Applying IFRS
Impairment of nancial
instruments under IFRS 9
April 2018
1 April 2018 Impairment of financial instruments under IFRS 9
Contents
In this issue:
1 Introduction ........................................................................... 6
1.1 Brief history and background of the impairment
project .......................................................................... 6
1.2 Overview of IFRS 9 impairment requirements .................... 9
1.3 Key changes from the IAS 39 impairment
requirements and the impact and implications ................. 11
1.4 Key differences from the FASB’s standard ....................... 13
1.5 The IFRS Transition Resource Group for Impairment
of Financial Instruments (ITG) and IASB webcasts ............ 14
1.6 Other guidance on expected credit losses ........................ 17
2 Scope .................................................................................. 18
3 Approaches .......................................................................... 18
3.1 General approach ......................................................... 19
3.2 Simplified approach ...................................................... 21
3.3 Purchased or originated credit-impaired financial
assets ......................................................................... 23
4 Measurement of expected credit losses ................................... 25
4.1 Definition of default ...................................................... 26
4.2 Lifetime expected credit losses ...................................... 26
4.3 12-month expected credit losses .................................... 27
4.4 Probability of default (PD) and loss rate approaches ......... 29
4.4.1 Probability of default (PD) approach .................... 30
4.4.2 Loss rate approach ............................................ 33
4.5 Expected life versus contractual period ........................... 35
4.6 Probability-weighted outcome and multiple
scenarios ..................................................................... 38
4.7 Time value of money ..................................................... 43
4.8 Losses expected in the event of default........................... 45
4.8.1 Credit enhancements: collateral and
financial guarantees .......................................... 45
4.8.2 Cash flows from the sale of a defaulted loan ......... 50
4.9 Reasonable and supportable information ........................ 51
4.9.1 Undue cost or effort .......................................... 51
4.9.2 Sources of information ...................................... 52
2 April 2018 Impairment of financial instruments under IFRS 9
4.9.3 Information about past events, current
conditions and forecasts of future economic
conditions ........................................................ 52
5 General approach: determining significant increases in
credit risk ............................................................................ 57
5.1 Change in the risk of a default occurring ......................... 58
5.1.1 Impact of collateral, credit enhancements
and financial guarantee contracts ....................... 60
5.1.2 Contractually linked instruments (CLIs) and
subordinated interests ....................................... 62
5.1.3 Determining change in the risk of a default
under the loss rate approach .............................. 63
5.2 Factors or indicators of changes in credit risk .................. 63
5.2.1 Examples of factors or indicators of changes
in credit risk ..................................................... 64
5.2.2 Past due status and more than 30 days past
due rebuttable presumption ............................... 67
5.2.3 Illustrative examples of assessing significant
increases in credit risk ....................................... 68
5.2.4 Use of behavioural factors ................................. 73
5.3 What is significant? ....................................................... 74
5.4 Operational simplifications ............................................ 76
5.4.1 Low credit risk operational simplification ............. 76
5.4.2 Delinquency ...................................................... 81
5.4.3 12-month risk as an approximation for
change in lifetime risk ........................................ 82
5.4.4 Assessment at the counterparty level .................. 84
5.4.5 Determining maximum initial credit risk for a
portfolio ........................................................... 85
5.5 Collective assessment ................................................... 88
5.5.1 Example of individual assessment of
changes in credit risk ......................................... 89
5.5.2 Basis of aggregation for collective
assessment ...................................................... 90
5.5.3 Example of collective assessment (‘bottom
up’ and ‘top down’ approach) .............................. 92
5.6 Determining the credit risk at initial recognition of
an identical group of financial assets .............................. 95
5.7 Multiple scenarios for the assessment of significant
increases in credit risk .................................................. 96
6 Other matters and issues in relation to the expected
credit loss calculations .......................................................... 98
6.1 Basel guidance on accounting for expected credit
losses .......................................................................... 98
6.2 Global Public Policy Committee (GPPC) guidance ........... 102
3 April 2018 Impairment of financial instruments under IFRS 9
6.3 Measurement dates of expected credit losses ................ 103
6.3.1 Date of derecognition and date of initial
recognition ..................................................... 103
6.3.2 Trade date and settlement date accounting........ 104
6.4 Interaction between the initial measurement of debt
instruments acquired in a business combination and
the impairment model of IFRS 9 ................................... 105
6.5 Interaction between expected credit losses
calculations and fair value hedge accounting ................. 106
7 Modified financial assets ...................................................... 107
7.1 Accounting treatment if modified financial assets
are derecognised ........................................................ 107
7.2 Accounting treatment if modified financial assets
are not derecognised .................................................. 107
8 Financial assets measured at fair value through other
comprehensive income ........................................................ 110
8.1 Accounting treatment for debt instruments
measured at fair value through other comprehensive
income ...................................................................... 110
8.2 Interaction between foreign currency translation,
fair value hedge accounting and impairment .................. 111
9 Trade receivables, contract assets and lease receivables ........ 119
9.1 Trade receivables and contract assets .......................... 119
9.2 Lease receivables ....................................................... 120
10 Loan commitments and written financial guarantee
contracts ........................................................................... 121
11 Revolving credit facilities ..................................................... 127
11.1 Scope of the exception ................................................ 127
11.2 The period over which to measure expected credit
losses ........................................................................ 130
11.3 Exposure at default (EAD) ............................................ 137
11.4 Time value of money ................................................... 138
11.5 Determining significant increase in credit risk ................ 139
12 Intercompany loans ............................................................ 140
13 Presentation of expected credit losses in the statement of
financial position ................................................................ 144
13.1 Allowance for financial assets measured at
amortised cost, contract assets and lease
receivables ................................................................ 144
4 April 2018 Impairment of financial instruments under IFRS 9
13.1.1 Write-off ........................................................ 145
13.1.2 Presentation of the gross carrying amount
and expected credit loss allowance for
credit-impaired assets ..................................... 146
13.2 Provisions for loan commitments and financial
guarantee contracts ................................................... 149
13.3 Accumulated impairment amount for debt
instruments measured at fair value through other
comprehensive income ................................................ 150
14 Disclosures ........................................................................ 150
14.1 Introduction ............................................................... 150
14.2 Scope and objectives .................................................. 150
14.3 EDTF recommendations on ECL disclosures for
banks ........................................................................ 151
14.4 Credit risk management practices ................................ 151
14.5 Quantitative and qualitative information about
amounts arising from expected credit losses ................. 155
14.5.1 Changes in the loss allowance and the gross
exposures ...................................................... 155
14.5.2 Modifications ................................................... 161
14.5 3. Collateral and other credit enhancements .......... 161
14.6 Credit risk exposure .................................................... 162
14.7 Collateral and other credit enhancements obtained
during the period ........................................................ 163
5 April 2018 Impairment of financial instruments under IFRS 9
What you need to know
The Expected Credit Loss (ECL) impairment requirements in the new
standard, IFRS 9 Financial Instruments, are based on an expected credit
loss model and replace the IAS 39 Financial Instruments: Recognition and
Measurement incurred loss model.
The ECL impairment requirements must be adopted with the other IFRS 9
requirements from 1 January 2018, with early application permitted
The expected credit loss model applies to debt instruments recorded at
amortised cost or at fair value through other comprehensive income, such
as loans, debt securities and trade receivables, lease receivables and most
loan commitments and financial guarantee contracts.
All entities are required to recognise an allowance for either 12-month or
lifetime expected credit losses (ECLs), depending on whether there has
been a significant increase in credit risk since initial recognition.
The measurement of ECLs reflects a probability-weighted outcome, the time
value of money and the best available forward-looking information.
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. The increased level of judgement
required in making the expected credit loss calculation may also mean that
it will be more difficult to compare the reported results of different entities.
However, entities are required to explain their inputs, assumptions and
techniques used in estimating the ECL requirements, which should provide
greater transparency in respect of entities’ credit risk and provisioning
processes.
The need to assess whether there has been a significant increase in credit
risk will also require new data and processes.
The effect of the new requirements will be to require larger loss allowances
for banks and similar financial institutions and for investors in debt
securities. On transition, this will reduce equity and have an impact on
regulatory capital. The level of allowances will also be more volatile in
future, as forecasts change.
The other major impact will be the application to intercompany loans in
the separate financial statements of group companies.
6 April 2018 Impairment of financial instruments under IFRS 9
1 Introduction
This publication discusses the new forward-looking expected credit loss (ECL)
model as set out in IFRS 9. The ECL requirements must be adopted with the
requirements of IFRS 9 for classification and measurement for annual reporting
periods beginning after 1 January 2018. Early application is permitted if the
IFRS 9 classification and measurement requirements are adopted at the same
time.
This is a second edition of a publication we originally produced in early 2015.
In the last three years, many of the application issues have been the subject of
discussion by the IFRS Transition Resource Group for Impairment of Financial
Instruments (ITG) established by the IASB and further guidance has been
provided by the IASB in the form of webcasts and by banking regulators. At
the same time, many more issues have arisen from implementation projects.
1.1 Brief history and background of the impairment project
During the 2007/08 global financial crisis, the delayed recognition of credit
losses that are associated with loans and other financial instruments was
identified as a weakness in existing accounting standards. This is primarily
due to the fact that the impairment requirements under IAS 39 were based
on an incurred loss model, i.e., credit losses are not recognised until
a credit loss event occurs. Since losses are rarely incurred evenly over the
lives of loans, there was 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. A further
identified weakness was the complexity of different entities using different
approaches to calculate impairment.
The development of IFRS 9 was complex and took five and a half years. The
history of this process is summarised in our publication International GAAP
2018. Here we focus on some key points of this history that are helpful in
understanding the requirements of the standard.
In November 2009 the IASB issued an Exposure Draft – Financial Instruments:
Amortised Cost and Impairment (the 2009 ED). This proposed an impairment
model based on expected losses rather than on incurred losses, for all financial
assets recorded at amortised cost. In this approach, the initial ECLs were
to be recognised over the life of a financial asset, by including them in the
computation of the effective interest rate (EIR) when the asset was first
recognised. This would build an allowance for credit losses over the life of
a financial asset and so match the recognition of credit losses with that of
the credit spread implicit in the interest charged. Subsequent changes in credit
loss expectations would be reflected in catch-up adjustments to profit or loss
based on the original EIR.
Comments received on the 2009 Exposure Draft and during the IASB’s
outreach activities indicated that constituents were generally supportive of
a model that distinguished between the effect of initial estimates of ECLs and
subsequent changes in those estimates. However, they were also concerned
about the operational difficulties in implementing the model proposed.
To address these operational challenges and as suggested by the EAP, the IASB
decided to decouple the measurement and allocation of initial ECLs from the
determination of the EIR (except for purchased or originated credit-impaired
financial assets). Therefore, the financial asset and the loss allowance would be
measured separately, using an original EIR that is not adjusted for initial ECLs.
Such an approach would help address the operational challenges raised and
allow entities to leverage their existing accounting and credit risk management
The IASB has sought to
address concerns that
the incurred loss model
in IAS 39 contributes to
the delayed recognition
of credit losses.
7 April 2018 Impairment of financial instruments under IFRS 9
systems and so reduce the extent of the necessary integration between these
systems.
1
By decoupling ECLs from the EIR, an entity must measure the present value
of ECLs using the original EIR. This presents a dilemma, because measuring
ECLs using such a rate double-counts the ECLs that were priced into the
financial asset at initial recognition. This is because the fair value of the loan
at original recognition already reflects the ECLs, so to provide for the ECLs
as an additional allowance would be to double count these losses. Hence,
the IASB concluded that it was not appropriate to recognise lifetime ECLs
on initial recognition. In order to address the operational challenges while
trying to reduce the effect of double-counting, as well as to replicate (very
approximately) the outcome of the 2009 Exposure Draft, the IASB decided to
pursue a dual-measurement model that would require an entity to recognise:
2
•
A portion of the lifetime ECLs from initial recognition as a proxy for
recognising the initial ECLs over the life of the financial asset
•
The lifetime ECLs when credit risk had increased since initial recognition
(i.e., when the recognition of only a portion of the lifetime ECLs would
no longer be appropriate because the entity has suffered a significant
economic loss)
It is worth noting that any approach that seeks to approximate the outcomes
of the model in the 2009 Exposure Draft, without the associated operational
challenges, will include a recognition threshold for lifetime ECLs. This gives
rise to what has been referred to as ‘a cliff effect’, i.e., the significant increase
in allowance that represents the difference between the portion that was
recognised previously and the lifetime ECLs.
3
Subsequently, the IASB and FASB spent a considerable amount of time and
effort developing a converged impairment model. However, due to concerns
raised by the FASB’s constituents about the model’s complexity, the FASB
decided to develop an alternative expected credit loss model. (see 1.4 below).
4
In March 2013, the IASB published a new Exposure Draft – Financial
Instruments: Expected Credit Losses (the 2013 ED), based on proposals that
grew out of the joint project with the FASB. The 2013 ED proposed that entities
should recognise a loss allowance or provision at an amount equal to 12-month
credit losses for those financial instruments that had not yet seen a significant
increase in credit risk since initial recognition, and lifetime ECLs once there had
been a significant increase in credit risk. This new model was designed to:
•
Ensure a more timely recognition of ECLs than the existing incurred
loss model
•
Distinguish between financial instruments that have significantly
deteriorated in credit quality and those that have not
•
Better approximate the economic ECLs
5
This two-step model was designed to approximate the build-up of the allowance,
as proposed in the 2009 Exposure Draft, but involving less operational
complexity. Figure 1 below illustrates the stepped profile of the new model,
shown by the solid line, compared to the steady increase shown by the black
dotted line proposed in the 2009 Exposure Draft (based on the original ECL
1
IFRS 9.BC5.92
2
IFRS 9.BC5.93
3
IFRS 9.BC5.95
4
IFRS 9.BC5.112
5
IASB Snapshot: Financial Instruments: Expected Credit Losses Exposure Draft, March 2013.
A two-step model was
designed to approximate
the build-up of the
allowance, as proposed
in the 2009 ED, but
involving less operational
complexity.
8 April 2018 Impairment of financial instruments under IFRS 9
assumptions and assuming no subsequent revisions of this estimate). It shows
that the two step model first overstates the allowance (compared to the method
set out in the 2009 Exposure Draft), then understates it as the credit quality
deteriorates, and then overstates it once again, as soon as the deterioration
is significant.
Figure 1: Accounting for expected credit losses: 2009 ED versus
IFRS 9
Source: Based on illustration provided by the IASB in March 2013 it its snapshot: Financial Instruments:
Expected Credit Losses, page 9.
The IASB finalised the impairment requirements and issued them in July 2014,
as part of the final version of IFRS 9.
Since then further guidance has been provided from a number of sources:
•
The IASB set up an IFRS Transition Resource Group for Impairment of
Financial Instruments (ITG) (see 1.5 below).
•
The IASB also has published two webcasts, one on multiple macroeconomic
scenarios and another on revolving facilities (see sections 4.6 and 11.2
below).
•
The Basel Committee provided guidance aimed primarily at internationally
active banks on the implementation of the IFRS 9 impairment model
(see sections 1.6 and 6.1 below), as has the Enhanced Disclosure
Task Force (see section 14.3).
•
The Global Public Policy Committee has published guidance: (1) to help
those charged with governance to identify the elements of a high-quality
implementation of IFRS 9 impairment by banks; and (2) to assist audit
committees oversee the audit of ECLs (see section 6.2 below).
The IASB issued
the impairment
requirements in July
2014 as part of the final
IFRS 9 and set up an
IFRS Transition Resource
Group for Impairment of
Financial Instruments.
9 April 2018 Impairment of financial instruments under IFRS 9
1.2 Overview of IFRS 9 impairment requirements
The new impairment requirements in IFRS 9 are based on an ECL model
and replace the IAS 39 incurred loss model. The ECL model applies to
debt instruments (such as bank deposits, loans, debt securities and trade
receivables) recorded at amortised cost or at fair value through other
comprehensive income, plus lease receivables and contract assets. Loan
commitments and financial guarantee contracts that are not measured at
fair value through profit or loss are also included in the scope of the new
ECL model.
The guiding principle of the ECL model is to reflect the general pattern of
deterioration, or improvement, in the credit quality of financial instruments.
The ECL approach has been commonly referred to as the three-bucket
approach, although IFRS 9 does not use this term. Figure 2 below summarises
the general approach in recognising either 12-month or lifetime ECLs.
Figure 2: General approach
The amount of ECLs recognised as a loss allowance or provision depends on
the extent of credit deterioration since initial recognition. Under the general
approach (see 3.1 below), there are two measurement bases:
•
12-month ECLs (stage 1), which apply to all items as long as there is no
significant deterioration in credit risk
•
Lifetime ECLs (stages 2 and 3), which apply when a significant increase
in credit risk has occurred on an individual or collective basis
When assessing significant increases in credit risk, there are a number of
operational simplifications available, such as the low credit risk simplification
(see section 5.4.1 below).
Stage 1 Stage 2 Stage 3
12-month
expected
credit losses
Loss allowance
updated at each
reporting date
Lifetime
expected credit
losses criterion
Interest
revenue
calculated
based on
Lifetime expected credit losses
credit losses that
result from default
events that are
possible within the
next 12 months
Credit risk has increased
significantly since initial
recognition
whether on an individual or collective basis
+
Credit-
impaired
Effective
interest rate on
gross carrying
amount
Effective
interest rate on
gross carrying
amount
Effective
interest rate on
gross carrying
amount less
loss allowance
Change in credit risk since initial recognition
Improvement Deterioration
10 April 2018 Impairment of financial instruments under IFRS 9
Stages 2 and 3 differ in how interest revenue is recognised. Under stage 2
(as under stage 1), there is a full decoupling between interest recognition
and impairment, and interest revenue is calculated on the gross carrying
amount. Under stage 3 (when a credit event has occurred, defined similarly
to an incurred credit loss under IAS 39), interest revenue is calculated on
the amortised cost (i.e., the gross carrying amount adjusted for the impairment
allowance).
The following example illustrates how the ECL allowance changes when a loan
moves from stage 1 to stage 3:
Example 1: Expected credit loss allowance in stages 1, 2 and 3
under the general approach
On 31 December 2016, Bank A originates a 10 year loan with a gross
carrying amount of $1,000,000, with interest being due at the end of each
year and the principal due on maturity. There are no transaction costs and
the loan contracts include no options (for example, prepayment or call
options), premiums or discounts, points paid, or other fees.
At origination, the loan is in stage 1 and a corresponding 12-month ECL
allowance is recognised.
By 31 December 2019, the loan has shown signs of significant deterioration
in credit quality and Bank A moves the loan to stage 2. A corresponding
lifetime ECL allowance is recognised. In the following year, the loan defaults
and is moved to stage 3.
The ECL allowance in each stage is shown below and the detailed calculation
is illustrated in Example 3 at 4.4.1 below.
There are two alternatives to the general approach:
•
The simplified approach, that is either required or available as a policy
choice for trade receivables, contract assets and lease receivables (see
section 3.2 below)
•
The credit-adjusted effective interest rate approach, for purchased or
originated credit-impaired financial assets (see section 3.3 below)
ECLs are an estimate of credit losses over the life, or the next 12 months, of a
financial instrument and when measuring ECLs (see section 4 below), an entity
needs to take into account:
•
The probability-weighted outcome (see section 4.6 below), as ECLs should
not be simply either a best or a worst-case scenario, but should, instead,
reflect the possibility that a credit loss occurs and the possibility that no
credit loss occurs. Following discussion at the ITG, this is understood to
include a need to consider multiple economic scenarios (see 4.6 below)
•
The time value of money (see section 4.7 below)
Stage 1: 12-month
expected credit losses
On 31 December 2016,
the loan is originated. An
allowance of $422 is
recognised
Stage 2: lifetime
expected credit losses
On 31 December 2019,
the loan has shown signs
of a significant increase
in credit risk. An
allowance of $50,285 is
recognised (the 12-
month ECL is $3,495)
Stage 3: lifetime
expected credit losses
On 31 December 2020,
the loan defaults. An
allowance of $262,850
is recognised.
The two alternatives to
the general approach
are: the simplified
approach and the credit-
adjusted effective
interest rate approach.
11 April 2018 Impairment of financial instruments under IFRS 9
•
Reasonable and supportable information that is available without undue
cost or effort at the reporting date about past events, current conditions
and forecasts of future economic conditions (see 4.9 below).
1.3 Key changes from the IAS 39 impairment requirements
and the impact and implications
The new IFRS 9 impairment requirements eliminate the IAS 39 threshold for
the recognition of credit losses, i.e., it is no longer necessary for a credit event
to have occurred before credit losses are recognised. Instead, an entity always
accounts for ECLs, and updates the loss allowance for changes in these ECLs
at each reporting date to reflect changes in credit risk since initial recognition.
Consequently, the holder of the financial asset needs to take into account more
timely and forward-looking information.
The main implications for both financial and non-financial entities are as follows:
•
The scope of the impairment requirements is now much broader.
Previously, under IAS 39, there were different impairment models
for financial assets measured at amortised cost and available-for-sale
financial assets. Under IFRS 9, there is a single impairment model for all
debt instruments measured at amortised cost and at fair value through
other comprehensive income. Furthermore, loan commitments and
financial guarantee contracts that were previously in the scope of
IAS 37 Provisions, Contingent Liabilities and Contingent Assets are now
in the scope of the IFRS 9 impairment requirements (section 10 below).
•
Previously, under IAS 39, loss allowances were only recorded for impaired
exposures. The new impairment requirements result in earlier recognition
of credit losses, by necessitating a 12-month ECL allowance for all
credit exposures not measured at fair value through profit or loss. In
addition, there will be a larger allowance for all credit exposures that
have significantly deteriorated (as compared to the recognition of incurred
losses under IAS 39 today). While credit exposures in stage 3, as illustrated
in Figure 2 above, are similar to those deemed by IAS 39 to have suffered
individual incurred losses, credit exposure in stages 1 and 2 will essentially
replace those exposures measured under IAS 39’s collective approach.
