The International Accounting Standards Board (IASB) issued the revised version of IFRS 9: Financial Instruments, that brought together the classification and measurement (including impairment) and hedge
accounting to replace IAS 39 on Financial Instruments: Recognition and Measurement and all previous versions of IFRS 9. Contrary to widespread belief, application of IFRS 9 can have a disruptive effect on equity and profits of not only financial institutions but on all organisations that have significant financial assets on their balance sheet as at the reporting date.
The mandatory application date of IFRS 9 is 1 January 2018, which has forced organisations to hit the ground running for its timely and proper implementation.
Introduction to Expected Credit Loss (ECL)
Among other things, the most important concept introduced by revised IFRS 9 on Financial Instruments is
recognition of a loss allowance for Expected Credit Losses (ECL), which replaces the Incurred Loss (IL) methodology as required by IAS 39. The IL model was widely criticized by many for not recognizing the credit losses at an early stage and underestimating the losses, especially during economic downturns and financial crisis situations. The new impairment requirements for financial assets in IFRS 9 provide a forward-looking ‘Expected Credit Loss’ framework, which unlike the previous regime, does not recognize losses based only upon a set of past and current information.
Approaches to Recognizing Expected Credit Losses
- The ‘simplified approach’ is generally applied to trade receivables, contract assets, retentions and
- The ‘general approach’ is applied to all other financial assets, such as those classified at
amortised cost (loans, deposits, debt securities, etc.) or fair value through other comprehensive
income, loan commitments and financial guarantee contracts.
THE ‘General Approach’ TO ECL
Under the general approach, an entity must identify, whether the financial asset is in one of following three stages in order to determine
- The amount of ECL to recognize; and
- How interest income on the financial asset should be recognized?
Stage 1 – Credit risk has not increased significantly since initial recognition:
For financial assets in stage 1, entities are required to recognize 12 months ECL and recognise interest income on a gross basis – this means that interest will be calculated on the gross carrying amount of the financial asset before adjusting for ECL.
Stage 2 – Credit risk has increased significantly since initial recognition:
The requirements have a rebuttable presumption that credit risk has increased significantly when contractual payments are more than 30 days past due. When a financial asset transfers to stage 2, entities are required to recognise lifetime ECL but interest income will continue to be recognised on a gross basis.
Stage 3 – Financial asset is credit impaired:
This is the point of incurred loss event under the IAS 39 model. For financial assets in stage 3, entities will continue to recognize lifetime ECL, but they will now recognize interest income on a net basis (i.e.net of ECL provisioning amount).
Measurement OF ECL
According to IFRS 9, measurement of ECL should be done in a way that reflects the following 3 factors
Unbiased and probability weighted amount
Time value of Money
Present value using discount rate or an approximation
Reasonable & supportable information
Available without undue cost or efforts about past events, current conditions and forecasts
Considering the application of IFRS 9, the ECL formula can be defined as
PD = Probability of default
LGD = Loss given default
EAD = Exposure at default
D = Discount factor
The ‘simplified approach’ to ECL for trade, contract and lease receivables
IFRS 9 requires an entity to use a simplified approach for calculating expected losses as a practical expedient (e.g., for trade receivables). To implement the simplified approach on IFRS 9 compliant “ECL provision matrix” needs to be carefully developed by the organization considering the following factors:
- Historical credit loss experience (e.g. average Delay and Default rate) Credit loss arises even if the entity expects to be paid in full but later than when contractually due. Separate Provision matrix is required to address the ‘Default’ risk and ‘Delay’ risk’. Additionally, provisions are required to be made on case to case basis for ‘Performance/Work’ issues.
- Type of customer and industry the entity deals in.
- Forward looking information on trade, contract and lease receivables, including current economic scenario etc.
ECL provisioning is to be applied retrospectively. While restatement of comparatives is not required unless possible without use of hindsight, it should adjust the opening balance of its retained earnings for the effect of applying the standard in the year of initial application.
The revised IFRS 9 ECL provisioning norms have significant implications both in terms of timing of recognition and measurement of bad debt provision. In particular, those entities, which have significant trade/contract receivables, due from customers for contract work, contract retentions, third party and intercompany loans, loan commitments, financial guarantees, etc. will have to quickly gear up to address the new requirements of ECL provisioning.
Management will be required to build up “ECL matrix/ models” to determine both 12 month and lifetime ECL
which will require complex judgements as regards to probability of delay/default, exposure, discount factor etc. It can well be understood that the implementation process will require significant amount of professional knowledge/ expertise, time and planning for an entity to achieve compliance with the equirements of revised IFRS 9.
(This article is compiled by Mr. Kushal Parikh, Deputy Manager in PKF L.L.C., the PKF member firm in the Sultanate of Oman.)