IFRS 9 Impairment

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Background:-

Due to the financial crisis in market, the delayed recognition of credit losses that are associated with loans and other financial instruments was identified as a weakness of the existing impairment requirement of IAS 39. The issue arose as the existing impairment model was based on incurred loss model which contributed the delayed recognition of credit losses. Thus, losses are rarely incurred evenly over the lives of loans, there is a mismatch in the timing of the recognition of the credit spread inherent in the interest charged on the loans over their lives and any impairment losses that only get recognised at a later date. As such, IASB has introduced a forward-looking expected credit loss model in IFRS 9.

Scope of Impairment:-

The expected credit loss model applies to

• Financial assets that are debt instruments such as loans, debt securities, bank balances and deposits and trade receivables that are measured at amortised cost

• Financial assets that are debt instruments measured at fair value through other comprehensive income (FVOCI). However, the loss allowance shall be recognised in other comprehensive income and shall not reduce the carrying amount of the financial asset in the statement of financial position.

• Lease receivables under IFRS 16 Leases

• Contract assets under IFRS 15 Revenue from Contracts with Customers . IFRS 15 defines a contract asset as an entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passage of time (for example, the entity’s future performance)

• Loan commitment : The scope excludes loan commitments designated as financial liabilities at fair value through profit and loss and loan commitments that can be settled net in cash or by delivering or issuing another financial instrument

• Financial guarantee contracts that are not measured at fair value through profit or loss (FVTPL) under IFRS 9 . The scope excludes financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition or when the continuing involvement approach applies

Type of impairment models:-

· General approach, applicable if the other two model doesn’t apply

· The simplified approach, that is either required or available as a policy choice for trade receivables, contract assets and lease receivables

· The credit-adjusted EIR approach, for purchased or originated credit-impaired financial assets

General Approach

The guiding principle for expected credit loss in general model is to reflect the general pattern of deterioration or improvement in the credit quality of financial instruments. Under the general approach, the model is elaborated in 3 stages:-

· Stage 1—as soon as a financial instrument is originated or purchased, 12-month expected credit losses are recognised in profit or loss and a loss allowance is established. This serves as a proxy for the initial expectations of credit losses. For financial assets, interest revenue is calculated on the gross carrying amount (ie without deduction for expected credit losses).

· Stage 2—if the credit risk increases significantly and is not considered low, full lifetime expected credit losses are recognised in profit or loss. The calculation of interest revenue is the same as for Stage 1.

· Stage 3—if the credit risk of a financial asset increases to the point that it is considered credit-impaired, interest revenue is calculated based on the amortised cost (ie the gross carrying amount less the loss allowance). Financial assets in this stage will generally be assessed individually. Lifetime expected credit losses are recognised on these financial assets.

Simplified Approach:-

The simplified approach does not require an entity to track the changes in credit risk, but, instead, requires the entity to recognise a loss allowance based on lifetime ECLs at each reporting date, right from origination.

- An entity is required to apply the simplified approach for trade receivables or contract assets that result from transactions within the scope of IFRS 15 and that do not contain a significant financing component, or

-when the entity applies the practical expedient for contracts that have a maturity of one year or less, in accordance with IFRS 15.

However, an entity has a policy choice to apply either the simplified approach or the general approach for the following:

• All trade receivables or contract assets that result from transactions within the scope of IFRS 15 and that contain a significant financing component in accordance with IFRS 15. The policy choice may be applied separately to trade receivables and contract assets

• All lease receivables that result from transactions that are within the scope of IFRS 16. The policy choice may be applied separately to finance and operating lease receivables

Purchased or Originated Credit-Impaired Approach-

On initial recognition of a financial asset, an entity is required to determine whether the asset is ‘credit-impaired’. A financial asset is credit-impaired when one or more events that have a detrimental impact on the estimated future cash flows of that financial asset have occurred. Evidence that a financial asset (on purchase or origination) is credit-impaired includes observable data about such events.

IFRS 9 provides a list of events that are substantially the same as the IAS 39 ‘loss events’ for an individual asset assessment:

• Significant financial difficulty of the issuer or the borrower

• A breach of contract, such as a default or past due event

• The lender(s) of the borrower, for economic or contractual reasons relating to the borrower’s financial difficulty, having granted to the borrower a concession(s) that the lender(s) would not otherwise consider

• It is becoming probable that the borrower will enter bankruptcy or other financial reorganisation

• The disappearance of an active market for that financial asset because of financial difficulties

• The purchase or origination of a financial asset at a deep discount that reflects the incurred credit losses It may not be possible for an entity to identify a single discrete event. Instead, the combined effect of several events may have caused the financial asset to become credit-impaired.