•
The ECL 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 and information that provides objective evidence that financial
assets are impaired in relation to incurred losses, but they are now required
to consider reasonable and supportable information that includes forecasts
of future economic conditions including, where relevant, multiple scenarios,
when calculating ECLs, on an individual and collective basis.
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.
12 April 2018 Impairment of financial instruments under IFRS 9
How we see it
• The application of the new IFRS 9 impairment requirements is expected
to increase the credit loss allowances (with a corresponding reduction
in equity on first-time adoption) 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.
• Moreover, 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 are forecast to become more favourable. This may
be further compounded by the significant increase in the loss allowance
when financial instruments move between 12-month and lifetime ECLs
and vice versa. However, the need to consider the effect of multiple
macroeconomic scenarios (see 4.6 below) may help to reduce the
volatility, depending on the circumstances.
• The need to incorporate forward-looking information, including
establishing multiple macroeconomic scenarios, determining
the probability of their occurrence and assessing how changes in
macroeconomic factors will affect ECLs, means that the application
of the standard will require considerable judgement. Also, the increased
level of judgement required in making the ECL calculation and assessing
when significant deterioration has occurred 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 ECLs requirements,
should provide greater transparency over entities’ credit risk and
provisioning processes. The Enhanced Disclosures Task Force, established
in 2012 by the Financial Stability Board to recommend best practice
market risk disclosures, has published guidance to promote greater
transparency and comparability about the application of the ECL model.
• In financial institutions, finance and credit risk management systems
and processes have to be better connected, because of the necessary
alignment between risk and accounting in the new model. Risk models
and data will have to be more extensively used to make the assessments
and calculations required for accounting purposes, which are both a major
change from IAS 39 and a key challenge.
• In addition, financial institutions need to fully understand the complex
interactions between the IFRS 9 and regulatory capital requirements in
relation to credit losses. The Basel Committee on Banking Supervision
has now finalised what it calls an ‘interim’ approach and transitional
arrangements, providing national jurisdictions with a framework for
any arrangement. This is contained in the BCBS document Standards –
Regulatory treatment of accounting provisions – interim approach and
transitional arrangements. However, the long-term regulatory treatment
of ECL provisions remains to be determined. In many cases, it is expected
that the new IFRS 9 ECL requirements will result in a reduction in the
regulatory capital of financial institutions.
13 April 2018 Impairment of financial instruments under IFRS 9
• For corporates, the ECL model will most likely not give rise to
a major increase in allowances for short-term trade receivables because
of their short-term nature. Moreover, the standard includes practical
expedients, in particular, the use of a provision matrix, which should
help in measuring the loss allowance for short-term trade receivables.
6
However, the model may give rise to challenges for the measurement of
long-term trade receivables, bank deposits and debt securities which are
measured at amortised cost or at fair value through other comprehensive
income. For example, a corporate that has a large portfolio of debt
securities that are currently held as available-for-sale under IAS 39,
is likely to classify its holdings as measured at fair value through other
comprehensive income if the contractual cash flow characteristics and
business model test are met. For these securities, the corporate would be
required to recognise a loss allowance based on 12-month ECLs even for
debt securities that are highly rated (e.g. AAA- or AA-rated bonds).
• For many group companies, one of the bigger challenges is the application
of the new ECL model to intercompany debt.
Given that the IFRS 9 impairment requirements apply to lease receivables
and that the IASB in its project to replace IAS 17 Leases decided to eliminate
the distinction between finance and operating leases, there was a concern that
this could give rise to significant ECL allowances for those that are currently
classified as operating leases. However, the IASB, in finalising IFRS 16 Leases,
decided not to require a similar treatment for lessors as for lessees, so that they
will not need to record financial assets for operating leases. With this change
in the final standard, the effect of the IFRS 9 impairment requirements for
many lessors has been significantly reduced. As the requirement under IFRS 9
is to take into account only those cash flows used to measure the receivable,
there is no need to make a provision against future cash flows that are not
yet recognised in the statement of financial position. As a result, the new
impairment requirements will have a greater impact on lessors of leases
that are currently classed as finance leases, particularly if they opt to apply
the simplified approach (see section 3.2 below). In such situations, the effect
would be to recognise a potentially significant allowance based on the lifetime
ECLs of the lease. However, the lessor’s ‘loan’ is in substance collateralised by
the leased asset, which will reduce the ECLs.
1.4 Key differences from the FASB’s standard
On 16 June 2016, the FASB issued an Accounting Standard Update (ASU),
Financial Instruments – Credit Losses (Topic 326), that aims to address
the same fundamental issue that the IASB’s ECL model (in IFRS 9) addresses,
namely the delayed recognition of credit losses resulting from the incurred
credit loss model. It is therefore also an ECL model, but it is not the same as
the model in IFRS 9. The most significant differences between the FASB’s
and the IASB’s ECL models are, as follows:
•
The FASB’s ECL model (known as the Current ECL or CECL model) will
not be applied to debt securities measured at fair value through other
comprehensive income (i.e., available for sale securities under US GAAP).
Rather, for these securities, the FASB’s existing other-than-temporary
impairment model will be modified to require an allowance to recognise
estimated credit losses rather than a direct write-down, among other
things.
6
IFRS 9.B5.5.35
The requirements of the
US CECL model differ
from those of IFRS 9.
14 April 2018 Impairment of financial instruments under IFRS 9
•
The FASB’s ECLs will be calculated based on the losses expected over
the remaining contractual life of an asset, considering the effect of
prepayments. An allowance for lifetime ECLs will be required when
the loan is initially recognised instead of 12-month ECLs. As a result,
the FASB’s model does not require an entity to assess whether there
has been a significant deterioration in credit quality, in contrast to
the assessment required by IFRS 9. This is similar to the IFRS 9 simplified
approach (see section 3.2 below).
•
The FASB’s standard is less prescriptive about how ECLs should be
measured, in particular, probability weighted outcomes are not required
to be considered. On the other hand, the consideration of multiple
scenarios should be compatible with the FASB’s model.
•
For purchased credit-impaired assets defined as ‘acquired individual
financial assets (or acquired groups of financial assets with shared risk
characteristics) that, as of the date of acquisition, have experienced
a more-than-insignificant deterioration in credit quality since origination,
as determined by an acquirer’s assessment’, the FASB’s model will
require an entity to increase the purchase price by the allowance for
ECLs upon acquisition. In doing so, the FASB model will gross up the
asset’s carrying amount by the ECLs existing upon acquisition, but also
recognise a corresponding credit loss allowance, thereby resulting in
a net carrying amount equal to the purchase price (see section 3.3 below
for the accounting treatment of credit-impaired assets under IFRS 9).
•
There is no exception for revolving credit facilities (e.g., commitments
connected with overdrafts and credit cards) under the FASB’s model
(see 11 below for the IFRS 9 treatment) and therefore, no impairment
allowance is required if the commitment is legally revocable without any
conditions.
The FASB standard has tiered effective dates, starting in 2020 for calendar-
year reporting public business entities that meet the definition of a U.S.
Securities and Exchange Commission (SEC) filer. Early adoption is permitted
for all entities but this cannot be before 2019 for calendar-year entities.
1.5 The IFRS Transition Resource Group for Impairment of
Financial Instruments (ITG) and IASB webcasts
The IASB has set up an ITG that aims to:
•
Provide a public discussion forum to support stakeholders on
implementation issues arising from the new impairment requirements
that could create diversity in practice
•
Inform the IASB about the implementation issues, which will help
the IASB determine what action, if any, will be needed to address them
7
However, the ITG does not issue any guidance.
Members of the ITG include financial statement preparers and auditors from
various geographical locations with expertise, skills or practical knowledge
on credit risk management and accounting for impairment. Board members
and observers from the Basel Committee on Banking Supervision and the
International Organisation of Securities Commissions also attend the meetings.
7
IASB Website Announcement. IASB to establish transition resource group for impairment of
financial instruments, 23 June 2014 and Transition Resource Group for Impairment of
Financial Instruments – Meeting Summary, 22 April 2015.
The ITG has had three
substative meetings.
The ITG has had three
substantive meetings.
15 April 2018 Impairment of financial instruments under IFRS 9
The ITG agenda papers are prepared by the IASB staff and are made public
before the meetings. The staff also provides ITG meeting summaries which are
not authoritative. Both the staff papers and the meeting summaries represent
educational reading on the issues submitted.
Following its inaugural meeting in December 2014 to discuss its operating
procedures, the ITG met three times, on 22 April 2015, on16 September 2015,
and on 11 December 2015. Although no further meetings have been planned,
the group has not been disbanded and stakeholders may continue to submit
potential implementation issues following the submission guidelines. Further
meetings will be convened if warranted.
On 22 April 2015, the ITG discussed eight implementation issues raised by
stakeholders. These included:
8
•
When applying the impairment requirements at the reporting date, whether
and how to incorporate events and forecasts that occur after economic
forecasts have been made, but before the reporting date, and between
the reporting period end and the date of signing the financial statements
(see section 4.9.3 below)
•
Whether the impairment requirements in IFRS 9 must also be applied
to other commitments to extend credit, in particular, a commitment (on
inception of a finance lease) to commence a finance lease at a date in
the future and a commitment by a retailer through the issue of a store
account to provide a customer with credit when the customer buys
goods or services from the retailer in the future (see section 10 below)
•
Whether there is a requirement to measure ECLs at dates other than
the reporting date, namely the date of derecognition and the date of
initial recognition (see section 6.3.1 below)
•
Whether an entity should consider the ability to recover cash flows through
an integral financial guarantee contract when assessing whether there
has been a significant increase in the credit risk of the guaranteed debt
instrument since initial recognition (see section 5.1.1 below)
•
The maximum period to consider when measuring ECLs on a portfolio
of mortgage loans that have a stated maturity of 6 months, but contain
a contractual feature whereby the term is automatically extended every
6 months subject to the lender’s non-objection (see section 4.5 below)
•
The maximum period to consider when measuring ECLs for revolving
credit facilities and the determination of the date of initial recognition of
the revolving facilities for the purposes of assessing them for significant
increases in credit risk (see section 11.2 below)
•
Whether the measurement of ECLs for financial guarantee contracts issued
should consider future premium receipts due from the holder and, if so,
how (see section 10 below)
•
The measurement of ECLs in respect of a modified financial asset, the
calculation of the modification gain or loss and subsequent requirement to
measure ECLs on the modified financial asset as well as the appropriate
presentation and disclosure (see section 7.1 below)
8
IASB Transition Resource Group for Impairment of Financial Instruments, Meeting Summary,
22 April 2015.
16 April 2018 Impairment of financial instruments under IFRS 9
On 16 September 2015, the ITG held its third meeting to discuss six
implementation issues raised by stakeholders. These included:
9
•
How to identify a significant increase in credit risk for a portfolio of retail
loans when identical pricing and contractual terms are applied to customers
across broad credit quality bands (see section 5.2.1 below)
•
The possibility of using behavioural indicators of credit risk for the purpose
of the assessment of significant increases in credit risk since initial
recognition (see section 5.2.4 below)
•
When assessing significant increases in credit risk, whether an entity
would be required to perform an annual review to determine whether
circumstances still support the use of the 12-month risk of a default
occurring as an approximation of changes in the lifetime risk of a default
occurring (see section 5.4.3 below)
•
When measuring ECLs for revolving credit facilities, how an entity should
estimate future drawdowns on undrawn lines of credit when an entity has
a history of allowing customers to exceed their contractually set credit
limits on overdrafts and other revolving credit facilities (see section 11.3
below)
•
At what level should forward-looking information be incorporated – at
the level of the entity or on a portfolio-by-portfolio basis (see section 4.9.3
below)
•
How to determine what is reasonable and supportable forward-looking
information and how to treat shock events with material, but uncertain,
economic consequences (see section 4.9.3 below)
On 11 December 2015, the ITG held its fourth meeting to discuss eleven
implementation issues raised by stakeholders. These included:
10
•
What was meant by the ‘current EIR’ when an entity recognises interest
revenue in each period based on the actual floating-rate applicable to
that period (see section 4.7 below)
•
What was meant by ‘part of the contractual terms’, specifically whether
a credit enhancement must be an explicit term of the related asset’s
contract in order for it to be taken into account in the measurement of
ECLs, or whether other credit enhancements that are not recognised
separately can also be taken into account (see section 4.8.1 below)
•
Whether cash flows that are expected to be recovered from the sale
on default of a loan could be included in the measurement of ECLs (see
section 4.8.2 below)
•
Application of the revolving credit facilities exception set out in
paragraph 5.5.20 of IFRS 9 to multi-purpose facilities (see section 11
below)
•
How future drawdowns should be estimated for charge cards when
measuring ECLs if there is no specified credit limit in the contract (see
section 11.3 below)
•
How an entity should determine the starting-point and the ending-point
of the maximum period to consider when measuring ECLs for revolving
credit facilities (see section 11.2 below)
9
IASB Transition Resource Group for Impairment of Financial Instruments, Meeting Summary,
16 September 2015.
10
IASB Transition Resource Group for Impairment of Financial Instruments, Meeting Summary,
11 December 2015.
17 April 2018 Impairment of financial instruments under IFRS 9
•
When measuring ECLs, whether an entity can use a single forward-looking
economic scenario or whether an entity needs to incorporate multiple
forward-looking scenarios, and if so how (see section 4.6 below)
•
When assessing significant increases in credit risk, whether an entity
can use a single forward-looking economic scenario or whether the entity
needs to incorporate multiple forward-looking scenarios, and if so how
(see section 5.7 below)
•
Whether there is a requirement to assess significant increases in
credit risk for financial assets with a maturity of 12 months or less
(see section 5.4.3 below)
•
How to measure the gross carrying amount and loss allowance for
credit-impaired financial assets that are not purchased or originated
credit-impaired and that are measured at amortised cost (see
section 13.1.2 below)
•
Whether an entity is required to present the loss allowance for financial
assets measured at amortised cost (or trade receivables, contract assets
or lease receivables) separately in the statement of financial position (see
section 13.1 below)
The FASB (see section 1.4 above) has also set up its own Transition Resource
Group (TRG) for credit losses and its discussions may prove relevant to
the application of IFRS 9 in areas where the two ECL models are similar.
In addition, as part of its activities to support implementation, the IASB has
published two educational webcasts since IFRS 9 was published.
11
•
The first, on forward-looking information and multiple scenarios was
released on 25 July 2016. It discusses when multiple scenarios need to
be considered and the concept of non-linearity, consistency of scenarios,
probability-weighted assessment of significant increase in credit risk, and
approaches to incorporating forward-looking scenarios (see section 4.6
below).
•
The second, on the expected life of revolving facilities was released on
16 May 2017. It focuses on how credit risk management actions would
affect the expected life of revolving facilities for the purpose of measuring
ECLs (see section 11.2 below).
1.6 Other guidance on expected credit losses
In December 2015, the Basel Committee on Banking Supervision issued its
Guidance on accounting for expected credit losses, which sets out supervisory
expectations regarding sound credit risk practices associated with implementing
and applying an ECL accounting framework (see section 6.1 below).
On 17 June 2016, the Global Public Policy Committee of representatives of
the six largest accounting networks (the GPPC) published The implementation
of IFRS 9 impairment by banks – Considerations for those charged with
governance of systemically important banks (the GPPC guidance) to promote
a high standard in the implementation of accounting for ECLs. It aims to help
those charged with governance to evaluate management’s progress during
the implementation and transition phase (see section 6.2 below). A year later,
on 28 July 2017, the GPPC issued a paper titled The Auditor’s Response to
the Risks of Material Misstatement Posed by Estimates of Expected Credit
Losses under IFRS 9.
11
IASB website, www.ifrs.org
18 April 2018 Impairment of financial instruments under IFRS 9
2 Scope
IFRS 9 requires an entity to recognise a loss allowance for ECLs on:
12
•
Financial assets that are debt instruments such as loans, debt securities,
bank balances and deposits and trade receivables (see section 9 below)
that are measured at amortised cost
13
•
Financial assets that are debt instruments measured at fair value through
other comprehensive income (see section 8 below)
14
•
finance lease receivables (i.e. net investments in finance leases) and
operating lease receivables under IAS 17 and IFRS 16 (when applied)
(see section 9.2 below)
•
Contract assets under IFRS 15 (see 9.1 below). 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 conditional
on something other than the passage of time (for example, the entity’s
future performance)
15
•
Loan commitments that are not measured at fair value through profit or
loss under IFRS 9 (see 10 and 11 below). The scope therefore 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
16
•
Financial guarantee contracts that are not measured at fair value through
profit or loss under IFRS 9 (see 10 below)
3 Approaches
In applying the IFRS 9 impairment requirements, an entity needs to follow one
of the approaches below:
•
The general approach (see section 3.1 below)
•
The simplified approach (see section 3.2 below)
•
The purchased or originated credit-impaired approach (see section 3.3
below)
Figure 3 below, based on a diagram from the standard, summarises the process
steps in recognising and measuring ECLs.
12
IFRS 9.5.5.1
13
IFRS 9.4.1.2
14
IFRS 9.4.1.2A
15
IFRS 15 Appendix A, IFRS 9 Appendix A
16
IFRS 9.2.1(g), 2.3, 4.2.1(a), 4.2.1(d)
The scope of the IFRS 9
ECL model is broader
than that of the IAS39
incurred loss model.
19 April 2018 Impairment of financial instruments under IFRS 9
Figure 3: Application of the impairment requirements at
a reporting date
3.1 General approach
Under the general approach, at each reporting date, an entity recognises
a loss allowance based on either 12-month ECLs or lifetime ECLs, depending
on whether there has been a significant increase in credit risk on the financial
instrument since initial recognition.
17
The changes in the loss allowance
balance are recognised in profit or loss as an impairment gain or loss.
18
Essentially, an entity must make the following assessment at each reporting
date:
•
For credit exposures where there have not been significant increases
in credit risk since initial recognition, an entity is required to provide for
12-month ECLs, i.e. the portion of lifetime ECLs that represent the ECLs
that result from default events that are possible within the 12-months
after the reporting date (stage 1 in Figure 2 at section 1.2 above).
19
•
For credit exposures where there have been significant increases in
credit risk since initial recognition on an individual or collective basis,
a loss allowance is required for lifetime ECLs, i.e. ECLs that result from
all possible default events over the expected life of a financial instrument
(stages 2 and 3 in Figure 2 at section 1.2 above).
20
Or
•
In subsequent reporting periods, if the credit quality of the financial
instrument improves such that there is no longer a significant
17
IFRS 9.5.5.3, 5.5.5
18
IFRS 9.5.5.8, Appendix A
19
IFRS 9.5.5.3, Appendix A
20
IFRS 9.5.5.4, 5.5.5, Appendix A
Is the financial instrument a purchased
or originated credit-impaired financial
asset? (see 3.3)
Is the simplified approach for trade
receivables, contract assets and lease
receivables applicable? (see 3.2)
Does the financial instrument have low
credit risk at the reporting date?
(see 5.4.1)
Has there been a significant increase in
credit risk since initial recognition?
(see 5)
Recognise lifetime expected credit
losses (see 4.2)
Is the financial instrument a
credit-impaired financial asset?
(see 3.1)
Calculate a credit-
adjusted effective
interest rate and
always recognise a
loss allowance for
changes in lifetime
expected credit
losses (see 3.3)
Recognise 12-month
expected credit
losses and calculate
interest revenue on
gross carrying
amount
(see 4.3)
Is the low credit risk
simplification
applied? (see 5.4.1)
Calculate interest
revenue on amortised
cost i.e., the gross
carrying amount net
of loss allowance
(see 3.1)
Calculate
interest revenue
on the gross
carrying amount
(see 3.1)
Yes
Yes
Yes
No Yes
No
No
No
No
Yes
And
YesNo
20 April 2018 Impairment of financial instruments under IFRS 9
increase in credit risk since initial recognition, then the entity
reverts to recognising a loss allowance based on 12-month ECLs
(i.e., the approach is symmetrical).
21
It may not be practical to determine, for every individual financial
instrument, whether there has been a significant increase in credit risk,
because they may be small and many in number and/or because there
may not be the evidence available to do so.
22
Consequently, it may be
necessary to measure ECLs on a collective basis, to approximate the
result of using comprehensive credit risk information that incorporates
forward-looking information at an individual instrument level (see
section 5.5 below).
23
To help enable an entity’s assessment of significant increases in credit risk,
IFRS 9 provides the following operational simplifications:
•
A low credit risk threshold equivalent to investment grade (see 5.4.1
below), below which no assessment of significant increases in credit
risk is required.
•
The ability to rely on past due information if reasonable and
supportable forward looking information is not available without
undue cost or effort (see section 5.4.2 below). This is subject to
the rebuttable presumption that there has been a significant increase
in credit risk if the loan is 30 days past due (see section 5.2.2 below).
•
Use of a change in the 12-month risk of a default as an approximation for
change in lifetime risk (see section 5.4.3 below).
The IFRS 9 illustrative examples also provide the following suggestions on how
to implement the assessment of significant increases in credit risk:
•
Assessment at the counterparty level (see 5.4.4 below)
•
Asset transfer threshold by determining maximum initial credit risk
for a portfolio (see 5.4.5 below)
In stages 1 and 2, there is a complete decoupling between interest recognition
and impairment. Therefore, interest revenue is calculated on the gross carrying
amount (without deducting the loss allowance). If a financial asset subsequently
becomes credit-impaired (stage 3 in Figure 2 at section 1.2 above), an entity
is required to calculate the interest revenue by applying the EIR in subsequent
reporting periods to the amortised cost of the financial asset (i.e., the gross
carrying amount net of loss allowance) rather than the gross carrying amount.
24
Financial assets are assessed as credit-impaired using substantially the same
criteria as for the impairment assessment of an individual asset under IAS 39.
25
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 is 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:
26
•
Significant financial difficulty of the issuer or the borrower
•
A breach of contract, such as a default or past due event
21
IFRS 9.5.5.7
22
IFRS 9.B5.5.1
23
IFRS 9.BC5.141
24
IFRS 9.5.4.1, Appendix A
25
IAS 39.59, IFRS 9 Appendix A
26
IFRS 9 Appendix A
In Stages 1 and 2,
there is a decoupling
of interest recognition
and impairment.
