PwC's Mercedes Baño highlights the key challenges now facing preparers as the new expected credit losses impairment model in IFRS 9, Financial Instruments, replaces IAS 39, Financial Instruments: Recognition and Measurement
Almost five years after the publication of the first phase of the replacement of IAS 39, the International Accounting Standards Board (IASB) completed its project to improve accounting for financial instruments by amending the classification and measurement requirements and adding a new expected credit losses model for the recognition of impairment.
Expected credit losses model
A major change included in the standard is the new expected credit losses (‘ECL’) model which aims at addressing the criticism of ‘too little, too late’ raised during the last economic crisis because current IFRS only allowed impairment losses to be recognised when they were ‘incurred’.
The new model is applied to all debt instruments measured at amortised cost or fair value though other comprehensive income (FVOCI) as well as to issued loan commitments and most financial guarantee contracts. It contains a ‘three stage’ approach which is based on the change in credit quality of financial assets since initial recognition. Assets move through the three stages as credit quality changes and the stages dictate how an entity measures impairment losses and applies the effective interest rate method:
Stage 1 includes financial instruments that have not had a significant increase in credit risk since initial recognition or which have low credit risk at the reporting date. For these items, 12-month ECL are recognised and interest revenue is calculated on the gross carrying amount of the asset (ie, without deduction for credit allowance). The 12-months ECL are the expected credit losses that result from default events that are possible within 12 months after the reporting date. It is not the expected cash shortfalls over the 12 month period but the entire credit loss on an asset weighted by the probability that the loss will occur in the next 12 months.
Stage 2 includes financial instruments that have had a significant increase in credit risk since initial recognition (unless they have low credit risk at the reporting date) but that do not have objective evidence of impairment. For these items, lifetime expected credit losses are recognised, but interest revenue is still calculated on the gross carrying amount of the asset. 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 weight.
Stage 3 includes financial assets that have objective evidence of impairment at the reporting date. For these items, lifetime expected credit losses are recognised and interest revenue is calculated on the net carrying amount (ie net of credit allowance).
In practice, the new rules mean that entities will have to record a day 1 loss equal to the 12-month ECL on initial recognition of financial assets that are not credit impaired (or lifetime ECL for trade receivables, see Operational Simplifications below). This may have a large impact on entities holding significant portfolios of financial assets measured at amortised cost or FVOCI.
As explained above, the ECL model relies on a relative assessment of credit risk; this means that a loan with the same characteristics could be included in Stage 1 for one entity and in Stage 2 for another depending on credit risk at initial recognition for each entity. Moreover, an entity could have different loans with the same counterparty that could be included in different stages depending on the credit risk that each one had at origination.
The model includes some operational simplifications for trade receivables and lease receivables. This provides relief by eliminating the need to calculate 12-month ECL and to assess when a significant increase in credit risk has occurred. This is because often trade receivables have a maturity less than one year so lifetime expected credit losses and the 12-month expected credit losses would be very similar.
In addition, if the credit risk of a financial instrument is low (ie, at least investment grade) at the reporting date, the entity may measure impairment using 12-month expected credit losses and therefore does not have to assess whether a significant increase in credit risk has occurred.
Determining significant increases in credit risk
One of the major areas of judgment will be assessing when there has been a significant increase in credit risk. The standard requires entities to compare the risk of a default occurring on the financial instrument as at the reporting date with the risk of a default occurring as at the date of initial recognition and determine if there has been a significant increase. Entities will need to apply judgement in determining how to assess increases in risk of default and what constitutes a significant increase. This will be a key area in which regulators may provide guidance.
The standard includes a rebuttable presumption that credit risk has increased significantly since initial recognition no later than when contractual payments are more than 30 days past due. This rebuttable presumption should be used as a backstop if more forward looking information is not available.