In this model, 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.

At each reporting date, an entity shall recognise in profit or loss the amount of the change in lifetime expected credit losses as an impairment gain or loss. An entity shall 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 expected credit losses that were included in the estimated cash flows on initial recognition.

Basis for estimating expected credit losses

The measurement of expected credit losses shall reflect an unbiased and probability-weighted amount that is determined by evaluating the range of possible outcomes as well as incorporating the time value of money. Also, the entity should consider reasonable and supportable information about past events, current conditions and reasonable and supportable forecasts of future economic conditions when measuring expected credit losses.

Thus, an entity needs to take the following into account:

• The probability-weighted outcome

• The time value of money, so that ECLs are discounted to the reporting date

• Reasonable and supportable information that is available without undue cost or effort

To reflect time value of money, expected losses should be discounted to the reporting date using the effective interest rate of the asset (or an approximation thereof) that was determined at initial recognition.

The maximum period to consider when measuring expected credit losses is the maximum contractual period (including extension options) over which the entity is exposed to credit risk and not a longer period, even if that longer period is consistent with business practice.

An entity shall recognise in profit or loss, as an impairment gain or loss, the amount of expected credit losses (or reversal) that is required to adjust the loss allowance at the reporting date to the amount that is required to be recognised in accordance with this Standard.

For application of the model to a loan commitment, an entity will consider the risk of a default occurring under the loan to be advanced, whilst application of the model for financial guarantee contracts requires consideration of the risk of a default occurring on the specified debtor

Expected credit losses of undrawn loan commitments should be discounted by using the effective interest rate (or an approximation thereof) that will be applied when recognising the financial asset resulting from the commitment. If the effective interest rate of a loan commitment cannot be determined, the discount rate should reflect the current market assessment of time value of money and the risks that are specific to the cash flows but only if, and to the extent that, the risks are taken into account by adjusting the discount rate, instead of adjusting the cash shortfalls being discounted. This approach should also be used to discount expected credit losses of financial guarantee contracts for which the effective interest rate cannot be determined. Note- For loan commitments and financial guarantee contracts, the date that the entity becomes a party to the irrevocable commitment shall be considered to be the date of initial recognition for the purposes of applying the impairment requirements

Significant increase in credit risk - A significant increase in credit risk is defined as a significant increase in the probability of a default occurring since initial recognition. Under the Standard, an entity may use various approaches to assess whether credit risk has increased significantly. An approach can be consistent with the requirements even if it does not include an explicit probability of default (PD) occurring as an input. The application guidance provides a list of factors (refer paragraph B5.5.15 -5.5.24 of bear standard) that may assist an entity in making the assessment.

Following points also need to consider:-

Ø 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

Ø Individual or collective assessment: In principle the assessment of loss should be based on lifetime expected credit losses is to be made on an individual asset basis, some factors or indicators might not be available at an instrument level. In this case, the entity should perform the assessment on appropriate groups or portions of a portfolio of financial instruments.

Ø Rebuttable presumption: If reasonable and supportable forward-looking information is available without undue cost or effort, an entity cannot rely solely on past due information when determining whether credit risk has increased significantly since initial recognition. However, when information that is more forwardlooking than past due status (either on an individual or a collective basis) 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. Regardless of the way in which an entity assesses significant increases in credit risk, there is a 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. An entity can rebut this presumption if the entity has reasonable and supportable information that is available without undue cost or effort, that demonstrates that the credit risk has not increased significantly since initial recognition even though the contractual payments are more than 30 days past due. When an entity determines that there have been significant increases in credit risk before contractual payments are more than 30 days past due, the rebuttable presumption does not apply.

Ø Significant reversal in credit risk: IFRS 9 also requires that (other than for purchased or originated credit impaired financial instruments) if a significant increase in credit risk that had taken place since initial recognition, has reversed by a subsequent reporting period (i.e., at the reporting date credit risk has not significantly increased since initial recognition) then the loss allowance reverts to 12-month expected credit losses.