21 April 2018 Impairment of financial instruments under IFRS 9
•
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
Or
•
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.
27
In subsequent reporting periods, if the credit quality of the financial asset
improves so that the financial asset is no longer credit-impaired and the
improvement can be related objectively to the occurrence of an event (such
as an improvement in the borrower’s credit rating), then the entity should
once again calculate the interest revenue by applying the EIR to the gross
carrying amount of the financial asset.
28
When the entity has no reasonable expectations of recovering the financial
asset, then the gross carrying amount of the financial asset should be directly
reduced in its entirety. A write-off constitutes a derecognition event (see
section 13.1.1 below).
3.2 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.
29
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.
30
Paragraphs 60-65 of IFRS 15 provide
the requirements for determining the existence of a significant financing
component in the contract, including the use of the practical expedient for
contracts that have a maturity of one year or less.
A contract asset is defined 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 conditional on something other than the passage of time (for
example, the entity’s future performance).
31
IFRS 15 describes contracts
with a significant financing component as those for which the agreed timing
of payment provides the customer or the entity with a significant benefit of
financing on the transfer of goods or services to the customer. Hence, in
determining the transaction price, an entity is required to adjust the promised
27
IFRS 9 Appendix A
28
IFRS 9.5.4.2
29
IFRS 9.5.5.15
30
IFRS 9.5.5.15(a)(i)
31
IFRS 15 Appendix A
The simplified approach
requires the entity to
recognise a loss
allowance based on
lifetime ECLs from
origination.
22 April 2018 Impairment of financial instruments under IFRS 9
amount of consideration for the effects of the time value of money.
32
However,
if the entity expects, at contract inception, that the period between when it
transfers a promised good or service to a customer and when the customer
pays for that good or service will be one year or less, as a practical expedient,
the entity need not adjust the promised amount of consideration for the effects
of a significant financing component.
33
How we see it
Application of the simplified approach to trade receivables and contract
assets that do not contain a significant financing component intuitively
makes sense. In particular, for trade receivables and contract assets that
are due in 12 months or less, the 12-month ECLs are the same as the
lifetime ECLs.
However, an entity has a policy choice to apply either the simplified approach or
the general approach for the following:
34
•
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 (see 9.1 below
).
35
•
All lease receivables that result from transactions that are within the scope
of IAS 17 and IFRS 16 (when applied). The policy choice may be applied
separately to finance and operating lease receivables (see 9.2 below).
36
The IASB noted that offering this policy choice would reduce comparability.
However, the IASB believes it would alleviate some of the practical concerns
of tracking changes in credit risk for entities that do not have sophisticated
credit risk management systems.
37
How we see it
Trade receivables may be sold to a factoring bank, whereby all risks and
rewards are transferred to the bank. Consequently, the trade receivables
are derecognised by the transferring entity and recognised by the factoring
bank which obtains the right to receive the payments made by the debtor
for the invoiced amount. In such a case, we believe that the ‘factored’ trade
receivables are outside the scope of the simplified approach for the purpose
of the factoring bank applying the IFRS 9 ECL model. This is because
the simplified approach is limited to trade receivables that result from
transactions within the scope of IFRS 15, i.e., based on a contract to
obtain goods or services. This is not the case for the factoring bank since
it has acquired the trade receivables through a factoring agreement.
Moreover, the simplified approach was introduced to assist entities with
less sophisticated credit risk management systems.
38
Factoring banks are
likely to have more sophisticated credit risk management systems in place.
32
IFRS 15.60
33
IFRS 15.63
34
IFRS 9.5.5.16
35
IFRS 9.5.5.15(a)(ii)
36
IFRS 9.5.5.15(b)
37
IFRS 9.BC5.225.
38
IFRS 9.BC5.104
23 April 2018 Impairment of financial instruments under IFRS 9
3.3 Purchased or originated credit-impaired financial assets
On initial recognition of a financial asset, an entity is required to determine
whether the asset is credit-impaired. The criteria are set out at section 3.1
above.
39
A financial asset may be purchased credit-impaired because it has already met
the criteria. Such an asset is likely to be acquired at a deep discount. However,
this does not mean that an entity is required to apply the credit-adjusted EIR to
a financial asset solely because the financial asset has a high credit risk at initial
recognition, if it has not yet met those criteria.
40
It may be also possible that an entity originates a credit-impaired financial
asset, for example, following a substantial modification of a distressed financial
asset that resulted in the derecognition of the original financial asset (see
section 7 below).
41
Again this does not mean that the asset should be considered credit-impaired
just because it is high risk. Consider an example of a bank originating a loan of
€100,000 with interest of 30% per annum charged over the term of the loan,
payable in monthly amortising instalments. The bank’s customer has a high
credit risk on origination and the bank expects a large portion of this type of
customer to pay late or fail to pay some or all of their instalment payments.
Although the loan is of high credit risk (which is supported by the high interest
rate), none of the loss events listed above have occurred and the loan was not
the result of a substantial modification and derecognition of a distressed debt.
Hence, the bank should assess the loan not to be credit-impaired on origination.
For financial assets that are considered to be credit-impaired on purchase or
origination, the EIR is calculated taking into account the initial lifetime ECLs
in the estimated cash flows.
42
This accounting treatment is the same as that
under IAS 39 for similar assets.
43
It is also consistent with the original method
for measuring impairment proposed in the 2009 Exposure Draft.
Consequently, no allowance is recorded for 12-month ECLs for financial assets
that are credit-impaired on initial recognition. The rationale for not recording
a 12-month ECL allowance for these assets is that the losses are already
reflected in the fair values at which they are initially recognised. The same
logic could be applied to all the other financial assets which are not credit-
impaired, arguing that they, too, are initially recognised at a fair value that
reflects expectations of future losses. The distinction is made because the
double-counting of 12-month ECLs on initial recognition would be too large
for assets with such a high credit risk since default has already occurred and
the 12-month ECLs are already reflected in the initial fair value. The exclusion
of initial ECLs from the computation of the EIR would lead to a distortion that
would be too significant to be acceptable.
39
IFRS 9.5.5.3, 5.5.5, 5.5.13
40
IFRS 9.B5.4.7
41
IFRS 9.B5.5.26
42
IFRS 9.B5.4.7, Appendix A, BC5.214, BC5.217
43
IAS 39.AG5
For financial assets that
are credit-impaired on
purchase or origination,
the accounting
treatment is the same
as under IAS 39.
24 April 2018 Impairment of financial instruments under IFRS 9
For financial assets that were credit-impaired on purchase or origination,
the credit-adjusted EIR is also used subsequently to discount the ECLs. In
subsequent reporting periods an entity is required to recognise:
•
In the statement of financial position, the cumulative changes in lifetime
ECLs since initial recognition, discounted at the credit-impaired EIR (see
section 4.7 below), as a loss allowance
44
•
In profit or loss, the amount of any change in lifetime ECLs as
an impairment gain or loss. An impairment gain is recognised if
favourable changes result in the lifetime ECLs estimate becoming
lower than the original estimate that was incorporated in the estimated
cash flows on initial recognition when calculating the credit-adjusted
EIR
45
How we see it
For favourable changes that result in lower lifetime ECLs than the original
estimate on initial recognition, IFRS 9 does not provide guidance on where
in the statement of financial position the debit entry should be booked. In
our view, the impairment gain should be recognised as a direct adjustment
to the gross carrying amount. This is supported by the application guidance
in IFRS 9, for purchased or originated credit-impaired financial assets, the
ECLs are included in the estimated cash flows when calculating the credit-
adjusted EIR and hence, the changes in estimates of ECLs should adjust
the gross carrying amount of the financial asset. An alternative treatment
would be to recognise a negative loss allowance which would reflect the
favourable changes in lifetime ECLs.
Along with the other credit risk disclosure requirements (see section 14 below),
the holder is required to explain how it has determined that assets are credit-
impaired (including the inputs, assumptions and estimation techniques used).
It is also required to disclose the total amount of undiscounted ECLs at initial
recognition for financial assets initially recognised during the reporting period
that were purchased or originated credit-impaired.
46
The accounting treatment for a purchased credit-impaired financial asset is
illustrated in the following example:
Example 2: Calculation of the credit-adjusted effective interest
rate and recognition of a loss allowance for a purchased credit-
impaired financial asset
On 1 January 2012, Company D issued a bond that required it to pay an
annual coupon of €800 in arrears and to repay the principal of €10,000 on
31 December 2021. By 2017, Company D was in significant financial difficulties
and was unable to pay the coupon due on 31 December 2017. On 1 January 2018,
Company V estimates that the holder could expect to receive a single payment
of €4,000 at the end of 2019. It acquires the bond at an arm’s length price of
€3,000. Company V determines that the debt instrument is credit-impaired
on initial recognition, because of evidence of significant financial difficulty of
Company D and because the debt instrument was purchased at a deep discount.
It can be shown that using the contractual cash flows (including the €800 overdue)
gives rise to an EIR of 70.1% (the net present value of €800 now and annually
thereafter until 2021 and €10,000 receivable at the end of 2021 equals €3,000
44
IFRS 9.5.5.13, B5.5.45
45
IFRS 9.5.5.14
46
IFRS 7.35H(c)
In calculating interest
revenue for purchased
or originated credit-
impaired assets, the
holder applies the credit-
adjusted EIR to the
amortised cost of these
financial assets from
initial recognition.
25 April 2018 Impairment of financial instruments under IFRS 9
Example 2: Calculation of the credit-adjusted effective interest
rate and recognition of a loss allowance for a purchased credit-
impaired financial asset (cont’d)
when discounted at 70.1%). However, because the bond is credit-impaired, V should
calculate the EIR using the estimated cash flows of the instrument. In this case,
the EIR is 15.5% (the net present value of €4,000 receivable in two years equals
€3,000 when discounted at 15.5%).
All things being equal, interest income of €464 (€3,000 × 15.5%) would be recognised
on the instrument during 2018 and its carrying amount at the end of the year would
be €3,464 (€3,000 + €464). However, if at the end of the year, based on reasonable
and supportable evidence, the cash flow expected to be received on the instrument
had increased to, say, €4,250 (still to be received at the end of 2019), an adjustment
would be made to the asset’s amortised cost. Accordingly, its carrying amount
would be increased to €3,681 (€4,250 discounted over one year at 15.5%) and
an impairment gain of €217 would be recognised in profit or loss.
On the other hand, if at the end of the year, based on reasonable and supportable
evidence, the cash flow expected to be received on the instrument had decreased to,
say, €3,500 (still to be received at the end of 2019), an adjustment would be made
to the asset’s amortised cost. Accordingly, its carrying amount would be decreased to
€3,031 (€3,500 discounted over one year at 15.5%) and an impairment loss of €433
would be recognised in profit or loss.
4 Measurement of expected credit losses
The standard defines credit loss as the difference between all contractual cash
flows that are due to an entity in accordance with the contract and all the cash
flows that the entity expects to receive (i.e., all cash shortfalls), discounted
at the original EIR (or credit-adjusted EIR for purchased or originated credit-
impaired financial assets). When estimating the cash flows, an entity is required
to consider:
47
•
All contractual terms of the financial instrument (including prepayment,
extension, call and similar options) over the expected life of the financial
instrument (see section 4.5 below). The maximum period to consider when
measuring ECLs is the maximum contractual period (including extension
options at the discretion of the borrower) over which the entity is exposed
to credit risk (with an exception for revolving facilities)
•
Cash flows from the sale of collateral held (see 4.8.2 below) or other credit
enhancements that are integral to the contractual terms
Also, the standard goes on to define ECLs as ‘the weighted average of credit
losses with the respective risks of a default occurring as the weights’.
48
The standard does not prescribe specific approaches to estimate ECLs, but
stresses that the approach used must reflect the following:
49
•
An unbiased and probability-weighted amount that is determined by
evaluating a range of possible outcomes (see 4.6 below)
•
The time value of money (see 4.7 below)
•
Reasonable and supportable information that is available without undue
cost or effort at the reporting date about past events, current conditions
and forecasts of future economic conditions (see 4.9 below)
47
IFRS 9 Appendix A
48
IFRS 9 Appendix A
49
IFRS 9.5.5.17
As ECLs take into
account both the
amount and the timing
of payments, a credit
loss arises even if
the holder expects
to receive all the
contractual payments
due, but at a later date.
26 April 2018 Impairment of financial instruments under IFRS 9
4.1 Definition of default
Default is not defined for the purposes of determining the risk of a default
occurring. Because it is defined differently by different institutions (for
instance, 30, 90 or 180 days past due), the IASB was concerned that
defining ‘default’ could result in a definition that is inconsistent with that
applied internally for credit risk management. In particular, since default
is the anchor point used to measure probabilities of default and losses
given default in Basel modelling, requiring a different definition would
require building a different set of models for accounting purposes. Therefore,
the standard requires an entity to apply a definition of default that is consistent
with how it is defined for normal credit risk management practices, consistently
from one period to another. It follows that an entity might have to use different
default definitions for different types of financial instruments. However, the
standard stresses that an entity needs to consider qualitative indicators of
default when appropriate in addition to days past due, such as breaches of
covenant.
50
The IASB did not originally expect ECL calculations to vary as a result of
differences in the definition of default, because of the counterbalancing
interaction between the way an entity defines default and the credit losses
that arise as a result of that definition of default.
51
(For instance, if an entity
uses a shorter delinquency period of 30 days past due instead of 60 days
past due, the associated loss given default (LGD) will be correspondingly
smaller as it is to be expected that more debtors that are 30 days past due
will in due course recover). However, the notion of default is fundamental
to the application of the model, particularly because it affects the subset
of the population that is subject to the 12-month ECL measure.
52
The standard restricts diversity resulting from this effect by establishing a
rebuttable presumption that default does not occur later than when a financial
asset is 90 days past due. This presumption may be rebutted only if an entity
has reasonable and supportable information to support an alternative default
criterion
.
53
A 90 day default definition would also be consistent with that used by banks
for the advanced Basel II regulatory capital calculations (with a few exceptions).
How we see it
We observe that most banks intend to align their regulatory and accounting
definitions of default. This generally means aligning the number of days
past due trigger to 90 days under IFRS 9, with some exceptions for certain
portfolios such as mortgages for which the regulatory definition may allow
longer delinquency periods. Most banks also intend to align the accounting
definition of credit-impaired for transfer to stage 3 with the definition of
default.
4.2 Lifetime expected credit losses
IFRS 9 defines lifetime ECLs as the ECLs that result from all possible default
events over the expected life of a financial instrument (i.e. an entity needs
to estimate the risk of a default occurring on the financial instrument during
its expected life).
54
The expected life considered for the measurement of
50
IFRS 9.B5.5.37
51
IFRS 9.BC5.248
52
IFRS 9.BC5.249
53
IFRS 9.B5.5.37, BC5.252
54
IFRS 9 Appendix A, B5.5.43
The standard restricts
diversity by establishing
a rebuttable presumption
that default does not
occur later than when
a financial asset is 90
days past due.
27 April 2018 Impairment of financial instruments under IFRS 9
lifetime ECLs cannot be longer than the maximum contractual period (including
extension options at the discretion of the borrower) over which the entity is
exposed to credit risk. However, there is an exception for revolving facilities
(see section 11 below).
ECLs should be estimated based on the present value of all cash shortfalls over
the remaining expected life of the financial asset, i.e., the difference between:
55
•
The contractual cash flows that are due to an entity under the contract
•
The cash flows that the holder expects to receive
As ECLs take into account both the amount and the timing of payments, a credit
loss arises even if the holder expects to receive all the contractual payments
due, but at a later date.
56
When estimating lifetime ECLs for undrawn loan commitments (see section 10
below), the provider of the commitment needs to:
•
Estimate the expected portion of the loan commitment that will be drawn
down over the expected life of the loan commitment. Except for revolving
facilities (see section 11 below), the expected life will be capped at the
maximum contractual period, including extension options at the discretion
of the borrower, over which the entity is exposed to credit risk (see 4.3
below for 12-month ECLs)
57
•
Calculate the present value of cash shortfalls between the contractual cash
flows that are due to the entity if the holder of the loan commitment draws
down that expected portion of the loan and the cash flows that the entity
expects to receive if that expected portion of the loan is drawn down
58
For a financial guarantee contract (see section 10 below), the guarantor is
required to make payments only in the event of a default by the debtor in
accordance with the terms of the instrument that is guaranteed. Accordingly,
the estimate of lifetime ECLs would be based on the present value of the
expected payments to reimburse the holder for a credit loss that it incurs,
less any amounts that the guarantor expects to receive from the holder, the
debtor or any other party. If an asset is fully guaranteed, the ECL estimate
for the financial guarantee contract would be the same as the present value
of the estimated cash shortfall for the asset subject to the guarantee.
59
4.3 12-month expected credit losses
The 12-month ECLs is defined as a portion of the lifetime ECLs that represent
the ECLs that result from default events on a financial instrument that are
possible within the 12 months after the reporting date.
60
The standard explains
further that the 12-month ECLs are a portion of the lifetime ECLs that will result
if a default occurs in the 12 months after the reporting date (or a shorter period
if the expected life of a financial instrument is less than 12 months), weighted
by the probability of that default occurring.
61
Because the calculation is based on the probability of default (PD), the standard
emphasises that the 12-month ECL is not the lifetime ECL that an entity will
incur on financial instruments that it predicts will default in the next 12 months
(i.e., for which the PD over the next 12 months is greater than 50%). For
instance, the PD might be only 5%, in which case, this should be used to
55
IFRS 9.B5.5.29
56
IFRS 9.B5.5.28
57
IFRS 9.B5.5.31
58
IFRS 9.B5.5.30
59
IFRS 9.B5.5.32
60
IFRS 9 Appendix A
61
IFRS 9.B5.5.43
12-month ECLs are the
portion of the lifetime
ECLs that results from
default events that are
possible within the next
12 months, weighted by
the probability of that
default ocurring.
28 April 2018 Impairment of financial instruments under IFRS 9
calculate 12-month ECLs, even though it is not probable that the asset will
default. Also, the 12-month ECLs are not the cash shortfalls that are predicted
over only the next 12 months. For an asset defaulting in the next 12 months,
the lifetime ECLs that need to be included in the calculation will normally be
significantly greater than just the cash flows that were contractually due in
the next 12 months.
If the financial instrument has a maturity of less than 12 months then the
12-month ECLs are the credit losses expected over the period to maturity.
For undrawn loan commitments (see section 10 below), an entity’s estimate of
12-month ECLs should be based on its expectations of the portion of the loan
commitment that will be drawn down within 12 months of the reporting date.
62
As already mentioned at section 1.2 above, the IASB believes that the 12-
month ECLs serve as a proxy for the recognition of initial ECLs over time,
as proposed in the 2009 Exposure Draft, and they mitigate the systematic
overstatement of interest revenue that is recognised under IAS 39.
63
This
practical approximation was necessary as a result of the decision to decouple
the measurement and allocation of initial ECLs from the determination of
the EIR following the re-deliberations of the 2009 Exposure Draft.
64
How we see it
The stage 1, 12-month allowance overstates the necessary allowance for
each financial instrument after initial recognition. However, this is offset
by the fact that the allowance is not further increased (except for changes
in the 12-month ECLs) until the instrument’s credit risk has significantly
increased and it is transferred to stage 2. For a portfolio of instruments, with
various origination dates, the overall provision may (very approximately)
be a similar size as might be achieved using a more conceptually robust
approach. Although there is no conceptual justification for an allowance
based on 12-month ECLs, it was designed to be a pragmatic solution
to achieve an appropriate balance between faithfully representing the
underlying economics of a transaction and the cost of implementation.
How accurate a proxy the 12-month and lifetime ECL model is for
a more conceptually pure approach will depend on the nature of
the portfolio. Also, the effect of recording a 12-month ECL in the
first reporting period that a financial instrument is recognised will
not have a significant effect on reported income if the portfolio
is stable in size from one period to the next. The 12-month ECL
allowance may, however, significantly reduce the reported income
for entities which are expanding the size of their portfolio.
Although the choice of 12 months is arbitrary, it is the same time horizon
as used for the more advanced bank regulatory capital calculation under
the Basel framework.
65
The definition in IFRS 9 of 12-month ECLs is similar to
the Basel Committee’s definition of ECL, although the modelling requirements
differ significantly.
66
The 12-month requirement under IFRS 9 will always differ
62
IFRS 9.B5.5.31
63
IFRS 9.BC5.135
64
IFRS 9.BC5.199
65
Basel Committee on Banking Supervision, International Convergence of Capital Measurement and
Capital Standards, June 2006 and Basel III:A global regulatory framework for more resilient banks
and banking systems, June 2011.
66
Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013
on prudential requirements for credit institutions and investment firms and amending Regulation
(EU) No 648/2012.
29 April 2018 Impairment of financial instruments under IFRS 9
from that computed for regulatory capital purposes, as the IFRS 9 measure
is a point-in-time estimate, reflecting currently forecast economic conditions,
while the Basel regulatory figure is based on through-the-cycle assumptions
of default and conservative estimates of losses given default. However, banks
that use an advanced approach to calculate their capital requirements should
be able to use their existing systems and methodologies as a starting point and
make the necessary adjustments to flex the calculation to comply with IFRS 9.
As mentioned above, the 12-month ECLs are defined as a portion of the lifetime
ECLs that represent the ECLs that result from default events on a financial
instrument that are possible within the 12-months after the reporting date.
67
When measuring 12-month ECLs, one question is whether the cash shortfalls
used should take into account only default events within the next 12 months
or subsequent default events as well. The issue arises for instruments that are
expected to default and cure (i.e., to restore to performing) and then default
again after curing.
IFRS 9 does not explicitly mention the treatment of cures and subsequent
defaults when calculating ECLs. However, the ITG briefly talked about this in
its discussion about the life of revolving credit card portfolios in April 2015:
‘As regards assets in Stage 2, it was acknowledged that the probability of
assets defaulting and curing would have to be taken into account and that it
would be necessary to build this into any models dealing with expected credit
loss calculations. However, it was noted that materiality would need to be
considered.’
