from a default in the 12 months following the reporting date.
For all financial instruments undergoing a significant increase in credit risk, a lifetime ECL is recognized. If afterwards, the credit risks decreases, so that the criteria for recognizing a lifetime ECL is no longer met, then the entity measures the loss allowance as the 12-month ECL.
The ECL is the present value of the expected cash shortfalls over the life of the financial instrument. Measurement should take into account an unbiased and probability weighted estimate of cash flows under a range of possible outcomes. The degree to which judgment is exercised will depend on the availability of information.
In assessing credit risk, only the risk of default over the remaining term of the financial instrument is considered. The exercise can be performed for a portfolio of instruments with shared credit risk. Although the standard does not prescribe the method to use, the objective is to use all reasonable and supportable information including forward-looking information, which is available without undue cost or effort.
Interest revenue is calculated using the effective interest method applied to the gross carrying amount of the financial instrument. When there is objective evidence of impairment, interest is calculated based on the net carrying amount (the gross carrying amount net of the ECL).
To decrease the burden of applying the new standard, entities are allowed to recognize a 12-month ECL allowance for any financial instruments considered low risk (for which criteria must be met) at the reporting date. Therefore, a credit risk assessment is not required. An example of a low risk instrument is one meeting the definition of 'investment grade' at the reporting date.
A rebuttable presumption is included: that there has been a significant increase in credit risk when contractual payments are more than 30 days past due. However, in assessing whether there has been a significant increase in credit risk for such instruments, information that is more forward-looking should also be considered.
The default definition that is applied must be consistent with the credit risk management practices applied. It must also take into account qualitative indicators of default (such as instruments that have financial covenants attached). There is a second rebuttable presumption: default does not occur later than after 90 days past due, unless the entity can support a longer timeframe using reasonable and supportable information.
An ECL is recognized for loan commitments and financial guarantee contracts for the period over which the entity is exposed to credit risk and future drawdowns cannot be avoided.
A simplified approach is allowed for trade receivables and lease receivables, which eliminates the need to calculate the 12-month ECL. An entity can opt to measure the loss allowance at an amount equal to the lifetime ECL throughout the life of these assets.
The need for timely consideration of the new standard
The change to an expected loss model will require detailed planning and implementation.
The IASB typically allows for an 18-month implementation period between issuance of a final standard and the standard's effective date. However, respondents to the Impairment Exposure Draft agree a three-year implementation period is needed to effectively plan and test. Therefore, the IASB has tentatively decided that the mandatory effective date for IFRS 9 will be no earlier than year-ends commencing on or after January 1, 2017.
The factors driving the need for early consideration of the new standard include:
- The ECL model must be applied retrospectively. Adoption will require the credit risk of financial instruments at initial recognition to be quantified when determining whether credit risk has increased significantly. Many of those financial instruments may have been recognized prior to the effective date. An entity is not required to expend undue cost or effort when obtaining the information; but instead can approximate the credit risk using the best information available.
- Significant changes to existing risk models or the development of entirely new models for some entities will be necessary. The systems will have to capture forward-looking data to measure changes in expected credit risks.
- For some entities, it will be the first time forward-looking data is being captured. Locating the appropriate data may be an issue. What is crucial is allowing sufficient time to collect enough of data to analyze accurately any trends.
- Due to the scale of the changes required, for many entities they will have to run the new system and model parallel with existing risk systems. This will enable management to understand, more fully, how the new system operates and what factors and assumptions drive the expected losses.
Any entity required to adopt the new standard should consider the detail of the requirements early and put a plan of action in place. For further information, contact your Crowe Soberman advisor.
About the Author
Paul is a partner in the Audit & Advisory Group. His professional experience includes construction, manufacturing, real estate and internal audit engagements.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.