Ø As a practical expedient, IFRS 9 allows an entity to assume that the credit risk on a financial instrument has not increased significantly if it is determined to have a ‘low’ credit risk at the reporting date. The Standard considers credit risk to be ‘low’ if there is 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 fulfill its contractual cash flow obligations. The Standard suggests that an ‘investment grade’ rating might be an indicator for a low credit risk.

Ø The standard contains an important simplification that, if a financial instrument has a low credit risk, then an entity is allowed to assume at the reporting date that no significant increases in credit risk have occurred. The low credit risk concept was intended, by the IASB, to provide relief for entities from tracking changes in the credit risk of high quality financial instruments. This simplification is optional and the low credit risk simplification can be elected on an instrument-by-instrument basis.

Note: An entity always accounts for ECLs, and updates the loss allowance for changes in ECLs at each reporting date to reflect changes in credit risk since initial recognition.

Modifications and write-offs:

If a renegotiation or other modification of the contractual cash flows of a financial asset results in derecognition under IFRS 9, the revised instrument is treated as a new instrument. The impairment model would then apply to the new instrument as normal.

If a renegotiation or other modification of the contractual cash flows of a financial asset does not result in derecognition, the entity recalculates the gross carrying amount of the financial asset (i.e. amortised cost amount before adjusting for any loss allowance). This is done by discounting the new expected contractual cash flows (post modification) at the original effective interest rate and recognising any resulting modification gain or loss in profit or loss. From this date, the entity assesses whether the credit risk of the financial instrument has increased significantly since initial recognition of the instrument by comparing the credit risk at the reporting date (under modified terms) to that at initial recognition (under original, unmodified terms).

The Standard requires an entity to directly reduce the gross carrying amount of a financial asset when the entity has no reasonable expectation of recovery. IFRS 9 states that a write-off constitutes a derecognition event and may relate to either the asset in its entirety or a portion of it.

Refer below diagram for quick glimpse of ECL recognition:-

Important Definitions:-

12‑month expected credit losses - The portion of lifetime expected credit losses that represent the expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date.
Expected credit losses - The weighted average of credit losses with the respective risks of a default occurring as the weights.
Lifetime expected credit losses - The expected credit losses that result from all possible default events over the expected life of a financial instrument.
Loss allowance- The allowance for expected credit losses on financial assets measured in, lease receivables and contract assets, the accumulated impairment amount for financial assets measured as advised by standard and the provision for expected credit losses on loan commitments and financial guarantee contracts.

Refer the below list of major changes and impacts from IAS 39 impairment:

Impacts and implications of the new ECL model are jotted down below:

• Scope of the impairment requirements has become broader. Under IAS 39, loss allowances were only recorded for impaired exposures. Now, entities are required to record loss allowances for all credit exposures not measured at fair value through profit or loss.

• IFRS 9 is designed to result in earlier recognition of credit losses, by necessitating a 12-month ECL allowance for all credit exposures. In addition, the recognition of lifetime ECLs is expected to be earlier and larger for all credit exposures that have significantly increase in credit risk.

• New impairment model is more forward looking than the IAS 39 impairment model. This is because holders of financial assets are not only required to consider historical information that is adjusted to reflect the effects of current conditions. They are now required to consider reasonable and supportable information that includes forecasts of future economic conditions when calculating ECLs, on an individual and collective basis.

• The application of the new IFRS 9 impairment requirements is expected to increase the credit loss allowances of many entities, particularly banks and similar financial institutions. However, the increase in the loss allowance will vary by entity, depending on its portfolio and current practices. Entities with shorter term and higher quality financial instruments are likely to be less significantly affected. Similarly, financial institutions with unsecured retail loans are more likely to be affected to a greater extent than those with collateralised loans such as mortgages.

• The focus on expected losses will possibly result in higher volatility in the ECL amounts charged to profit or loss, especially for financial institutions. The level of loss allowances will increase as economic conditions are forecast to deteriorate and will decrease as economic conditions become more favourable. This may be compounded by the significant increase in loss allowance when financial instruments move between 12-month and lifetime ECLs and vice versa.

• The need to incorporate forward-looking information means that application of the standard will require considerable judgement as to how changes in macroeconomic factors will affect ECLs. Also, the increased level of judgement required in making the ECL calculation may mean that it will be difficult to compare the reported results of different entities. However, the more detailed disclosures (compared with those required to complement IAS 39) that require entities to explain their inputs, assumptions and techniques used in estimating ECLrequirements, should provide greater transparency over entities’ credit risk and provisioning processes.

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