68
How we see it
We conclude from the ITG discussion that cure events should only be
reflected in the calculation of the LGD to the extent that they are expected
to be effective. Consequently, if it is predicted that the asset will re-default
in subsequent years, this need not be included in the calculation of 12-
month expected losses if the defaults are expected to be unrelated to the
first default. In practice, however, IFRS 9 acknowledges that a variety of
techniques can be used to meet the objective of ECL and that the definition
of default may vary, by product, across a bank and between banks.
69
When measuring ECLs, the treatment of re-defaults affects both the PD and
the LGD. Therefore, the same treatment should be applied consistently to
determine both the PD and the LGD.
4.4 Probability of default (PD) and loss rate approaches
As mentioned above, the standard does not prescribe specific approaches to
estimate ECLs. Some of the common approaches include the PD and loss rate
approaches (see sections 4.4.1 and 4.4.2, respectively).
67
IFRS 9 Appendix A
68
Transition Resource Group for Impairment of Financial Instruments, Meeting Summary,
Paragraph 42(b), 22 April 2015.
69
IFRS 9.B5.5.37, BC5.252, BC5.265
30 April 2018 Impairment of financial instruments under IFRS 9
4.4.1 Probability of default (PD) approach
Calculations of the 12-month and lifetime ECLs are illustrated below:
Example 3: 12-month and lifetime expected credit loss
measurement based on a PD approach
On 31 December 2016, Bank A originates a 10 year loan with a gross carrying
amount of $1,000,000, with interest being due at the end of each year and the
principal due at maturity. In line with IFRS 9, Bank A must recognise an impairment
allowance for the ECLs, considering current and forward looking credit risk
information.
The ECLs are a probability-weighted estimate of the present value of estimated cash
shortfalls, i.e. the weighted average of credit losses, with the respective risks of
a default occurring used as the weights. For this purpose, the following parameters
must be estimated:
•
Probability of Default (PD) – Estimate of the likelihood of default over a given
time horizon (e.g., from
to
). A default may only happen at a
horizon
if the facility has not been previously derecognised and is still in the portfolio.
An early exit (EE may occur in case of default unless the facility reverts to
performing without significant modification of the contractual terms. The
marginal probability of default for the period
to
is then adjusted from
the probability that an early exit occurred during the previous periods:
We note that, for simplicity, Bank A may decide to model EE within the PD
component
.
•
Loss Given Default (LGD) – Estimate of the loss arising in case a default occurs at
a given time (e.g.,
). It is based on the difference between the contractual cash
flows due and those that the lender would expect to receive, including from the
realization of any collateral. It is usually expressed as a percentage of the EAD.
•
Exposure at Default (EAD) – Estimate of the exposure at a future default date,
taking into account expected changes in the exposure after the reporting date,
including repayments of principal and interest, whether scheduled by contract
or otherwise, expected drawdowns on committed facilities, and accrued interest
from missed payments.
•
Discount Rate (r) – Rate used to discount an expected loss to a present value at
the reporting date.
Based on these parameters, an ECL can be computed for any horizon – typically for
each due date of an exposure. The computation formula can be expressed, as follows:
ECL
t
n
=
PD
t
i
×
(1-EE
t
j
)
j=i-1
j=1
× LGD
t
i
× EAD
t
i
(1 + r
i
)
t
i
t
i
=t
n
t
i
=t
1
Where:
= each future payment
= maturity of the payment
= horizon considered (either 12-month or lifetime)
31 April 2018 Impairment of financial instruments under IFRS 9
Example 3: 12-month and lifetime expected credit loss
measurement based on a PD approach (cont’d)
Stage 1: 12-month ECLs of $422
At origination, the loan is in stage 1. Thus a corresponding 12-month ECL allowance
is recognised, i.e. the portion of the lifetime ECLs that result from default events that
are possible within 12 months after the reporting date.
Based on statistical and qualitative information, Bank A has computed the following
ECL parameters at origination.
As interest is paid on a yearly basis, ECLs are calculated using annual periods.
Each year, EAD equals the outstanding principal plus accrued interest due at the end
of the year. This loan does not allow any prepayment, therefore the EAD is constant.
The effective interest rate of the loan is assumed to be the contractual rate, which
is 3%.
Bank A sets EE =
× 0.8, on the basis that a proportion of the loans which
default are expected to cure and will once again be at risk of default.
Based on provided guarantees and collateral, LGD is estimated at 25% of EAD,
whatever the date of default.
Year
EAD
Discount
rate
Cumula-
tive
PD @
origin-
ation
Marginal
PD
Cumula-
tive
EE
t-1
@ origin-
ation
LGD
Marginal
ECL
2016
1,000,000
2017
1,030,000
3%
0.17%
0.17%
0.00%
25%
$422
12m ECL
2018
1,030,000
3%
0.49%
0.32%
0.14%
25%
$775
2019
1,030,000
3%
0.86%
0.37%
0.39%
25%
$877
2020
1,030,000
3%
1.38%
0.53%
0.69%
25%
$1,196
2021
1,030,000
3%
1.84%
0.47%
1.11%
25%
$1,027
2022
1,030,000
3%
2.37%
0.54%
1.47%
25%
$1,141
2023
1,030,000
3%
2.85%
0.49%
1.90%
25%
$1,014
2024
1,030,000
3%
3.30%
0.46%
2.28%
25%
$912
2025
1,030,000
3%
3.84%
0.56%
2.64%
25%
$1,073
2026
1,030,000
3%
4.50%
0.69%
3.07%
25%
$1,280
$9,718
Lifetime
ECL
Marginal PD
i
= 1
1 Cum PD
i
1 Cum PD
i1
Marginal ECL
i
=
PD
i
× Cum EE
i1
× LGD
i
× EAD
i
(1 + r
i
)
i
Stage 2: lifetime ELCs of $50,285
On 31 December 2019 – 3 years after origination, the loan shows signs of significant
deterioration in credit quality based on the creditworthiness of the obligor and
forward looking information, and Bank A moves it to stage 2. Example 10 below
shows the calculation underlying this assessment.
Consistent with the significant increase in credit risk, the PD of the obligor has
increased. In consequence, the probability of an early exist has also increased,
because of the higher level of default. For the purposes of this example, we assume
that there are no significant fluctuations in collateral values and the LGD remains
constant.
32 April 2018 Impairment of financial instruments under IFRS 9
Example 3: 12-month and lifetime expected credit loss
measurement based on a PD approach (cont’d)
Year
EAD
Dis-
count
rate
Cumula-
tive
PD
Marginal
PD
Cumula-
tive
EE
t-1
LGD
Marginal
ECL
2019
1,000,000
0.00%
2020
1,030,000
3%
1.40%
1.40%
0.00%
25%
$3,495
12m ECL
2021
1,030,000
3%
3.87%
2.51%
1.12%
25%
$6,017
2022
1,030,000
3%
8.82%
5.15%
3.10%
25%
$11,756
2023
1,030,000
3%
12.84%
4.40%
7.06%
25%
$9,366
2024
1,030,000
3%
16.04%
3.67%
10.27%
25%
$7,322
2025
1,030,000
3%
18.98%
3.50%
12.83%
25%
$6,585
2026
1,030,000
3%
21.60%
3.23%
15.18%
25%
$5,745
$50,285
Life time
ECL
Stage 3: lifetime ECLs of $262,850
In the following year, on 31 December 2020, the obligor does not pay the amount
due. Based on credit information available, it is already considered to be in default
and is moved to stage 3 – credit-impaired. At this time, the exposure is $1,030,000.
Once a facility becomes credit-impaired, impairment must still represent ECLs.
Therefore, it must be probability-based. At the reporting date, Bank A updates
the appraisal value of the collateral and considers three probable scenarios:
•
Scenario 1 – Cure: the obligor eventually pays past dues and the loan reverts
to performing. In this case, ECL corresponds to lifetime losses expected
from loans that have recently defaulted. Based on its historical data and
using the methodology described above, Bank A expects an ECL of $130,000.
•
Scenario 2 – Restructure: Bank A comes to a restructuring agreement with
the obligor. After 6 months of negotiation, the loan is written off and a new
loan is initiated with a net present value of $800,000.
•
Scenario 3 – Liquidation: The loan is written off and the bank starts the collection
of the contractual collateral. Bank A expects to sell the collateral within a year
and to collect $700,000 net of recovery costs.
The ECL of each scenario can be calculated, as follows:
ECL = EAD
CF
t
i
RC
t
i
(1 + r
i
)
t
i
t
i
=t
n
t
i
= t
1
Where:
CF
= expected future cash flows
RC
= expected recovery costs
33 April 2018 Impairment of financial instruments under IFRS 9
Example 3: 12-month and lifetime expected credit loss
measurement based on a PD approach (cont’d)
Probable
scenarios
Prob-
ability
EAD
Disc-
count
rate
Expected
net future
cash flows
Expected
recovery
time
ECL of
each
scenario
Weighted
ECL
Scenario 1:
Cure
20%
1,030,000
3%
900,000
0.0
$130,000
$26,000
Scenario 2:
Restructure
40%
1,030,000
3%
800,000
0.5
$241,737
$96,695
Scenario 3:
Liquidation
40%
1,030,000
3%
700,000
1.0
$350,388
$140,155
Weighted
average
ECL
$262,850
% of EAD:
26%
ECL = EAD
Exp. net future CF
(1+r)
exp recovery time
How we see it
Our observation of emerging practices suggests that most sophisticated
banks intend to develop their IFRS 9 solutions by adjusting and extending
their existing Basel models. This is true for all types of component models:
PD, LGD and EAD. This is perhaps unsurprising given the historical
investment large banks have made in their Basel models, and the fact that
IFRS 9 shares fundamental similarities in expected loss modelling. But, for
many banks, creating lifetime estimates and altering models to satisfy the
complex and detailed IFRS 9 requirements will still require significant work.
4.4.2 Loss rate approach
Not every entity calculates a separate risk of a default occurring and an LGD,
but instead some use a loss rate approach. Using this approach, the entity
develops loss-rate statistics on the basis of the amount written off over the life
of the financial assets. It must then adjust these historical credit loss trends for
current conditions and expectations about the future. The following Illustrative
Example 9 from IFRS 9 is designed to illustrate how an entity measures 12-
month ECLs using a loss rate approach:
70
Example 4: 12-month expected credit losses measurement based
on a loss rate approach
Bank A originates 2,000 loans with a total gross carrying amount of $500,000.
Bank A segments its portfolio into borrower groups (Groups X and Y) on the basis
of shared credit risk characteristics at initial recognition. Group X comprises 1,000
loans with a gross carrying amount per client of $200, for a total gross carrying
amount of $200,000. Group Y comprises 1,000 loans with a gross carrying amount
per client of $300, for a total gross carrying amount of $300,000. There are
no transaction costs and the loan contracts include no options (for example,
prepayment or call options), premiums or discounts, points paid, or other fees.
70
IFRS 9 IG Example 9, IE53-IE57
34 April 2018 Impairment of financial instruments under IFRS 9
Example 4: 12-month expected credit losses measurement based
on a loss rate approach (cont’d)
Bank A measures ECLs on the basis of a loss rate approach for Groups X and Y. In
order to develop its loss rates, Bank A considers samples of its own historical default
and loss experience for those types of loans. In addition, Bank A considers forward-
looking information, and updates its historical information for current economic
conditions as well as reasonable and supportable forecasts of future economic
conditions. Historically, for a population of 1,000 loans in each group, Group X’s
loss rates are 0.3 per cent, based on four defaults, and historical loss rates for
Group Y are 0.15 per cent, based on two defaults.
Number
of
clients in
sample
Estimated
per client
gross
carrying
amount
at default
Total
estimated
gross
carrying
amount at
default
Historic
per
annum
average
defaults
Estimated
total gross
carrying
amount at
default
Present
value of
observed
loss (a)
Loss rate
Group
A
B
C = A × B
D
E = B × D
F
G = F ÷ C
X
1,000
$200
$200,000
4
$800
$600
0.3%
Y
1,000
$300
$300,000
2
$600
$450
0.15%
(a) ECLs should be discounted using the EIR. However, for the purposes of this example, the present
value of the observed loss is assumed.
71
At the reporting date, Bank A expects an increase in defaults over the next 12 months
compared to the historical rate. As a result, Bank A estimates five defaults in the next
12 months for loans in Group X and three for loans in Group Y. It estimates that the
present value of the observed credit loss per client will remain consistent with the
historical loss per client.
On the basis of the expected life of the loans, Bank A determines that the expected
increase in defaults does not represent a significant increase in credit risk since initial
recognition for the portfolios. On the basis of its forecasts, Bank A measures the loss
allowance at an amount equal to 12-month ECLs on the 1,000 loans in each group
amounting to $750 and $675 respectively. This equates to a loss rate in the first year
of 0.375 per cent for Group X and 0.225 per cent for Group Y.
Number
of
clients
in
sample
Estimated
per client
gross
carrying
amount
at default
Total
estimated
gross
carrying
amount at
default
Expected
defaults
Estimated
total gross
carrying
amount at
default
Present
value of
observed
loss
Loss rate
Group
A
B
C = A × B
D
E = B × D
F
G = F ÷ C
X
1,000
$200
$200,000
5
$1,000
$750
0.375%
Y
1,000
$300
$300,000
3
$900
$675
0.225%
Bank A uses the loss rates of 0.375 per cent and 0.225 per cent
respectively to estimate 12-month ECLs on new loans in Group X and
Group Y originated during the year and for which credit risk has not
increased significantly since initial recognition.
71
IFRS 9.5.5.17(b)
35 April 2018 Impairment of financial instruments under IFRS 9
The example above illustrates that under the loss rate approach, an entity
would compute its loss rates by segmenting its portfolio into appropriate
groupings (or sub-portfolios) based on shared credit risk characteristics
and then updating its historical loss information with more forward-looking
information. The loss rate was derived simply by computing the ratio between
the present value of observed losses (the numerator) and the gross carrying
amount of the loans (the denominator).
How we see it
Although the loss rate approach does not require an explicit risk of a default
occurring, there has to be an estimate of the number of defaults in order
to determine whether there has been a significant increase in credit risk
(see 5.5 below). Hence, IFRS 9 will require any entities that intend to use
this approach to track the likelihood of default.
ECLs must be discounted at the EIR. However, in this example, the present
value of the observed loss is assumed. This is an additional area of complexity
that entities have to take into account when trying to build upon their existing
loss rate approaches.
4.5 Expected life versus contractual period
Lifetime ECLs are defined as the ECLs that result from all possible default
events over the expected life of a financial instrument.
72
This is consistent
with the requirement that an entity should assess whether the credit risk on
a financial instrument has increased significantly since initial recognition by
using the change in the risk of a default occurring over the expected life of
the financial instrument
.
73
An entity must, therefore, estimate cash flows and the instrument’s life by
considering all contractual terms of the financial instrument (for example,
prepayment, extension, call and similar options). There is a presumption that
the expected life of a financial instrument can be estimated reliably. In those
rare cases when it is not possible to reliably estimate the expected life of
a financial instrument, the entity must use the remaining contractual term
of the financial instrument.
74
However, the maximum period to consider when measuring ECLs must be 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.
75
Although an exception to this principle
has been added for revolving facilities (see section 11 below), the IASB remains
of the view that the contractual period over which an entity is committed to
provide credit (or a shorter period considering prepayments) is the correct
conceptual outcome. The IASB noted that most loan commitments will expire
at a specified date, and if an entity decides to renew, or extend, its commitment
to extend credit, it will be a new instrument for which the entity has the
opportunity to revise the terms and conditions.
76
This means that extension options must only be reflected in the measurement
of ECLs as long as this does not extend the horizon beyond the maximum
contractual period over which the entity is exposed to credit risk. Extension
options at the discretion of the lender must, therefore, be excluded from the
72
IFRS 9 Appendix A
73
IFRS 9.5.5.9
74
IFRS 9 Appendix A, B5.5.51
75
IFRS 9.5.5.19
76
IFRS 9.BC5.260
When measuring ECLs,
entities must consider
the maximum
contractual period
over which the entity is
exposed to credit risk.
36 April 2018 Impairment of financial instruments under IFRS 9
measurement of ECLs. Similarly, a lender’s ability to require prepayment limits
the horizon over which it is exposed to credit risk. The first prepayment date at
the discretion of the lender should, therefore, represent the maximum period to
be reflected in the expected loss calculation.
When assessing the impact of extension options at the discretion of the
borrower, an entity should estimate both the probability of exercise of the
extension option as well as the portion of the loan that will be extended (if
the extension option can be exercised for a portion of the loan only). This
is consistent with how lifetime expected losses must be assessed for loan
commitments where an entity’s estimate of ECLs must be consistent with its
expectations of drawdowns on that loan commitment. Although the standard is
not explicit on this point, the effect of extension options would be best modelled
not by estimating an average life of the facility, but by estimating the EAD each
year over the maximum lifetime. This is because use of an average life would
not reflect losses expected to occur beyond the average life.
77
Expected prepayments at the discretion of borrowers should also be reflected
in the measurement of ECLs. As with extension options, an entity must estimate
both the probability of exercise of the prepayment option as well as the portion
of the loan that will be prepaid (if the prepayment option can be exercised
for a portion of the loan only). As with extension options, the standard
does not specify whether prepayment patterns should be reflected through
an amortising EAD over the maximum contractual period of the financial
instruments or, rather, by shortening the horizon over which to measure
ECLs to the average life of the financial instruments.
How we see it
Similar to the treatment of extension options, described above, in our view,
it is more appropriate to adjust the EAD for the facility each year over the
maximum lifetime. We consider this a more transparent way of incorporating
product features and potential impacts of different macroeconomic
scenarios that can, for example, affect prepayment patterns and
customers’ ability to refinance.
Further complexity in assessing expected prepayments and extensions
arises if one considers that the behaviour of borrowers is affected by their
creditworthiness. This means that prepayment and extension patterns
should probably be estimated separately for stage 1 and stage 2 assets. This
may represent a significant challenge, as making such estimates would require
distinct historical observations for each of the stage 1 and 2 populations, which
are unlikely to be available given that these populations were never identified
in the past. Prepayment assumptions for stage 2 assets would need to factor
in the probabilities that some may subsequently default and some may cure.
A further complication is that expected prepayment and extension behaviour
may vary with changes in the macroeconomic outlook.
The standard is clear that, for loan commitments and financial guarantee
contracts, the time horizon to measure ECLs is the maximum contractual
period over which an entity has a present contractual obligation to extend
credit.
78
However, for certain revolving credit facilities (e.g., credit cards
and overdrafts), as an exception to the normal rule, this period is extended
beyond the maximum contractual period and includes the period over which
the entity is exposed to credit risk and ECLs would not be mitigated by credit
77
IFRS 9.B.5.5.31
78
IFRS 9.B5.5.38
37 April 2018 Impairment of financial instruments under IFRS 9
risk management actions (see section 11 below). This exception is limited to
facilities that include both a loan and an undrawn commitment component,
that do not have a fixed term or repayment structure and usually have a short
contractual cancellation period (for example, one day.)
79
At its April 2015 meeting, the ITG discussed, how to determine the maximum
period for measuring ECLs, by reference to the following example:
80
Example 5: Determining the maximum contractual period when
measuring expected credit losses
Bank A manages a portfolio of variable rate mortgages on a collective basis. The
mortgage loans are issued to retail customers in Country X with the following terms:
•
the stated maturity is 6 months with an automatic extension feature whereby,
unless the borrower or lender take action to terminate the loan at the stated
maturity date, the loan automatically extends for the following 6 months;
•
the interest rate is fixed for each 6-month period at the beginning of the period.
The interest rate is reset to the current market interest rate on the extension
date; and
•
the lender’s right to refuse an extension is unrestricted.
It is assumed that the mortgage loans meet the criteria for amortised cost
measurement under paragraph 4.1.2 of IFRS 9.
In practice, borrowers are generally expected not to elect to terminate their loans on
the stated maturity date, because moving the mortgage to another bank, or applying
for a new product, generally involves an administrative burden and has little or no
economic benefit for the borrower.
Furthermore, Bank A does not complete regular credit file reviews for individual loans
and as a result does not usually cancel the loans unless it receives information about
an adverse credit event in respect of a particular borrower. On the basis of historical
evidence, such loans extend many times and can last for up to 30 years.
The ITG noted that:
•
IFRS 9 is clear that the maximum period to consider when measuring
ECLs in this example would be restricted to 6 months, because this is
the maximum contractual period over which the lender is exposed to
credit risk, i.e., the period until the lender can next object to an extension.
81
•
The standard requires that extension options must be considered when
determining the maximum contractual period, but does not specify whether
these are lender or borrower extension options. However, if the extension
option is within the control of the lender, the lender cannot be forced
to continue extending credit. Therefore, such an option cannot be
considered as lengthening the maximum period of exposure to credit
risk. Conversely, if a borrower holds an extension option that could force
the lender to continue extending credit, this would have the effect of
lengthening that maximum contractual period of credit exposure.
•
The maximum contractual period over which the entity is exposed to credit
risk should be determined in accordance with the substantive contractual
terms of the financial instrument. To further illustrate this point, a situation
in which a lender is legally prevented from exercising a contractual right
should be seen as distinct from a situation in which a lender chooses not
to exercise a contractual right for practical or operational reasons.
79
IFRS 9.5.5.20, B5.5.39, B5.5.40
80
Transition Resource Group for Impairment of Financial Instruments, Agenda ref 1, The maximum
period to consider when measuring expected credit losses, 22 April 2015.
81
IFRS 9.B5.5.19
Options for the lender
to extend the period
of credit would not be
considered in measuring
ECLs.
38 April 2018 Impairment of financial instruments under IFRS 9
•
In the example presented, the facility is not of a revolving nature and
the borrower does not have any such flexibility regarding drawdowns.
Consequently, it would not be appropriate to analogies the 6-month
mortgage loan to a revolving credit facility that has been fully drawn
at the reporting date. Hence, the example falls outside the narrow scope
exception for revolving credit facilities (e.g., credit cards and overdraft
facilities) in which the maximum period to consider when measuring ECLs
is over the period that the entity is exposed to credit risk and ECLs would
not be mitigated by credit risk management actions, even if that period
extends beyond the maximum contractual period (section 11 below).