The 12-month expected credit losses used for regulatory purposes are normally ‘through the cycle’ (ie, probability of default in cycle neutral economic conditions) and can include an adjustment for prudence
One way of performing the assessment is by using probability of default information. Generally a lifetime probability of a default (over the remaining life of the instrument) would be used; but as a practical expedient, a 12-month probability of a default can be used if it is not expected to give a different result to using lifetime probability of default.
It is important to mention that such probabilities of default are not necessarily the same used for regulatory purposes. The 12-month expected credit losses used for regulatory purposes are normally ‘through the cycle’ (ie, probability of default in cycle neutral economic conditions) and can include an adjustment for prudence.
Probabilities of default used for IFRS 9 purposes should be ‘point in time’ (ie, probability of default in current economic conditions) and do not contain adjustment for prudence.
Collateral should not be taken into account when assessing significant increases in credit risk, but it should be factored in the calculation of ECL.
Illustrative examples in the standard provide guidance on how to perform the assessment based on specific facts and circumstances. These assume that all entities have the information to analyse credit risk in a similar manner (eg, correlation of interest rates and default rates on mortgages), which may not always be the case.
Estimating expected credit losses
Expected credit losses represent a probability-weighted estimate of the difference over the remaining life of the financial instrument:
A credit loss is the difference between the cashflows that are due to an entity in accordance with the contract and the cashflows that the entity expects to receive discounted at the original effective interest rate.
This calculation of lifetime ECL could be challenging, as IFRS 9 requires entities to take into account all information that is reasonably available, including information about past events, current conditions and reasonable and supportable forecasts of future events and economic conditions when performing the assessment. Therefore, the calculation of the impairment provision will require a significant amount of judgment especially with regards to how to incorporate forward looking information in the measurement.
1 January 2018
IFRS 9 is effective for annual periods beginning on or after this date
IFRS 9 establishes that for periods beyond ‘reasonable and supportable forecasts’ an entity should consider how best to reflect its expectations by considering information at the reporting date about the current conditions, as well as forecasts of future events and economic conditions. As the forecast horizon increases, the availability of detailed information decreases and the degree of judgment to estimate ECL increases.
The estimate of ECL does not require a detailed estimate for periods that are far in the future – for such periods, an entity may extrapolate projections from available, detailed information.
The standard is not specific on how to extrapolate projections from available information. Different ways of extrapolating may be used; an entity could apply the average expected credit losses over the remaining period or use a steady rate of expected credit losses based on the last available forecast. These are only examples and other methods might apply. This is a highly judgmental area which may have a big impact on the allowance for impairment.
As a result, the value of the allowance for impairment will vary depending on the movements in the projections and on the relative credit quality of the financial instruments. It is therefore expected that this will generate more volatility in the P&L than the current IAS 39 incurred loss model. Nevertheless this volatility should be more aligned to the information contained in credit risk management systems of financial institutions.
Extensive disclosures are required to identify and explain the amounts in the financial statements that arise from expected credit losses and the effect of deterioration and improvement in credit risk. The following diagram highlights some of the new requirements:
Sufficient information should be provided to allow users to reconcile line items that are presented in the statement of financial position. For disclosure purposes, financial instruments should be grouped into classes that facilitate the understanding for users. The information should also be provided on the same level of aggregation or disaggregation as the reconciliation of the related loss allowance and shall include relevant qualitative and quantitative information.
It is expected that in order to comply with the new disclosure requirements entities will need to modify their current information systems in order to gather and track the data required (ie, credit risk of the financial asset at inception).
Effective date and transition
IFRS 9 is effective for annual periods beginning on or after 1 January 2018. Earlier application is permitted. IFRS 9 is to be applied retrospectively but comparatives are not required to be restated. If an entity elects to early adopt IFRS 9 it must apply all of the requirements at the same time. Entities applying the standard before 1 February 2015 continue to have the option to apply the standard in phases. However, IFRS 9 is still subject to the endorsement process in Europe.
About the author
Mercedes Baño is a senior manager, PwC