82
•
Consequently, it was acknowledged that there may be a disconnect
between the accounting and credit risk management view in some
situations (e.g. an entity may choose to continue extending credit to
a long-standing customer despite being in a position to reduce or remove
the exposure). See further discussion on the application of the revolving
credit facilities exception to multi-purpose facilities (at section 11 below).
For demand deposits that have no fixed maturity and can be withdrawn by
the holder on very short notice (e.g., one day) (assuming there is no contractual
or legal constraint that could prevent the holder from withdrawing its cash at
any time), the period used by the holder of such demand deposits to estimate
ECLs would be limited to the contractual notice period, i.e., one day. This is the
maximum contractual period over which the holder is exposed to credit risk. In
accordance with paragraph 5.5.19 of IFRS 9, extension periods at the option of
the holder are excluded in estimating the maximum contractual period because
the holder can unilaterally choose not to extend credit and thus can limit the
period over which it is exposed to credit risk. Furthermore, demand deposits
do not fall under the revolving credit facility exception (see section 11 below)
as they do not comprise an undrawn element.
83
4.6 Probability-weighted outcome and multiple scenarios
ECLs must reflect an unbiased and probability-weighted estimate of credit
losses over the expected life of the financial instrument (i.e. the weighted
average of credit losses with the respective risks of a default occurring as
the weights).
84
The standard makes it clear that when measuring ECLs, in order to derive
an unbiased and probability-weighted amount, an entity needs to evaluate
a range of possible outcomes.
85
This involves identifying possible scenarios
that specify:
a) The amount and timing of the cash flows for particular outcomes
b) The estimated probability of these outcomes
Although an entity does not need to identify every possible scenario, it will need
to take into account the possibility that a credit loss occurs, no matter how low
that probability is.
86
This is not the same as a single estimate of the worst-case
or best-case scenario, or the most likely outcome (i.e., when there is a low risk
or probability of a default (PD) with high loss outcomes, the most likely outcome
could be no credit loss, even though an allowance would be required based on
probability-weighted cash flows).
87
It is worthwhile noting that it is implicit that
the sum of the weighted probabilities will be equal to one. A simple example of
application of a probability-weighted calculation is shown in Example 6.
82
IFRS 9.B5.5.20
83
IFRS 9.5.5.20
84
IFRS 9.5.5.17(a), Appendix A, B5.5.28
85
IFRS 9.5.5.17(a)
86
IFRS 9.5.5.18
87
IFRS 9.B5.5.41
ECLs are a probability-
weighted estimate of
credit losses over the
expected life of the
financial instrument.
39 April 2018 Impairment of financial instruments under IFRS 9
Without taking into account multiple economic scenarios (see below) calculating
a probability-weighted amount may not require a complex analysis or a detailed
simulation of a large number of scenarios and the standard suggests that
relatively simple modelling may be sufficient. For instance, the average credit
losses of a large group of financial instruments with shared risk characteristics
may be a reasonable estimate of the probability-weighted amount. In other
situations, the identification of scenarios that specify the amount and timing
of the cash flows for particular outcomes and the estimated probability of those
outcomes will probably be needed. In those situations, the ECLs shall reflect
at least two outcomes in accordance with paragraph 5.5.18 of IFRS 9.
88
At the December 2015 ITG meeting, the question was asked as to whether the
use of multiple scenarios referred to in the standard relates only to what might
happen to particular assets given a single forward-looking economic scenario
(i.e. default or no default), or whether application of the standard requires
an entity to use multiple forward-looking economic scenarios, and if so how.
The ITG members noted that the measurement of ECLs is required to reflect
an unbiased and probability-weighted amount that is determined by evaluating
a range of possible outcomes. Consequently, when there is a non-linear
relationship between the different forward-looking scenarios and their
associated credit losses, using a single forward-looking economic scenario
would not meet this objective. In such cases, more than one forward-looking
economic scenario would need to be used in the measurement of ECLs.
89
For
each scenario the associated ECLs would need to be multiplied by the weighting
allocated to that scenario.
The ITG also discussed the use of multiple economic scenarios to assess
whether exposures should be measured using lifetime economic losses (see
section 5.7 below). It was noted by the ITG that if the same variable is relevant
for determining significant increase in credit risk and for measuring ECLs,
the same forward-looking scenarios must be used for both.
The ITG discussed a particular example in which there are considered to be
three possible economic scenarios:
90
Example 6: Incorporating single versus multiple forward-looking
scenarios when measuring expected credit losses
Scenario
Future
unemployment
Likelihood of
occurrence
ECLs
(a)
4%
20%
£30
(b)
5%
50%
£70
(c)
6%
30%
£170
Use of a single central economic scenario based on the most likely outcome of 5 per
cent unemployment, i.e. scenario (b), would give rise to an ECL of £70. However,
using a probability-weighted range of scenarios, the ECL would be £92 ((£30 × 0.2) +
(£70 × 0.5) + (£170 × 0.3)). Consequently, the ITG observed that in this example,
using a single central forward-looking economic scenario would not result in an
unbiased and probability-weighted amount in accordance with the standard.
88
IFRS 9.B5.5.42
89
IASB Transition Resource Group for Impairment of Financial Instruments, Meeting Summary,
Paragraph 49, 11 December 2015.
90
IASB Transition Resource Group for Impairment of Financial Instruments, Meeting Summary,
Paragraphs 50 and 51, 11 December 2015.
Multiple macroeconomic
scenarios always need
to be consdered as the
effect of non-linearity
will often be material.
40 April 2018 Impairment of financial instruments under IFRS 9
The ITG were concerned about the distribution of possible losses often being
‘non-linear’, in that the increase in losses associated with those economic
scenarios that are worse than the central forecast will be greater than the
reduction in losses associated with those scenarios that are more benign. To
use statistical terminology, the distribution is skewed. Depending on how it is
calculated, a single scenario gives the mode of this distribution (i.e., the most
likely outcome) or the median (the central forecast). In contrast, the standard
requires the use of the mean (i.e., a probability-weighted estimation). A possible
distribution of the losses in the portfolio consistent with the above example is
shown in Figure 4 below.
Figure 4: Distribution of losses
At the ITG meeting, it was noted that there are a number of possible
approaches that might be used to incorporate multiple economic approaches.
IFRS 9 does not prescribe any particular method of measuring ECLs and
the measurement should reflect an entity’s own view. What the standard
does require is that the expected losses must reflect:
(a) An unbiased and probability-weighted amount that is determined using
a range of possible outcomes
(b) Reasonable and supportable information that is available without undue
cost or effort at the reporting date
With respect to reasonable and supportable information, ITG members made
the following observations:
(a) Although IFRS 9 does not specifically require an entity to consider external
information, an entity should consider information from a variety of
sources in order to ensure that the information used is reasonable
and supportable
(b) The information considered could vary depending on the facts and
circumstances including the level of sophistication of the entity,
geographical region and the particular features of the portfolio
(c) While entities are not expected to consider every possible scenario,
the scenarios considered should reflect a representative sample of
possible outcomes
91
ITG members recognised that materiality considerations would need to be
taken into account.
91
IASB Transition Resource Group for Impairment of Financial Instruments, Meeting Summary,
Paragraphs 53, 11 December 2015.
£100 £200
Likelihood of occurrence
Mean (£92
)
£0 £300 £400
Mode (£70)
Size of loss
41 April 2018 Impairment of financial instruments under IFRS 9
In an IASB webcast on 25 July 2016, it was noted that, having considered:
(a) Whether the effect of non-linearity is material
(b) Whether the entity has a reasonable and supportable basis for this multiple
scenario analysis
(c) Whether the application is possible without undue cost or effort
A conclusion may sometimes be reached that it is not necessary to actually use
multiple scenarios to apply the impairment requirements in IFRS 9. However,
multiple scenarios must always be considered.
At the December 2015 ITG meeting, the ITG also noted that consideration
should be given to the consistency of forward-looking information used for
the measurement of ECLs and for other purposes within the organisation, such
as budgeting and forecasting. ITG members acknowledged that there might
be differences, but observed that these should be understood and explainable.
ITG members also observed that the incorporation of forward-looking scenarios
will require judgement. Consequently, they emphasised the importance of the
IFRS 7 disclosure requirements relating to how forward-looking information has
been incorporated into the determination of ECLs (see 14.4 and Example 28).
92
How we see it
Since December 2015, banks have given significant attention to how
multiple economic scenarios can be incorporated into ECL calculations.
We have seen three main approaches being explored, as follows:
a) Probability weighted scenarios. This is similar to the method discussed
at the ITG meeting in December 2015 and illustrated in Example 6 above.
It involves establishing a number of scenarios (typically three scenarios,
but we have seen varying numbers, generally between two and four),
estimating the losses that would arise in those scenarios and allocating
a weighting to each scenario. Unlike Example 6 above, these do not
normally model economic variables such as unemployment rates in
isolation – to do so, would also require complex modelling of the
correlations between those variables. Instead, each scenario is
normally a coherent combination of economic variables. For example,
a scenario relevant to mortgage loans might include assumptions
about unemployment, interest rates and house prices. This approach
is transparent, but it may be difficult to assign the weightings to
each scenario, requiring judgement as well as experience of the past.
While selecting scenarios and respective weights, we expect banks
to take into consideration the entire distribution of macroeconomic
scenarios and select points (i.e. scenarios) from that distribution,
with their respective weights representing the area of the distribution
represented by the scenario. We would expect that the mean of the
selected scenarios and weights is similar to that of the entire distribution.
b) The second approach is to calculate ECLs based on a central forward-
looking scenario and to adjust the outcome where necessary by a factor
to reflect the non-linearity of the loss distribution. In practice, it may
be that a method similar to (a) above will need to be used in order to
calculate this factor – so that it is not a very different approach. However,
some banks view the merits of this approach as being less mechanistic
and allowing more room for judgement.
92
IASB Transition Resource Group for Impairment of Financial Instruments, Meeting Summary,
Paragraphs 56, 11 December 2015.
42 April 2018 Impairment of financial instruments under IFRS 9
c) Monte Carlo simulation. This method seeks to calculate the expected
losses associated with the entire distribution of possible scenarios,
around the bank’s central economic forecast. It has the advantage
that it does not require the bank to formulate specific scenarios or assign
weightings to them, but the simulation is dependent on assumptions that
may not be transparent to either users or preparers, so that this solution
can seem a ‘black box’. It is also very demanding as to the volume of data
that has to be manipulated and it is not how most banks manage credit
risk today. This method is rarely applied in practice.
The effect of multiple scenarios will affect not just the probability of default, but
also the losses given default. For instance, for property-based lending, it will
be necessary to forecast the value of collateral associated with each economic
scenario that is modelled. A consequence of this is that there may be a need
to record an ECL allowance for an asset that, based on the central forecast
of future collateral values, is fully collateralised. (Also, as a result, the loss
allowance for a stage 3 asset may be higher than for an impaired asset under
IAS 39).
The use of multiple scenarios may also have an effect on the estimated EAD.
How we see it
A number of other observations can be made about the use of multiple
scenarios.
a) Whatever approach is used to calculate the effect of non-linearity,
it will be necessary for banks to communicate the result of the
calculation in a manner which can be understood by readers of
the financial statements. One possible approach would be for banks
to report the losses associated with the central forecast and then,
separately, the effect of the consideration of other scenarios (see
Example 28). This would allow banks to communicate the amounts
they expect to lose and would permit comparison between banks of
the effect of the adjustment for non-linearity, even if the banks use
different methods to make the calculation.
b) It would seem that the effects of non-linearity depend on the countries
in which banks operate and the economic characteristics of those
countries. For instance, the effect of alternative scenarios of interest
rates and unemployment may be greater in countries where there is
more of a ‘boom and bust’ economic cycle. The size of the effect is also
dependent on origination practices and the particular lending products –
variable rate loans being more sensitive to interest rates than fixed-rate
ones, while defaults on credit cards are more affected by unemployment
rates. In some cases, the issue is seen as most relevant for exposures to
a particular economic variable, an example being lending to companies
involved in the oil industry. In this example, banks might model a number
of scenarios as to how oil prices could evolve. A similar approach may
be relevant for non-banks with similar exposures through long-term
construction contracts or leasing activities. There is also more likely
to be non-linearity in the calculation of ECLs when exposures are
collateralised by assets whose values also change in response to the
economic conditions that drive the probability of default. An example
is residential mortgage loans.
c) It should be stressed that the ITG discussion highlighted the importance
of calculating the effect of non-linearity using only reasonable and
supportable information, implying that if the information is not available,
then there is a limit to what can be done. However, banks will also need
to take into account their regulators’ expectations (see sections 1.6 and
6.1 for Basel Committee guidance).
43 April 2018 Impairment of financial instruments under IFRS 9
The process of forecasting future economic conditions is discussed further
in 4.9.3 below.
4.7 Time value of money
An entity needs to consider the time value of money when measuring ECLs,
by discounting the estimated losses to the reporting date using a rate that
approximates the EIR of the asset.
93
This has two components:
•
Discounting recoveries to the date of default, hence ‘a credit loss arises
even if the entity expects to be paid in full but later than when contractually
due’.
94
•
Discounting losses from the date of default to the reporting date. This
is needed because the gross amortised cost of the asset is based on the
contractual cash flows discounted at the EIR, and so not to discount cash
flows that are now not expected to be received would overstate the loss.
It is rare that customers just fail to pay amounts when due. In most cases,
default also involves payments being paid late, while default can lead to
the acceleration of payment of amounts that are not contractually due until
a later date. Therefore, modelling losses involves modelling the timing of
payments when default occurs and different patterns of timing of recoverable
cash flows, such as the time it takes to foreclose on and sell collateral and
complete bankruptcy proceedings, before the ECLs can be discounted back
to the reporting date.
Of these two components, the first has typically been included by banks in
their calculation of the LGD (although not necessarily using the EIR). However,
the second will also need to be calculated to comply with the standard.
The standard and its illustrative examples are silent on how the calculation
should be made. In Illustrative Example 9, the present value of the observed
loss is assumed and in Illustrative Example 8, a footnote states that, ‘because
the LGD represents a percentage of the present value of the gross carrying
amount, this example does not illustrate the time value of money’.
One approach would be to model various scenarios as to how cash is collected
once the loan has defaulted, and probability-weight the discounted cash flows
of these various scenarios.
The discount rate is calculated, as follows:
•
For a fixed-rate financial asset, entities are required to determine or
approximate the EIR on the initial recognition of the financial asset, while
for a floating-rate financial asset, entities are required to use the current
EIR
95
•
For a purchased or originated credit-impaired financial asset (see 3.3
above), entities are required to discount ECLs using the credit-adjusted
EIR determined on the initial recognition of the financial asset
96
•
For a loan commitment (see 10 below), entities are required to use the
EIR of the asset that will result once the commitment is drawn down. This
would give rise to a consistent rate for a credit facility that includes both
a loan (i.e., a financial asset) and an undrawn commitment (i.e., a loan
commitment). If the EIR of the resulting asset is not determinable, then
93
IFRS 9.5.5.17, B5.5.44
94
IFRS 9.B5.5.28
95
IFRS 9.B5.5.44
96
IFRS 9.B5.5.45
An entity needs to
consider the time value of
money when measuring
expected credit losses
by discounting losses to
the reporting date using
a rate that approximates
the effective interest rate
of the asset.
44 April 2018 Impairment of financial instruments under IFRS 9
entities are required to use the current risk-free rate (i.e., the discount
rate that reflects the current market assessment of the time value of
money). This should be adjusted for risks specific to the cash flows, but
only if the cash flows have not already been adjusted for these risks, in
order to avoid double counting
97
•
For financial guarantee contracts (see section 10 below) entities are
required to use the current risk-free rate adjusted for risks specific to
the cash flows, again to the extent that those cash flows have not already
been adjusted for the risks
98
•
For lease receivables (see section 9.2 below), entities are required to
discount the ECLs using the same discount rate used in the measurement
of the lease receivables in accordance with IAS 17 or IFRS 16 (when
applied)
99
LGD data available from Basel models should include a discounting factor and
sometimes this may be different from the rate required by IFRS 9. Furthermore,
the discount rate used in Basel models only covers the period between default
and subsequent recoveries. Therefore, entities will have to find ways to adjust
their LGDs to reflect the discounting effect required by the standard (i.e., based
on a rate that approximates the EIR and over the entire period from recoveries
back to the reporting date). Given the requirement to use an approximation to
the EIR, entities will need to work out how to determine a rate that is sufficiently
accurate. One of the challenges entities will face is to interpret how much
flexibility is afforded by the term ‘approximation’.
At its meeting in December 2015, the ITG also discussed what was meant by
the current EIR when an entity recognises interest revenue in each period based
on the actual floating-rate applicable to that period. The ITG first noted that the
definition of the EIR in IFRS 9 was carried forward essentially unchanged from
the definition within IAS 39. Consequently, similarly to IAS 39, IFRS 9 does not
specify whether an entity should use the current interest rate at the reporting
date or the projected interest rates derived from the current yield curve as
at the reporting date. There should be consistency between the rate used to
recognise interest revenue, the rate used to project future cash flows (including
cash shortfalls) and the rate used to discount those cash flows (see section 3
above).
How we see it
In relation to the guidance in paragraphs B5.5.47 and 48 on loan
commitments when the EIR on the resulting asset is not determinable and
for financial guarantee contracts, we make the following observations:
• Although it is not clear in the standard, any adjustment for the risks
specific to the cash flows would be a reduction of the risk free rate,
not an increase. This would be consistent with the approach applied to
provisions in IAS 37 and as was made clear in the staff paper presented
to the Board when this treatment was discussed in December 2013. For
financial guarantee contracts, the reduction in the risk-free discount
rate will increase the present value of the obligation to pay claims to
the guarantee holder. This reflects the additional compensation that
would be demanded to take on this risky obligation, in particular, to
bear the risk that claims payments will be higher than the probability-
weighted expected amount.
97
IFRS 9.B5.5.47, B5.5.48
98
IFRS 9.B5.5.48
99
IFRS 9.B5.5.46
45 April 2018 Impairment of financial instruments under IFRS 9
• For loan commitments when the EIR on the resulting asset is not
determinable, this approach provides a prudent calculation of ECLs,
given that it is likely that the entity which enters into the commitment
will receive a credit spread on the loan if it is drawn down. It is in a much
better position than the issuer of a financial guarantee contract, who
will receive no credit spread should it be required to pay out on the
guarantee.
• The idea that the rate should be adjusted only if the cash flows have not
already been adjusted for the risks may not be easy to apply in practice.
This is because the cash flows should have already been estimated with
regard to any non-linearities in the distribution of losses (see 5.4.6) and
so will already have been partly adjusted for risk. It may not be easy to
calculate the necessary adjustment to reflect a market assessment of
the remaining risks.
4.8 Losses expected in the event of default
This section discusses how to take into account, when measuring ECLs, credit
enhancements such as collateral and financial guarantees, cash flows from
the sale of a defaulted loan and collection costs paid to an external debt
collection agency.
4.8.1 Credit enhancements: collateral and financial guarantees
Although credit enhancements such as collateral and guarantees play only
a limited role in assessing whether there has been a significant increase in
credit risk (see 5.1 below), they do affect the measurement of ECLs. For
example, for a mortgage loan, even if an entity determines that there has
been a significant increase in credit risk on the loan since initial recognition,
if the expected proceeds from the collateral (i.e., the mortgaged property)
exceeds the amount loaned, then the entity may have nil ECLs, and, hence,
an allowance of zero.
In measuring the ECLs and hence the expected cash shortfalls for
a collateralised financial instrument, an entity should include the cash
flows from the realisation of the collateral and other credit enhancements
that are:
100
•
Part of the contractual terms
•
Not recognised separately by the entity
As is the case in IAS 39, the standard specifies that the estimate of cash
flows from collateral should include the effect of a foreclosure, regardless of
whether foreclosure is probable, and the resulting cash flows from foreclosure
on the collateral less the costs of obtaining and selling the collateral, taking
into account the amount and timing of these cash flows.
101
The wording does
not mean that the entity is required to assume that recovery will be through
foreclosure only, but rather, that the entity must calculate the cash flows
arising from the various ways that the asset may be recovered, only some
of which may involve foreclosure, and to probability-weight these different
scenarios (see Example 3 at 4.4 above).
Although the standard does not refer to fair value when determining the
valuation of the collateral, in practice, an entity is likely to estimate the cash
flows from the realisation of the collateral, based on the fair value of the
collateral. In the case of illiquid collateral, such as real estate, adjustments
100
IFRS 9.B5.5.55
101
IFRS 9.B5.5.55
46 April 2018 Impairment of financial instruments under IFRS 9
will probably need to be made for expected changes in the fair value, depending
on the economic conditions at the estimated date of selling the collateral.
Also, as in IAS 39, any collateral obtained as a result of foreclosure is not
recognised as an asset that is separate from the collateralised financial
instrument, unless it meets the relevant recognition criteria for an asset
in IFRS 9 or other standards.
102
If a loan is guaranteed by a third party as part of its contractual terms, it must
carry an allowance for ECLs based on the combined credit risk of the guarantor
and the guaranteed party, by reflecting the effect of the guarantee in the
measurement of losses expected on default.
A challenge is interpreting what constitutes ‘part of the contractual terms’. This
was addressed by the ITG at its meeting in December 2015, specifically whether
the credit enhancement must be an explicit term of the related asset’s contract
in order for it to be taken into account in the measurement of ECLs, or whether
other credit enhancements that are not recognised separately can also be taken
into account. The ITG noted that:
•
The definition of credit losses states that, when estimating cash flows,
an entity must include cash flows from the sale of collateral held or
other credit enhancements that are integral to the contractual terms.
Consequently, credit enhancements included in the measurement of
ECLs must not be limited to those that are explicitly part of the contractual
terms.
•
An entity must apply its judgement in assessing what is meant by ‘integral
to the contractual terms’ and in making that assessment, an entity should
consider all relevant facts and circumstances. Also, an entity must not
include cash flows from credit enhancements in the measurement of ECLs
if the credit enhancement is accounted for separately. This is particularly
important in order to avoid double counting.
•
IFRS 7 requires disclosures to enable users of financial statements to
understand the effect of collateral and other credit enhancements on
the amounts arising from ECLs (see section 14).
Although not reflected in the official minutes of the ITG meeting, the IASB
members highlighted during the course of the discussion that there was
no intention to alter the treatment when drafting IFRS 9. In practice, under
IAS 39, most banks incorporate guarantees as part of their measurement
of losses given default.
The ITG also emphasised that paragraph B5.5.55 of IFRS 9 was drafted
only with the intention to caution against double counting those credit
enhancements that are already recognised separately, and was not intended
to limit the inclusion of credit enhancements that were previously included in
IAS 39 allowances for loan losses.
However, the ITG discussion does not fully answer the question of how to
interpret when a financial guarantee is ‘integral to the contractual terms’
when it is not mentioned in the contractual terms of the loan.
It seems reasonably clear that a credit default swap on a loan entered into by
the lender to mitigate its credit risk on the loan, would not normally be classed
as integral to a loan’s contractual terms. The second criterion mentioned
in B5.5.55 is that the credit enhancement should not be recognised separately
and separate accounting for a derivative is clearly required by IFRS 9. Also,
102
IFRS 9.B5.5.55
Guarantees obtained
should only be included
in measuring ECLs if
they are ‘integral to
the loan’.
47 April 2018 Impairment of financial instruments under IFRS 9
payment under a credit default swap does not normally require the holder
of the instrument to have suffered the credit loss referenced by the swap.
As a result, cash flows from a credit default swap that is accounted for as
a derivative would not be included in the measurement of ECLs of the
associated loan.
For a financial guarantee (as defined in IFRS 9), one view is that it is integral
to the contractual terms of a loan only if it is, at least implicitly, part of the
contractual terms of the loan. Examples of implicit contractual linkage might
include:
•
Inseparability: The financial guarantee is inseparable from the loan
contract, i.e., the loan cannot be transferred without the guarantee.
•
Local laws and regulations: Credit enhancements required by local laws
and regulations that govern the loan contract, but that are not specifically
in the contract itself. For example, in some jurisdictions legislation requires
that lenders must take out financial guarantee contracts that contain little
or no down payment in respect of certain loans.
•
Business purpose: The guarantee and the loan have been contracted in
contemplation of one another, i.e., the loan would not have been
contracted without the guarantee.
•
Market convention: The exposure and the financial guarantee are traded
as a package in the market.
Another view is that any contract that meets the definition of a financial
guarantee under IFRS 9 can be considered ‘integral to the contractual terms’
of the guaranteed loan, as long as the guarantee is entered to at the same
time, or within a short time, after the loan is advanced. As the definition
of a financial guarantee contract requires that the loan is specified in the
contractual terms of the financial guarantee and it is necessary for the
lender to incur a credit loss on the loan to be reimbursed, there is a clear
contractual linkage that ensures that any credit loss incurred on the loan
will be compensated by the financial guarantee and no compensation will
arise on the financial guarantee unless a credit loss is actually incurred by
the lender on the guaranteed loan.
Although it is not clear when a financial guarantee contract would be
regarded as ‘integral’, this may not significantly affect the profit or
loss recognition by the lender. A financial guarantee contract is likely
to satisfy the definition of an insurance contract in IFRS 4 Insurance
Contracts, but will be excluded from the scope of IFRS 4 because it is a direct
insurance contract held by a policy holder (as opposed to a policyholder
of a reinsurance contract).
103
It is therefore outside the scope of IFRS 9.
104
IFRS 4 points to paragraphs 10 to 12 of IAS 8 Accounting Policies, Changes
in Accounting Estimates and Errors which address situations where no IFRS
specifically applies to a transaction, i.e., the holder of a financial guarantee
contract will normally need to develop its accounting policy in accordance
with the hierarchy in IAS 8.
105
103
IFRS 4.4(f)
104
IFRS 9.2.1(e)
105
IFRS 4 IG2 Example 1.11
48 April 2018 Impairment of financial instruments under IFRS 9
Applying the IAS 8 hierarchy, one possibility would be to look to IAS 37
and treat the guarantee as a right to a reimbursement in respect of
the impairment loss. IAS 37 permits a reimbursement of a liability to be
recognised as an asset when it is virtually certain that the reimbursement
will be received if the obligation for which a provision has been established
is settled.
106
In this instance, the benefit of the guarantee would be
recognised as an asset to the extent it is virtually certain a recovery could
be made if the lender were to suffer the impairment loss on the loan. One of
the key advantages of a financial guarantee contract, compared to a normal
insurance contract, is that they are typically drawn up using standard terms
and conditions and there is often little doubt that an obligation would arise
for the guarantor if the reference asset were to default. However, care
should be taken to establish, based on the contractual terms of the
arrangement, that a right to a recovery would, indeed, be virtually certain.
To record a reimbursement asset under IAS 37, it is less clear whether
the credit risk of the guarantor needs to be assessed in determining whether
recovery would be virtually certain, or whether the guarantor’s credit risk
would only be reflected in measuring the reimbursement asset. One view is
that the guarantor would either have to present a very low credit risk or else
the guarantee would itself need to be collateralised. In this case, care should
also be taken to ensure that there is no correlation between the credit risk
of the loan and that of the guarantee, as would be the case if the guarantor’s
financial strength were to reduce at the same time that the loan is likely to
default. Applying this view, if a reimbursement is considered virtually certain,
there would probably be no need also to reflect the guarantor’s credit risk
in the measurement of the asset. In contrast, the second view imposes a less
stringent criterion for recognising an asset, but would reduce the recognised
asset to reflect the probability that the guarantor may be unable to meet its
obligation.
An alternative approach would be to look to IFRS 3, since it requires that
all contingent liabilities are recognised on a business combination, whether
or not they are probable. This is closer to the IFRS 9 notion of an expected
credit loss than the contingent liability recognition threshold under IAS 37.
IFRS 3 allows an indemnification asset to be recognised, measured on the
same basis as the indemnified asset or liability, subject to any contractual
limitations on its amount and, for an indemnification asset that is not
subsequently measured at its fair value, subject also to management’s
assessment of the collectability of the indemnification asset.
107
Adopting
this indemnification asset approach, the credit risk of the guarantor
becomes a measurement, rather than a recognition issue. It would
not be necessary to assess if the credit risk of the guarantor is very low,
since credit risk is instead reflected in the measurement of the guarantee.
Whether an analogy is made to a reimbursement right under IAS 37 or an
indemnification asset under IFRS 3, an asset may be recognised in respect
of the guarantee, not exceeding the amount of the provision.
108
Except for
the possible treatment of the guarantor’s credit risk, using either of these
approaches, the overall effect on profit or loss for the lender may be often
106
IAS 37.53
107
IFRS3.57
108
IAS 37.53, IFRS 3.57
49 April 2018 Impairment of financial instruments under IFRS 9
the same as if the guarantee was included in the measurement of the ECL
of the guaranteed asset. The right would, however, be presented as an asset
rather than as a reduction of the impairment allowance.
Most guarantees require payment of a premium. To the extent that
the guarantee is considered integral to the loan, it would be consistent
with this notion to treat the cost of the guarantee as a transaction cost
of making the loan. This means that the lender would add this cost to the
initial carrying amount of the loan and so reduce the future EIR. It should
not make a difference to the accounting for the loan whether the guarantee
premium is paid upfront or in instalments over the life of the loan. If the
premium is payable in instalments, it follows (at least, in theory, although
the effect may not be material) that the full cost of the guarantee should
be included in setting the loan’s EIR.
It is less clear how to account for premiums paid for guarantees that are
not considered integral to the loan. If the entity who makes a loan and, at
the same time, pays for a guarantee, records both the unamortised cost of
the guarantee plus also a reimbursement or indemnification asset equivalent
to the 12-month ECLs, the total amount at which the guarantee is initially
recorded in the financial statements will exceed its fair value. This is because
the cost of the guarantee will already include the guarantor’s expectations
of future losses. One view is to consider this to be ‘double counting’ and so,
to restrict the reimbursement/indemnification right to the excess (if any)
of the ECL over the cost of the guarantee that is already reflected in the
balance sheet.
There is another view that recognising both the unamortised cost of the
guarantee and a reimbursement right/indemnification asset equal to the
ECL is necessary to be consistent with the accounting for the loan. Another
way of expressing this is to say that it is appropriate for the guarantee
to be recorded at more than its initial fair value as the guaranteed loan is
recorded initially at less than its fair value by a similar amount, i.e., the ECL.
The subsequent amortisation of the cost of the guarantee would be balanced
by the recognition of the credit spread in the interest earned on the loan.
Whatever view is taken on this issue, if the lender acquires the guarantee
subsequent to making the loan and the loan has, in the meantime, increased
in credit risk, it is likely that the lender will pay more for the guarantee, to
reflect this increase in credit risk. If so, this additional amount will crystallise
a loss for the lender and so should not be recorded as a reimbursement/
indemnification right and a reversal of a previously recognised impairment
loss.
We should add, as a word of warning, that IFRS 9 has been amended by
IFRS 17 Insurance Contracts. The scope exclusion for financial guarantee
contracts will change from those contracts that meet the definition of
insurance contracts to those that are in the scope of IFRS 17. As the
accounting by the holder of the guarantee is not in the scope of IFRS 17,
it will, by default, be in the scope of IFRS 9. The accounting treatment
under IFRS 9 for a financial asset that fails the ‘solely payment of principle
and interest’ test is to measure it at fair value through profit or loss. Hence,
unless the Board first amends IFRS 9, from years beginning on or after
1 January 2021 when IFRS 17 becomes effective, it would appear to be
50 April 2018 Impairment of financial instruments under IFRS 9
no longer possible to recognise a reimbursement or indemnification right
for over and above the fair value of a guarantee that is not considered
‘integral’ to the guaranteed loan.
There have also been some discussions in practice on whether financial
assets that are considered to be in default (e.g., because payments are more
than 90 days past due) but that are fully collateralised (so that there is no
ECL) would qualify as credit-impaired and therefore have to be transferred
to stage 3 (see 3.1 above). Although the definition of credit-impaired refers
to ‘a detrimental impact on the estimated future cash flows’, it is not clear
whether this should be read to include any recoveries from the realisation of
collateral and IFRS 9 has no explicit requirements to consider collateral when
assessing credit-impaired financial assets.
There are some strong arguments in favour of aligning the criteria for
transferring an asset to stage 3 with those for assessing whether it is in
default. First, IFRS 9 bases significant deterioration on risk of a default
occurring and it would therefore seem inconsistent (and potentially confusing
for users) if the value of collateral is considered for stage 3 allocation. Also,
if collateral value were to influence the stage 3 allocation, this could result
in some instability between stages 2 and 3, as exposures would potentially
go back and forth depending on the collateral value.
Aligning stage 3 with the default status affects the scope of instruments to
which the purchased or originated credit-impaired approach must be applied
(see 3 above). However, for any exposure which is fully collateralised and
where the expected loss is zero, classification as a purchased or originated
credit-impaired financial asset, or classification between stages 1, 2 or 3
does not affect the accounting. If the expected loss is zero, it will not affect
the EIR calculation.
Also, IFRS 7 requires a quantitative disclosure about the collateral held as
security and other credit enhancements for financial assets that are credit-
impaired at the reporting date (e.g. quantification of the extent to which
collateral and other credit enhancements mitigate credit risk).
109
4.8.2 Cash flows from the sale of a defaulted loan
At its meeting in December 2015, the ITG also discussed whether cash flows
that are expected to be recovered from the sale on default of a loan could be
included in the measurement of ECLs. ITG members noted that:
•
Such cash flows should be included in the measurement of ECLs if:
(a) Selling the loan is one of the recovery methods that the entity
expects to pursue in a default scenario
(b) The entity is neither legally nor practically prevented from realising
the loan using that recovery method
And
(c) The entity has reasonable and supportable information upon which
to base its expectations and assumptions
•
In order to support an entity’s expectation that loan sales would be used as
a recovery method in a default scenario, an entity’s past practice would be
an important consideration. However, future expectations, which may differ
from past practice, would also need to be considered. With respect to the
amount of recovery proceeds to be included in the measurement of ECLs,
an entity should consider relevant market related information relating to
loan sale prices.
109
IFRS 7.35K(c)
If there are scenarios in
which recovery will be
achieved by selling the
loans, these should be
considered in measuring
ECLs.
51 April 2018 Impairment of financial instruments under IFRS 9
•
In these circumstances, the inclusion of recovery sale proceeds in the
measurement of ECLs would be appropriate for financial instruments in
stages 1, 2 and 3 (see section 3.1 above). This is because when measuring
ECLs, IFRS 9 requires an entity to consider possible default scenarios for
financial instruments in all three stages.
•
Expected sale proceeds would only be relevant when considering the
possibility that a credit loss occurs (i.e., in a default scenario) and would
not be relevant when considering the possibility that no credit loss occurs
(i.e., in a performing scenario). For example if, in the case of a particular
loan, an entity concluded that there was a 10 per cent probability of
default occurring, it would only be when considering the outcome of this
default scenario that expected sale proceeds would be considered. If, in
that default scenario, the entity expected to recover 30 per cent of the
contractual cash flows of the loan through sale proceeds but only 25 per
cent through continuing to hold, then the LGD would be 70 per cent rather
than 75 per cent. In addition, the expected sale proceeds should be net of
selling costs.
4.9 Reasonable and supportable information
IFRS 9 requires an entity to consider reasonable and supportable information
that is available, without undue cost or effort at the reporting date, about past
events, current conditions and forecasts of future economic conditions that is
relevant to the estimate of ECLs, including the effect of expected
prepayments.
110
4.9.1 Undue cost or effort
The term ‘undue cost or effort’ is not defined in IFRS 9, although it is clear
from the guidance that information available for financial reporting purposes
is considered to be available without undue cost or effort.
111
Beyond that, although the standard explains that entities are not required to
undertake an exhaustive search for information, it does include, as examples
of relevant information, data from risk management systems, as described
in 4.9.2 below.
What is available without undue cost or effort would be an area subject
to management judgement in assessing the costs and associated benefits.
This is consistent with the guidance in International Financial Reporting
Standard for Small and Medium-sized Entities (IFRS for SMEs) in relation
to the application of undue cost or effort. Paragraph 2.14B of IFRS for SMEs
states that considering whether obtaining or determining the information
necessary to comply with a requirement would involve undue cost or effort
depends on the entity’s specific circumstances and on management’s
judgement of the costs and benefits from applying that requirement. This
judgement requires consideration of how the economic decisions of those that
are expected to use the financial statements could be affected by not having
that information. Applying a requirement would involve undue cost or effort by
an SME if the incremental cost (for example, valuers’ fees) or additional effort
(for example, endeavours by employees) substantially exceed the benefits that
those that are expected to use the SME’s financial statements would receive
from having the information. Paragraph 232 of the Basis for Conclusions to
IFRS for SMEs further observes that:
110
IFRS 9.5.5.17(c), B5.5.51
111
IFRS 9.B5.5.49
The term ‘undue cost
or effort’ is not defined
in IFRS 9, although it is
clear from the guidance
that information
available for financial
reporting purposes
is considered to be
available without undue
cost or effort.
52 April 2018 Impairment of financial instruments under IFRS 9
•
The undue cost or effort exemption is not intended to be a low hurdle. In
particular, the IASB observed that it would expect that if an entity already
had, or could easily and inexpensively acquire, the information necessary
to comply with a requirement, any related undue cost or effort exemption
would not be applicable. This is because, in that case, the benefits to
the users of the financial statements of having the information would
be expected to exceed any further cost or effort by the entity
•
An entity must make a new assessment of whether a requirement will
involve undue cost or effort at each reporting date
If the reporting entity is a bank, there would presumably be a higher hurdle
to determine what credit risk information would require undue cost or effort,
compared to a reporter that is not a bank, given that the benefit to users of its
financial statements would be also expected to be higher. This is also an issue
on which the Basel Committee has issued guidance (see 6.1 below).
4.9.2 Sources of information
The standard states that the information used should include factors that are
specific to the borrower, general economic conditions and an assessment of
both the current as well as the forecast direction of conditions at the reporting
date. Entities may use various sources of data, both internal (entity-specific)
data and external data that includes internal historical credit loss experience,
internal ratings, credit loss experience of other entities for comparable financial
instruments, and external ratings, reports and statistics. Entities that have no,
or insufficient, sources of entity-specific data may use peer group experience
for the comparable financial instrument (or groups of financial instruments).
112
Although the ECLs reflect an entity’s own expectations of credit losses, an
entity should also consider observable market information about the credit
risk of particular financial instruments.
113
Therefore, although entities with
in-house economic teams will inevitably want to use their internal economic
forecasts, while loss estimation models will be built based on historical data,
they should not ignore external market data.
4.9.3 Information about past events, current conditions and forecasts of
future economic conditions
One of the significant changes from the IAS 39 impairment requirements is
that entities are not only required to use historical information (e.g., their credit
loss experience) that is adjusted to reflect the effects of current conditions,
but they are also required to consider how forecasts of future conditions would
affect their historical data. Section 4.6 above contains a discussion of how this
process needs to consider the existence of non-linearity in how expected losses
will change with varying economic conditions and the need to assess multiple
economic scenarios. This section explores some of the other challenges in
forecasting future conditions and the consequent ECLs.
The degree of judgement that is required to estimate ECLs depends on
the availability of detailed information. An entity is not required to
incorporate detailed forecasts of future conditions over the entire expected
life of a financial instrument. The standard notes that as the forecast horizon
increases, the availability of detailed information decreases and the degree
of judgement required to estimate ECLs increases. Therefore, an entity is not
required to perform a detailed estimate for periods that are far in the future
and may extrapolate projections from available, more detailed information.
114
112
IFRS 9.B5.5.51
113
IFRS 9.B5.5.54
114
IFRS 9.B5.5.50
Entities are not only
required to use
historical information
(e.g., their credit loss
experience) adjusted to
reflect the effects of
current conditions, but
they must also consider
how forecasts of future
conditions would affect
their historical data.
53 April 2018 Impairment of financial instruments under IFRS 9
Most banks plan to apply either a 3-year or 5-year period over which macro-
economic variables would be forecasted reliably.
Beyond the horizon to which economic conditions can be reliably forecast, the
application guidance suggests that entities may often be able to assume that
economic conditions revert to their long-term average.
115
There are at least
two methods for how this might be done: either by reverting to the average
immediately beyond the forecast horizon; or by adjusting the forecast data
to the long-term average over a few years. The latter would, perhaps, more
effectively make use of all reasonable and supportable information.
Historical information should be used as a starting point from which
adjustments are made to estimate ECLs on the basis of reasonable and
supportable information that incorporates both current and forward-looking
information:
116
•
In most cases, adjustments would be needed to incorporate the effects
that were not present in the past or to remove the effects that are not
relevant for the future.
•
In some cases, unadjusted historical information may be the best estimate,
depending on the nature of the historical information and when it was
calculated, compared to circumstances at the reporting date and the
characteristics of the financial instrument being considered. But it
should not be assumed to be appropriate in all circumstances.
117
Additionally, when considering whether historical credit losses should be
adjusted, an entity will need to consider various items, including:
•
Whether the historical data captures ECLs that are through-the-cycle
(i.e., estimates based on historical credit loss events and experience
over the entire economic cycle) or point-in-time (i.e., estimates based
on information, circumstances and events at the reporting date).
•
The period of time over which its historical data has been captured
and the corresponding economic conditions represented in that history.
The historical data period may reflect unusually benign or harsh
conditions unless it is long enough. Meanwhile, products, customers
and lending behaviours all change over time. When using historical
credit loss experience, it is important that information about historical
credit losses is applied to groups that are defined in a manner that is
consistent with the groups for which the historical credit losses were
observed.
The estimates of changes in ECLs should be directionally consistent with
changes in related observable data from period to period (i.e., consistent with
trends observed on payment status and macroeconomic data such as changes
in unemployment rates, property prices, and commodity prices). Also, in order
to reduce the differences between an entity’s estimates and actual credit loss
experience, the estimates of ECLs should be back-tested and re-calibrated,
i.e., an entity should regularly review its inputs, assumptions, methodology
and estimation techniques used as well as its groupings of sub-portfolios with
shared credit risk characteristics (see 5.5 below).
115
IFRS 9.B5.5.54
116
IFRS 9.B5.5.52
117
IFRS 9.BC5.281
The estimates of
changes in ECLs must be
directionally consistent
with changes in related
observable data from
period to period.
54 April 2018 Impairment of financial instruments under IFRS 9
How we see it
Back testing will be considerably more challenging for forecasts over several
years than may be the case for just the 12-month risk of default, because
detailed information may not be available over the forecast horizon and
the degree of judgement increases as the forecast horizon increases.
118
Also, economic forecasts are usually wrong, as reality is much more complex
than can ever be effectively modelled. Therefore, it is probably not a useful
exercise to back test macroeconomic assumptions against what actually
transpires, but it is useful to back test whether, for a given macroeconomic
scenario, credit losses increased or decreased as expected
In estimating ECLs, entities must consider how to bridge the gap between
historical loss experience and current expectations. Estimating future
economic conditions is only the first step of the exercise. Having decided
what will happen to macroeconomic factors such as interest rates, house
prices, unemployment and GDP growth, entities then need to decide
how they translate into ECLs. This will need to reflect how such changes
in factors affected defaults in the past. However, it is possible that the
forecast combination of factors may have never been seen historically
together.
We observe that banks are also trying to align IFRS 9 to their existing risk
management practices. Many banks are making use of their regulatory
capital calculation and stress testing frameworks for their IFRS 9
calculations. This manifests itself in many of the individual decisions that
banks are making as part of their development of IFRS 9 methodologies
(e.g., definitions of default and alignment to stress testing). It is likely that
regulators and standard-setters will concur with this approach. Basel PDs
are used as a starting point and there is a need for a different calibration
for IFRS 9, in order to transform a Basel PD into an unbiased point in time
metric and include forward looking expectations. Stress testing resources,
previously working almost exclusively with capital issues, will likely play
a major role in calculating lifetime ECLs, although the scenarios modelled
for IFRS 9 will not be stressed. However, estimating losses (especially given
the need to consider multiple scenarios) will still be challenging for many
entities.
The ITG has discussed several aspects of the forecast of ECLs (see section 1.5
above). In April 2015, the ITG debated whether, and how, to incorporate events
and new information about forecasts of future economic conditions that occur
after the ECLs have been estimated. Due to operational practicality, entities
may perform their ECL calculations before the reporting period end in order
to publish their financial statements in a timely manner (e.g. forecasts of
future economic conditions developed in November may be used as the basis
for determining the ECLs at the reporting date as at 31 December). Further
information may then become available after the period end. The ITG noted
that:
•
If new information becomes available before the reporting date, subject to
materiality considerations in accordance with IAS 8, an entity is required
to take into consideration this information in the assessment of significant
increases in credit risk and the measurement of ECLs at the reporting date.
118
IFRS 9.B5.5.52, B5.5.53
55 April 2018 Impairment of financial instruments under IFRS 9
•
IFRS 9 does not specifically require new information that becomes available
after the reporting date to be reflected in the measurement of ECLs at
the reporting date. If new information becomes available between the
reporting date and the date the financial statements are authorised for
issue, an entity needs to apply judgement, based on the specific facts and
circumstances, to determine whether it is an adjusting or non-adjusting
event in accordance with IAS 10 Events after the Reporting Period.
Similarly, materiality considerations apply in accordance with IAS 8.
•
ECLs are similar in nature to the measurement of fair value at the reporting
date, in that movements in fair value after the reporting date are generally
not reflected in the measurement of fair value at the reporting date.
119
For
example, a change in interest rates or the outcome of a public vote after
the reporting date would not normally be regarded as adjusting events
for the ECL calculation.
•
However, ECLs are a probability-weighted estimate of credit losses
at the reporting date (see section 4.6 above). Accordingly, the
determination of ECLs should take into consideration relevant possible
future scenarios based on a range of expectations at the reporting date,
using the information available at that date. Hence, the probabilities
attached to future expected movements in interest rates and expected
outcomes of a future public vote based on information available at the
reporting date would be reflected in the determination of ECLs at that date.
•
Entities need robust processes and appropriate governance procedures
for incorporating information, including forecasts of future economic
conditions, to ensure transparent and consistent application of the
impairment requirements in IFRS 9. This includes processes for updating
ECLs for new information that becomes available after the initial modelling
has taken place up until the reporting date.
At its meeting on 16 September 2015, the ITG examined two further questions
about the use of forward-looking information:
120
•
The level at which forward-looking information should be incorporated –
whether at the level of the entity or on a portfolio-by-portfolio basis.
121
•
How to determine what is reasonable and supportable forward-looking
information and how to treat shock events with material, but uncertain,
economic consequences, such as an independence referendum. The same
considerations could apply to events such as natural disasters.
122
With respect to the first issue, the ITG members confirmed that forward-looking
information should be relevant for the particular financial instrument or group
of financial instruments to which the impairment requirements are being
applied. Different factors may be relevant to different financial instruments
and, accordingly, the relevance of particular items of information may vary
between financial instruments, depending on the specific drivers of credit risk.
This is highlighted in Illustrative Example 5 for IFRS 9 (see Example 16 below),
in which expectations about future levels of unemployment in a specific industry
and specific region are only relevant to a sub-portfolio of mortgage loans in
which the borrowers work in that industry in that specific region. Conversely,
it was also noted that if different financial instruments or portfolios being
assessed share some similar risk characteristics, then relevant forward-looking
119
IAS 10.11
120
Transition Resource Group for Impairment of Financial Instruments, Agenda ref 4, Forward-
looking information, 16 September 2015.
121
IFRS 9.B5.5.16, B5.5.51
122
IFRS 9.B5.5.49-54
IFRS 9 changes the way
in which post balance
sheet events should
be considered.
56 April 2018 Impairment of financial instruments under IFRS 9
information should be applied in a comparable and consistent manner to reflect
those similar characteristics.
With respect to the second issue, the ITG members noted:
•
There will be a spectrum of forward-looking information available, some of
which will be reasonable and supportable and some of which will have little
or no supportable basis. Determining the information that is relevant and
reasonable and supportable and its impact on the assessment of significant
increases in credit risk and measurement of ECLs can require a high level
of judgement. In addition, it can be particularly challenging and difficult
to determine the economic consequences (or ‘second-order effects’) of
uncertain future outcomes. For example, while it may be possible to assess
the likelihood of a particular event occurring, it may be more difficult to
determine the effect of the event on the risk of a default occurring and/or
on the credit loses that would be associated with that event using
reasonable and supportable information.
•
The objective of the IFRS 9 requirements for measuring ECLs is to reflect
probability-weighted outcomes. Accordingly, information should not be
excluded from the assessment of ECLs simply because:
(a) The event has a low or remote likelihood of occurring
Or
(b) The effect of that event on the credit risk or the amount of ECLs
is uncertain
•
An entity should make an effort in good faith to estimate the impact of
uncertain future events, including second-order effects, on the credit risk
of financial instruments and the measurement of ECLs. The estimate should
be based on all reasonable and supportable information that is relevant and
available without undue cost and effort. Furthermore:
(a) Estimates of ECLs should reflect an entity’s own expectations of
credit losses; however, entities should be able to explain how they
have arrived at their estimate and how it is based on reasonable
and supportable information.
(b) Estimates of ECLs are, by their nature, approximations, which will be
updated as more reasonable and supportable information becomes
available over time.
(c) Information does not necessarily need to flow through a statistical
model or credit-rating process in order to determine whether it is
reasonable and supportable and relevant for a particular financial
instrument or group of financial instruments.
•
If an entity could determine that an uncertain event has an impact on the
risk of a default occurring, then it should be possible to make an estimate
of the impact on ECLs, despite the potentially large range of outcomes.
However, in some exceptional cases, it was acknowledged that it may not
be possible to estimate the impact on ECLs, despite an entity’s best efforts.
•
In this regard, the importance of disclosure of forward-looking information
that is relevant, but that cannot be incorporated in the determination of
significant increases in credit risk and/or the measurement of ECLs because
of the lack of reasonable and supportable information was emphasised.
Such disclosures should be consistent with the objective in IFRS 7, which
is to enable users of the financial statements to understand the credit risk
to which the entity is exposed.
Even though future
events are uncertain,
entities should make
a good faith effort to
estimate their impact.
If a lack of reliable and
supportable information
means that forward
looking information
cannot be included in the
measurement of ECLs,
this must be disclosed if
the effect is likely to be
material.
57 April 2018 Impairment of financial instruments under IFRS 9
•
The need for good governance and processes in this area, because of
the uncertainties and continually changing circumstances associated
with forward-looking information. Furthermore, an entity should be able
to explain what information it had considered and why that information
had been included or excluded from the determination of ECLs.
This ITG discussion predated the discussion held in December 2015 on the use
of probability-weighted multiple economic scenarios (see section 4.6 above)
and some of the points that were noted by the ITG probably need to be updated
in the context of the later discussion. For instance, the ITG members noted
that the impact of scenarios for some uncertain future events, for which
there is reasonable and supportable information, may need to be incorporated
through the use of overlays to the ‘base model’ on a collective basis. In
applying a multiple scenario approach, an entity will not use just one base
model. Moreover, if the lender needs to estimate ECLs by considering multiple
economic scenarios, it would follow that many shock events will be included in
that process, with the event and its various possible consequences occurring
in some scenarios and not in others. There may still need to be cases when the
effect of shock events is added through an additional ‘overlay’ to the modelled
calculation of ECLs but, if so, as noted by the ITG members, care needs to be
taken to avoid double counting the consequences of the event with what has
already been assumed in the model.
Banks will also need to take account of guidance from their regulators (see
section 6.1 below).
The ITG members also noted that the effects of uncertain future events may
need to be reflected in the assessment of whether there has been a significant
increase in credit risk.
5 General approach: determining significant
increases in credit risk
One of the major challenges in implementing the general approach in the IFRS 9
ECL model is to track and determine whether there have been significant
increases in the credit risk of an entity’s credit exposures since initial
recognition.
The assessment of significant deterioration is key in establishing the point
of switching between the requirement to measure an allowance based on 12-
month ECLs and one that is based on lifetime ECLs. The standard is prescriptive
that an entity cannot align the timing of significant increases in credit risk and
the recognition of lifetime ECLs with the time when a financial asset is regarded
as credit-impaired or to an entity’s internal definition of default.
123
Financial
assets should normally be assessed as having increased significantly in credit
risk earlier than when they become credit-impaired (see section 3.1 above) or
default occurs.
124
As this area involves significant management judgement, entities are required
to provide both qualitative and quantitative disclosures under IFRS 7 to explain
the inputs, assumptions and estimation used to determine significant increases
in credit risk of financial instruments and any changes in those assumptions and
estimates (see section 14).
125
At its meeting in December 2015, the ITG members reaffirmed that, unless
a more specific exception applies, IFRS 9 requires an entity to assess whether
123
IFRS 9.B5.5.21
124
IFRS 9.B5.5.7
125
IFRS 7.35F(a), 35G(a)(ii), 35G(c)
Because of the
relationship between
the expected life and
the risk of default
occurring, the change
in credit risk cannot
be assessed simply by
comparing the change
in the absolute risk of
default over time,
because the risk of
default usually
decreases as time
passes if the credit risk
is unchanged.
58 April 2018 Impairment of financial instruments under IFRS 9
there has been a significant increase in credit risk for all financial instruments,
including those with a maturity of 12 months or less. Consistently with this
requirement, IFRS 7 requires corresponding disclosures that distinguish
between financial instruments for which the loss allowance is equal to
12-month or lifetime ECLs. In addition, the ITG members noted that:
•
The assessment of significant increases in credit risk is distinct from the
measurement of ECLs as highlighted by paragraph 5.5.9 of IFRS 9. For
example, a collateralised financial asset may have suffered a significant
increase in credit risk, but owing to the value of the collateral there may
not be an increase in the amount of ECLs even if measured on a lifetime
rather than a 12-month basis
•
Assessing changes in credit risk would be consistent with normal credit
risk management practices
•
The expected life of a financial instrument may change if it has suffered
a significant increase in credit risk
Finally, the ITG noted the importance of the IFRS 7 disclosure requirements and
observed that disclosing information regarding the increase in credit risk since
initial recognition provides users of financial statements with useful information
regarding the changes in the risk of default occurring in respect of that financial
instrument (see section 14).
5.1 Change in the risk of a default occurring
In order to make the assessment of whether there has been significant
credit deterioration, an entity should consider reasonable and supportable
information that is available without undue cost or effort and compare:
126
•
The risk of a default occurring on the financial instrument over its life as
at the reporting date
•
The risk of a default occurring on the financial instrument over its life as
at the date of initial recognition
For loan commitments, an entity should consider changes in the risk of a
default occurring on the potential loan to which a loan commitment relates.
For financial guarantee contracts, an entity should consider the changes in
the risk that the specified debtor will default.
127
An entity is required to assess significant increases in credit risk based on
the change in the risk of a default occurring over the expected life of the
financial instrument rather than the change in the amount of ECLs.
128
In
a departure from the Basel regulatory wording and to avoid suggesting that
statistical models are required (including the PD approach), the IASB changed
the terminology from ‘probability of a default occurring’ to ‘risk of a default
occurring’
.
129
In order to make the IFRS 9 impairment model operational, the IASB considered
a number of alternative methods for determining significant increases in credit
risk, but these were rejected for the following reasons:
•
Absolute level of credit risk: The IASB considered whether an entity should
be required to recognise lifetime ECLs on all financial instruments at, or
above, a particular credit risk at the reporting date. Although this approach
126
IFRS 9.5.5.9
127
IFRS 9.B5.5.8
128
IFRS 9.5.5.9
129
IFRS 9.BC5.157
59 April 2018 Impairment of financial instruments under IFRS 9
is operationally simpler to apply (because an entity is not required to track
changes in credit risk), such an approach would provide very different
information. It would not approximate the economic effect of changes
in credit loss expectations subsequent to initial recognition. In addition, it
may also result in overstatement or understatement of ECLs, depending
on the threshold set for recognising lifetime ECLs.
130
However, the IASB
noted that an absolute approach could be used for portfolios of financial
instruments with similar credit risk at initial recognition, by determining
the maximum initial credit risk accepted and then comparing the maximum
initial credit risk to the credit risk at the reporting date (see section 5.4.5
below).
131
•
Change in the credit risk management objective: The IASB also considered
whether the assessment of significant deterioration should be based
on whether an entity’s credit risk management objective changes (e.g.,
monitoring of financial assets on an individual basis, or a change from
collecting past due amounts to the recovery of these amounts). This
approach is operationally relatively easy to apply. However, it is likely
to have a similar effect to the IAS 39 incurred loss model and, hence,
may result in a delayed recognition of ECLs.
132
•
Credit underwriting policies: The IASB further considered whether the
change in the entity’s credit underwriting limit for a particular class of
financial instrument at the reporting date (i.e. an entity would not originate
new loans on the same terms) should form the basis of assessing significant
increase in credit risk. The IASB noted that this approach is similar to
the absolute approach above. Moreover, the change in an entity’s credit
underwriting limits may be driven by other factors that are not related to
a change in the credit risk of its borrowers (e.g., the entity may incorporate
favourable terms to maintain a good business relationship or to increase
lending), or that are dependent on circumstances existing at the reporting
date that are not relevant to the particular vintages of financial
instruments.
133
Similar to measuring ECLs, an entity may use different approaches when
assessing significant increases in credit risk for different financial instruments.
An approach that does not include PD as an explicit input can be consistent
with the impairment requirements as long as the entity is able to separate
the changes in the risk of a default occurring from changes in other drivers
of ECLs (e.g., collateral) and considers the following when making the
assessment:
134
•
The change in the risk of a default occurring since initial recognition
•
The expected life of the financial instrument
•
Reasonable and supportable information that is available, without undue
cost or effort, that may affect credit risk
In addition, because of the relationship between the expected life and the risk
of default occurring, the change in credit risk cannot be assessed simply by
comparing the change in the absolute risk of default over time, because
the risk of default usually decreases as time passes if the credit risk is
unchanged.
135
130
IFRS 9.BC5.160
131
IFRS 9.BC5.161
132
IFRS 9.BC5.162
133
IFRS 9.BC5.163, BC5.164, BC5.165
134
IFRS 9.B5.5.12
135
IFRS 9.B5.5.11
60 April 2018 Impairment of financial instruments under IFRS 9
Entities that do not use probability of loss as an explicit input will have to use
other criteria to identify a change in the risk of default occurring. These might
include deterioration in a behavioural score, or other indicators, of a heightened
risk of default. A collective approach may also be an appropriate supplement or
substitute for an assessment at the individual instrument level (see section 5.5
below).
A number of operational simplifications and presumptions are available to help
entities make this assessment (as described further below).
5.1.1 Impact of collateral, credit enhancements and financial guarantee
contracts
As already stressed, the assessment is based on the change in the lifetime
risk of default, not the amount of ECLs. Hence, the allowance for a fully
collateralised asset may need to be based on lifetime ECLs (because there
has been a significant increase in the risk of default) even though no loss
is expected to arise.
136
In such instances, the fact that the asset is being
measured using lifetime ECLs may have more significance for disclosure
than for measurement (see section 14 below).
The interaction between collateral, assessment of significant increases in credit
risk and measurement of ECLs is illustrated in the following example from the
standard
.
137
Example 7: Highly collateralised financial asset
Company H owns real estate assets which are financed by a five-year loan from
Bank Z with a loan-to-value (LTV) ratio of 50 per cent. The loan is secured by a first-
ranking security over the real estate assets. At initial recognition of the loan, Bank Z
does not consider the loan to be credit-impaired as defined in Appendix A of IFRS 9.
Subsequent to initial recognition, the revenues and operating profits of Company H
have decreased because of an economic recession. Furthermore, expected increases
in regulations have the potential to further negatively affect revenue and operating
profit. These negative effects on Company H’s operations could be significant and
ongoing.
As a result of these recent events and expected adverse economic conditions,
Company H’s free cash flow is expected to be reduced to the point that the coverage
of scheduled loan payments could become tight. Bank Z estimates that a further
deterioration in cash flows may result in Company H missing a contractual payment
on the loan and becoming past due.
Recent third party appraisals have indicated a decrease in the value of the real estate
properties, resulting in a current LTV ratio of 70 per cent.
At the reporting date, the loan to Company H is not considered to have low credit risk
in accordance with paragraph 5.5.10 of IFRS 9. Bank Z therefore needs to assess
whether there has been a significant increase in credit risk since initial recognition in
accordance with paragraph 5.5.3 of IFRS 9, irrespective of the value of the collateral
it holds. It notes that the loan is subject to considerable credit risk at the reporting
date because even a slight deterioration in cash flows could result in Company H
missing a contractual payment on the loan. As a result, Bank Z determines that
the credit risk (i.e. the risk of a default occurring) has increased significantly since
initial recognition. Consequently, Bank Z recognises lifetime ECLs on the loan to
Company H.
Although lifetime ECLs should be recognised, the measurement of the ECLs will reflect
the recovery expected from the collateral (adjusting for the costs of obtaining and
selling the collateral) on the property as required by paragraph B5.5.55 of IFRS 9
and may result in the ECLs on the loan being very small.
136
IFRS 9.5.5.9
137
IFRS 9 IG Example 3 IE18-IE23
An exposure may need to
be transferred to stage 2
(because there has been
a significant increase
in the risk of a default
occuring) even though
no loss is expected to
arise due to collateral.
61 April 2018 Impairment of financial instruments under IFRS 9
The ITG (see 1.5 above) discussed, in April 2015, whether an entity should
consider the ability to recover cash flows through a financial guarantee
contract that is integral to the contract when assessing whether there
has been a significant increase in the credit risk of the guaranteed debt
instrument since initial recognition. IFRS 9 requires that measurement of
the ECLs of the guaranteed debt instrument includes cash flows from the
integral financial guarantee contract (see 4.8.1 above
).
138
However, some ITG
members commented that IFRS 9 is clear that recoveries from integral financial
guarantee contracts should be excluded from the assessment of significant
increases in credit risk of the guaranteed debt instrument.
139
This is because
the focus of the standard is about the risk of the borrower defaulting when
making such an assessment, as highlighted in the examples in B5.5.17 of
the standard. These examples clarify that information about a guarantee
(or other credit enhancement) may be relevant to assessing changes
in credit risk, but only to the extent that it affects the likelihood of the
borrower defaulting on the instrument (see section 5.2.1 below for the list of
examples).
140
Furthermore, excluding recoveries from the financial guarantee
contract, when assessing significant increases in credit risk, would be consistent
with the treatment of other forms of collateral.
While the value of collateral does not normally affect the assessment of
significant increases in credit risk, if significant changes in the value of
the collateral supporting the obligation are expected to reduce the borrower’s
economic incentive to make scheduled contractual payments, then this would
have an effect on the risk of a default occurring. The standard provides an
example where, if the value of collateral declines because house prices decline,
borrowers in some jurisdictions have a greater incentive to default on their
mortgages.
141
The other examples provided by the standard of situations where the value of
a credit enhancement could have an impact on the ability or economic incentive
of the borrower to repay relate to guarantees or financial support provided
by a shareholder, parent entity or other affiliate and to interests issued in
securitisations:
•
A significant change in the quality of the guarantee provided by
a shareholder (or an individual’s parent) if the shareholder (or parent)
has an incentive and financial ability to prevent default by capital or
cash infusion.
142
138
IFRS 9.B5.5.55
139
IFRS 9.5.5.9
140
IFRS 9.B5.5.17
141
IFRS 9.B5.5.17(j)
142
IFRS 9.B5.5.17(k)
62 April 2018 Impairment of financial instruments under IFRS 9
•
Significant changes, such as reductions, in financial support from a parent
entity or other affiliate or an actual or expected significant change in the
quality of credit enhancement, that are expected to reduce the borrower’s
ability to make scheduled contractual payments. For example, such
a situation could occur if a parent decides to no longer provide financial
support to a subsidiary, which, as a result, would face bankruptcy or
receivership. This could, in turn, result in that subsidiary prioritising
payments for its operational needs (such as payroll and crucial suppliers)
and assigning a lower priority to payments on its financial debt, resulting
in an increase in the risk of default on those liabilities. Credit quality
enhancements or support include the consideration of the financial
condition of the guarantor and/or, for interests issued in securitisations,
whether subordinated interests are expected to be capable of absorbing
ECLs (for example, on the loans underlying the security).
143
5.1.2 Contractually linked instruments (CLIs) and subordinated interests
The last example in the previous section, referring to the effect of subordinated
interests in a securitisation deserves some comment. IFRS 9 sets out rules to
determine whether an investment in a CLI such as a tranche of a securitisation,
qualifies to be measured at amortised cost or at fair value through other
comprehensive income.
144
While some CLIs may pass the contractual cash
flow characteristics test and, consequently, may be measured at amortised
cost or fair value through other comprehensive income, the contractual cash
flows of the individual tranches are normally based on a pre-defined waterfall
structure (i.e., principal and interest are first paid on the most senior tranche
and then successively paid on more junior tranches). Consequently, CLIs do not
default. Meanwhile, Appendix A of IFRS 9 defines ‘credit loss’ as ‘the difference
between all contractual cash flows that are due to an entity in accordance with
the contract and all the cash flows that the entity expects to receive, discounted
at the original effective interest rate’. Under the contract, the issuer of a CLI
only passes cash flows that it actually receives, so the contractually defined
cash flows under the waterfall structure are always equal to the cash flows
that a holder expects to receive. Accordingly, one could argue that CLIs never
give rise to a credit loss, and so would never be regarded as impaired.
How we see it
Consistent with treating these assets at amortised cost because they meet
the SPPI criterion, for the purposes of the standard, the contractual terms
of the CLI are deemed to give rise on specified dates to cash flows that
are solely payments of principal and interest on the principal amount
outstanding. Hence, we believe that for the purposes of the impairment
requirements of IFRS 9, the lender needs to consider the deemed principal
and interest payments as the contractual cash flows when calculating
ECLs, instead of the cash flows determined under the waterfall structure.
Accordingly, any failure of the instrument to pay the investor the full
amount deemed to be due must be treated as a default and an estimation
of the amount of any losses that will be incurred must be reflected in the
credit loss allowance.
143
IFRS 9.B5.5.17(l)
144
IFRS 9.4.1.2-4.1.2A, B4.1.20-B4.1.26
63 April 2018 Impairment of financial instruments under IFRS 9
It also follows that paragraph B5.5.17(l) should be interpreted as saying
that the investment should be measured based on lifetime ECLs if there are
sufficient losses expected on the instruments underlying the securitisation
such that they may not be absorbed by subordinated interests in the
structure, and so there is a significantly increased risk that the investor
will suffer loss.
5.1.3 Determining change in the risk of a default under the loss rate
approach
Under the loss rate approach, introduced at 4.4.2 above, an entity develops
loss-rate statistics on the basis of the amount written off over the life of the
financial assets rather than using separate PD and LGD statistics. Entities
then must adjust these historical credit loss trends for current conditions
and expectations about the future.
The standard is clear that although a loss rate approach may be applied,
an entity needs to be able to separate the changes in the risk of a default
occurring from changes in other drivers of ECLs for the purpose of assessing
if there has been a significant increase in credit risk.
145
Under the loss rate
approach, the entity does not distinguish between a risk of a default occurring
and the loss incurred following a default. This is not so much of an issue for
measuring 12-month or lifetime ECLs. However, under the loss rate approach,
an entity would not be able to implement the assessment of significant
increases in credit risk that is based on the change in the risk of a default.
Therefore, entities using the loss rate approach would need an overlay of
measuring and forecasting the level of defaults, as illustrated in the extract
of Example 9 from the Implementation Guidance (see Example 4 above). For
entities that currently use only expected loss rates, it may be easier to develop
a PD approach than to use the method described in this example.
5.2 Factors or indicators of changes in credit risk
Similar to measuring ECLs (see 4 above), when assessing significant increases
in credit risk, an entity should consider all reasonable and supportable
information that is available without undue cost or effort (see 4.9.1 above)
and that is relevant for an individual financial instrument, a portfolio, portions
of a portfolio, and groups of portfolios.
146
The IASB notes that it did not intend to prescribe a specific or mechanistic
approach to assess changes in credit risk and that the appropriate approach
will vary for different levels of sophistication of entities, the financial instrument
and the availability of data.
147
It is important to stress that the assessment of
significant increases in credit risk often involves a multifactor and holistic
analysis. The importance and relevance of each specific factor will depend
on the type of product, characteristics of the financial instruments and
the borrower as well as the geographical region.
148
The guidance in
the standard is clear that, in certain circumstances, qualitative and non-
statistical quantitative information may be sufficient to determine that
a financial instrument has met the criterion for the recognition of lifetime
ECLs. That is, the information does not need to flow through a statistical
model or credit ratings process in order to determine whether there has
been a significant increase in the credit risk of the financial instrument. In
145
IFRS 9.B5.5.12
146
IFRS 9.B5.5.15, B5.5.16
147
IFRS 9.BC5.157
148
IFRS 9.B5.5.16
The IASB did not intend
to prescribe a specific or
mechanistic approach to
assess changes in credit
risk and the appropriate
approach will vary for
different levels of
sophistication of entities,
the financial instrument
and the availability of
data.
64 April 2018 Impairment of financial instruments under IFRS 9
other cases, the assessment may be based on quantitative information or
a mixture of quantitative and qualitative information.
149
5.2.1 Examples of factors or indicators of changes in credit risk
The standard provides a non-exhaustive list of factors or indicators which
an entity should consider when determining whether the recognition of
lifetime ECLs is required. This list of factors or indicators is, as follows:
150
•
Significant changes in internal price indicators of credit risk as a result
of a change in credit risk since inception, including, but not limited to,
the credit spread that would result if a particular financial instrument,
or similar financial instrument with the same terms and the same
counterparty were newly originated or issued at the reporting date.
•
Other changes in the rates or terms of an existing financial instrument that
would be significantly different if the instrument was newly originated or
issued at the reporting date (such as more stringent covenants, increased
amounts of collateral or guarantees, or higher income coverage) because
of changes in the credit risk of the financial instrument since initial
recognition.
•
Significant changes in external market indicators of credit risk for
a particular financial instrument or similar financial instruments with
the same expected life. Changes in market indicators of credit risk include,
but are not limited to: the credit spread; the credit default swap prices
for the borrower; the length of time or the extent to which the fair value
of a financial asset has been less than its amortised cost; and other market
information related to the borrower (such as changes in the price of
a borrower’s debt and equity instruments). The IASB noted that market
prices are an important source of information that should be considered
in assessing whether credit risk has changed, although market prices
themselves cannot solely determine whether significant deterioration
has occurred because market prices are also affected by non-credit
risk related factors such as changes in interest rates or liquidity risks.
151
•
An actual or expected significant change in the financial instrument’s
external credit rating.
•
An actual or expected internal credit rating downgrade for the borrower
or decrease in behavioural scoring used to assess credit risk internally.
Internal credit ratings and internal behavioural scoring are more reliable
when they are mapped to external ratings or supported by default studies.
•
Existing or forecast adverse changes in business, financial or economic
conditions that are expected to cause a significant change in the borrower’s
ability to meet its debt obligations, such as an actual or expected increase
in interest rates or an actual or expected significant increase in
unemployment rates.
•
An actual or expected significant change in the operating results of
the borrower. Examples include actual or expected declining revenues or
margins, increasing operating risks, working capital deficiencies, decreasing
asset quality, increased balance sheet leverage, liquidity, management
problems or changes in the scope of business or organisational structure
(such as the discontinuance of a segment of the business) that result in
a significant change in the borrower’s ability to meet its debt obligations.
149
IFRS 9.B5.5.18
150
IFRS 9.B5.5.17
151
IFRS 9.BC5.123
65 April 2018 Impairment of financial instruments under IFRS 9
•
Significant increases in credit risk on other financial instruments of
the same borrower.
•
An actual or expected significant adverse change in the regulatory,
economic, or technological environment of the borrower that results in
a significant change in the borrower’s ability to meet its debt obligations,
such as a decline in the demand for the borrower’s sales product because
of a shift in technology.
•
Significant changes in the value of the collateral supporting the obligation
or in the quality of third-party guarantees or credit enhancements,
which are expected to reduce the borrower’s economic incentive to
make scheduled contractual payments or to otherwise have an effect
on the risk of a default occurring. For example, if the value of collateral
declines because house prices decline, borrowers in some jurisdictions
have a greater incentive to default on their mortgages.
•
A significant change in the quality of the guarantee provided by a
shareholder (or an individual’s parents) if the shareholder (or parents)
have an incentive and financial ability to prevent default by capital or
cash infusion.
•
Significant changes, such as reductions, in financial support from a parent
entity or other affiliate or an actual or expected significant change in the
quality of credit enhancement, that are expected to reduce the borrower’s
economic incentive to make scheduled contractual payments. For example,
such a situation could occur if a parent decides to no longer provide
financial support to a subsidiary, which as a result would face bankruptcy
or receivership. This could in turn result in that subsidiary prioritising
payments for its operational needs (such as payroll and crucial suppliers)
and assigning a lower priority to payments on its financial debt, resulting
in an increase in the risk of default on those liabilities. Credit quality
enhancements or support include the consideration of the financial
condition of the guarantor and/or, for interests issued in securitisations,
whether subordinated interests are expected to be capable of absorbing
ECLs (for example, on the loans underlying the security).
•
Expected changes in the loan documentation (i.e. changes in contract
terms) including an expected breach of contract that may lead to covenant
waivers or amendments, interest payment holidays, interest rate step-ups,
requiring additional collateral or guarantees, or other changes to the
contractual framework of the instrument.
•
Significant changes in the expected performance and behaviour of
the borrower, including changes in the payment status of borrowers
in the group (for example, an increase in the expected number or extent
of delayed contractual payments or significant increases in the expected
number of credit card borrowers who are expected to approach or exceed
their credit limit or who are expected to be paying the minimum monthly
amount).
•
Changes in the entity’s credit management approach in relation to the
financial instrument, i.e. based on emerging indicators of changes in the
credit risk of the financial instrument, the entity’s credit risk management
practice is expected to become more active or to be focused on managing
the instrument, including the instrument becoming more closely monitored
or controlled, or the entity specifically intervening with the borrower.
•
Past due information, including the more than 30 days past due rebuttable
presumption (see section 5.2.2 below).
Banks are encouraged
to use the list of factors
or indicators contained
in the guidance to the
standard to calibrate
their criteria for their
staging analysis.
66 April 2018 Impairment of financial instruments under IFRS 9
This list raises the question as to whether an entity will be required to look
at each of these factors or indicators as soon as the information is readily
available, even though they may not be fully integrated in the entity’s credit
risk management systems and processes. This relates to our earlier discussion
about which information is available without undue cost or effort (see
section 4.9.1 above) and the Basel guidance (discussed at 6.1 below).
How we see it
• Many financial institutions should have readily available information
about the pricing and terms of various types of loans issued to a specific
customer (e.g. overdraft, credit cards and mortgage loans) in their credit
risk management systems and processes. However, in practice, it would
often be difficult to use such information because changes in pricing and
terms on the origination of a similar financial instrument at the reporting
date may not be so obviously related to a change in credit risk as other,
more commercial, factors come into play (e.g., different risk appetites,
change in management approach and underwriting standards). It may
be challenging to link the two sets of information (i.e., pricing processes
on the one hand and credit risk management on the other).
• Some collateralised loans are subject to cash variation margining
requirements, which means that the trigger for default is normally
the inability to pay a margin call. Therefore, in such circumstances
the PD may be driven by the value of the collateral and changes in
collateral values may need to be reflected in the staging assessment.
• Some of the factors or indicators are only relevant for the assessment
of significant deterioration on an individual basis and not on a portfolio
basis. For example, change in external market indicators of credit
risk, including the credit spread, the credit default swap prices of the
borrower and the extent of decline in fair value. However, it is worth
noting that external market information that is available for a quoted
instrument may be useful to help assess another instrument that is not
quoted but which is issued by the same debtor or one who operates in
the same sector.
• It is important to stress that the approach required by the standard is
more holistic and qualitative than is necessarily captured by external
credit ratings, which are adjusted for discrete events and may not reflect
gradual degradations in credit quality. External credit ratings should
not, therefore, be used on their own, but only in conjunction with other
qualitative information. Furthermore, although ratings are forward-
looking, it is sometimes suggested that changes in credit ratings may
not be reflected in a timely matter. Therefore, entities may have to take
account of expected change in ratings in assessing whether exposures
are low risk (See example 12 below) illustrates that there could be
significant differences between using agencies’ credit ratings or using
market data such as CDS spreads). The same point can, of course, be
made about the use of internal credit ratings, especially if they are
only reassessed on an annual basis.
At the September 2015 meeting, the ITG observed that credit grading systems
were not designed with the requirements of IFRS 9 in mind, and thus it should
not be assumed that they will always be an appropriate means of identifying
significant increases in credit risk. The appropriateness of using internal credit
grading systems as a means of assessing changes in credit risk since initial
recognition depends on whether the credit grades are reviewed with sufficient
67 April 2018 Impairment of financial instruments under IFRS 9
frequency, include all reasonable and supportable information and reflect
the risk of default over the expected life of the financial instrument. As credit
grading systems vary, care needs to be taken when referring to movements
in credit grades and how this reflects an increased risk of default occurring. In
addition, the assessment of whether a change in credit risk grade represents
a significant increase in credit risk in accordance with IFRS 9 depends on
the initial credit risk of the financial instrument being assessed. Because the
relationship between credit grades and changes in the risk of default occurring
differs between credit grading systems (e.g., in some cases the changes in the
risk of a default occurring may increase exponentially between grades, whereas
in others, it may not), this requires particular consideration. Also, some of the
factors or indicators are very forward-looking, such as forecasts of adverse
changes in business, financial or economic conditions that are expected to
result in significant future financial difficulty of the borrower in repaying
its debt. In practice, the analysis may have to be performed at the level of a
portfolio rather than at an individual level when forward-looking information
is not available at the individual level.
How we see it
Whilst IFRS 9 is not prescriptive, we observe differences in how banks intend
to implement the assessment of significant increase in credit risk. These
differences reflect various schools of thought along with differences in
credit processes, business model, sophistication, use of advanced models
for regulatory capital purposes, availability of data (e.g., historic data at
origination) and consistency of definitions across businesses or multiple
systems. As use of models and availability of data can vary within a bank,
it is probable that a number of approaches will be adopted within a single
institution.
In general, banks are considering the use of a combination of quantitative
and qualitative drivers to assess significant increases in credit risk. Some of
these are regarded as primary, others as secondary and some as backstops.
The primary driver is usually expected to be the most forward looking
indicator and is generally based on a relative measure. The most common
primary drivers being considered by the larger banks are.
• Changes in the lifetime risk of a default occurring, guided by scores
and ratings
• Changes in the lifetime or 12-month probability of default
Or
• Changes in ratings or credit scores for retail exposures and ratings for
corporate exposures
Forbearance and watch lists are likely to be used as secondary drivers and
delinquency, usually 30 days past due, as a backstop (see section 5.2.2
below).
5.2.2 Past due status and more than 30 days past due rebuttable
presumption
The IASB is concerned that past due information is a lagging indicator.
Typically, credit risk increases significantly before a financial instrument
becomes past due or other lagging borrower-specific factors (for example,
a modification or restructuring) are observed. Consequently, when reasonable
and supportable information that is more forward-looking than past due
68 April 2018 Impairment of financial instruments under IFRS 9
information is available without undue cost or effort, it must be used to
assess changes in credit risk and an entity cannot rely solely on past due
information.
152
However, the IASB acknowledged that many entities manage
credit risk on the basis of information about past due status and have a limited
ability to assess credit risk on an instrument-by-instrument basis in more detail
on a timely basis.
153
Therefore, if more forward-looking information (either on
an individual or collective basis) is not available without undue cost or effort,
an entity may use past due information to assess changes in credit risks.
154
Whether the entity uses only past due information or also more forward looking
information (e.g., macroeconomic indicators), 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.
However, the standard seems to make it clear that it is not possible to rebut
the 30 days past due presumption just because of a favourable economic
outlook.
155
The IASB decided that this rebuttable presumption was required
to ensure that application of the assessment of the increase in credit risk does
not result in a reversion to an incurred loss notion.
156
Moreover, as already stressed earlier, the standard is clear that an entity
cannot align the definition and criteria used to identify significant increases in
credit risk (and the resulting recognition of lifetime ECLs) to when a financial
asset is regarded as credit-impaired or to an entity’s internal definition of
default.
157
An entity should normally identify significant increases in credit
risk and recognise lifetime ECLs before default occurs or the financial asset
becomes credit-impaired, either on an individual or collective basis (see section
5.5 below).
An entity can rebut the 30 days past due presumption if it has reasonable and
supportable information that is available without undue cost or effort, that
demonstrates that credit risk has not increased significantly even though
contractual payments are more than 30 days past due.
158
Such evidence
may include, for example, knowledge that a missed non-payment is because
of administrative oversight rather than financial difficulty of the borrower, or
historical information that suggests significant increases in credit risks only
occur when payments are more than 60 days past due.
159
5.2.3 Illustrative examples of assessing significant increases in credit risk
The consideration of various factors or indicators when assessing significant
increases in credit risk since initial recognition is illustrated in Examples 8 and 9,
which are based on Examples 1 and 2 in the Implementation Guidance for the
standard.
160
Example 8: Significant increase in credit risk
Company Y has a funding structure that includes a senior secured loan facility with
different tranches. The security on the loan affects the loss that would be realised
if a default occurs, but does not affect the risk of a default occurring, so it is not
considered when determining whether there has been a significant increase in credit
risk since initial recognition as required by paragraph 5.5.3 of IFRS 9. Bank X provides
a tranche of that loan facility to Company Y. At the time of origination of the loan
152
IFRS 9.5.5.11, B5.5.2
153
IFRS 9.BC5.192
154
IFRS 9.5.5.11
155
IFRS 9.5.5.11, B5.5.19
156
IFRS 9.BC5.190
157
IFRS 9.B5.5.21
158
IFRS 9.5.5.11
159
IFRS 9.B5.5.20
160
IFRS 9 IG Example 1 IE7-IE17, IG Example 2 IE7-IE17
69 April 2018 Impairment of financial instruments under IFRS 9
Example 8: Significant increase in credit risk (cont’d)
by Bank X, although Company Y’s leverage was relatively high compared with other
issuers with similar credit risk, it was expected that Company Y would be able to meet
the covenants for the life of the instrument. In addition, the generation of revenue
and cash flow was expected to be stable in Company Y’s industry over the term of
the senior facility. However, there was some business risk related to the ability to
grow gross margins within its existing businesses.
At initial recognition, because of the considerations outlined above, Bank X considers
that, despite the level of credit risk at initial recognition, the loan is not an originated
credit-impaired loan because it does not meet the definition of a credit-impaired
financial asset in Appendix A of IFRS 9.
Subsequent to initial recognition, macroeconomic changes have had a negative effect
on total sales volume and Company Y has underperformed on its business plan for
revenue generation and net cash flow generation. Although spending on inventory
has increased, anticipated sales have not materialised. To increase liquidity,
Company Y has drawn down more on a separate revolving credit facility, thereby
increasing its leverage ratio. Consequently, Company Y is now close to breaching
its covenants on the senior secured loan facility with Bank X.
Bank X makes an overall assessment of the credit risk on the loan to Company Y
at the reporting date, by taking into consideration all reasonable and supportable
information that is available without undue cost or effort and that is relevant for
assessing the extent of the increase in credit risk since initial recognition. This
may include factors such as:
(a) Bank X’s expectation that the deterioration in the macroeconomic
environment may continue in the near future, which is expected to have
a further negative impact on Company Y’s ability to generate cash flows
and to de-leverage.
(b) Company Y is closer to breaching its covenants, which may result in a need
to restructure the loan or reset the covenants.
(c) Bank X’s assessment that the trading prices for Company Y’s bonds have
decreased and that the credit margins on newly originated loans have
increased reflecting the increase in credit risk, and that these changes
are not explained by changes in the market environment (for example,
benchmark interest rates have remained unchanged). A further comparison
with the pricing of Company Y’s peers shows that reductions in the price of
Company Y’s bonds and increases in credit margin on its loans have probably
been caused by company-specific factors.
(d) Bank X has reassessed its internal risk grading of the loan on the basis of
the information that it has available to reflect the increase in credit risk.
Bank X determines that there has been a significant increase in credit risk since initial
recognition of the loan in accordance with paragraph 5.5.3 of IFRS 9. Consequently,
Bank X recognises lifetime ECLs on its senior secured loan to Company Y. Even if
Bank X has not yet changed the internal risk grading of the loan, it could still reach
this conclusion – the absence or presence of a change in risk grading in itself is not
determinative of whether credit risk has increased significantly since initial
recognition.
70 April 2018 Impairment of financial instruments under IFRS 9
Example 9: No significant increase in credit risk
Company C is the holding company of a group that operates in a cyclical production
industry. Bank B provided a loan to Company C. At that time, the prospects for
the industry were positive, because of expectations of further increases in global
demand. However, input prices were volatile and given the point in the cycle,
a potential decrease in sales was anticipated.
In addition, in the past, Company C has focused on external growth, acquiring
majority stakes in other companies in related sectors. As a result, the group structure
is complex and has been subject to change, making it difficult for investors to analyse
the expected performance of the group and to forecast the cash that will be available
at the holding company level. Even though leverage is at a level that is considered
acceptable by Company C’s creditors at the time that Bank B originates the loan,
its creditors are concerned about Company C’s ability to refinance its debt because
of the short remaining life until the maturity of the current financing. There is also
concern about Company C’s ability to continue to service interest using the dividends
it receives from its operating subsidiaries.
At the time of the origination of the loan by Bank B, Company C’s leverage
was in line with that of other customers with similar credit risk and based on
projections over the expected life of the loan, the available capacity (i.e.,
headroom) on its coverage ratios before triggering a default event, was high.
Bank B applies its own internal rating methods to determine credit risk and
allocates a specific internal rating score to its loans. Bank B’s internal rating
categories are based on historical, current and forward-looking information
and reflect the credit risk for the tenor of the loans. On initial recognition, Bank B
determines that the loan is subject to considerable credit risk, has speculative
elements and that the uncertainties affecting Company C, including the group’s
uncertain prospects for cash generation, could lead to default. However, Bank B
does not consider the loan to be originated credit-impaired.
Subsequent to initial recognition, Company C has announced that three of its
five key subsidiaries had a significant reduction in sales volume because of
deteriorated market conditions, but sales volumes are expected to improve
in line with the anticipated cycle for the industry in the following months.
The sales of the other two subsidiaries were stable. Company C has also
announced a corporate restructure to streamline its operating subsidiaries.
This restructuring will increase the flexibility to refinance existing debt and
the ability of the operating subsidiaries to pay dividends to Company C.
Despite the expected continuing deterioration in market conditions, Bank B
determines, in accordance with paragraph 5.5.3 of IFRS 9, that there has not
been a significant increase in the credit risk on the loan to Company C since
initial recognition. This is demonstrated by factors that include:
(a)
Although current sale volumes have fallen, this was as anticipated by
Bank B at initial recognition. Furthermore, sales volumes are expected
to improve, in the following months.
(b) Given the increased flexibility to refinance the existing debt at the operating
subsidiary level and the increased availability of dividends to Company C,
Bank B views the corporate restructure as being credit enhancing. This is
despite some continued concern about the ability to refinance the existing
debt at the holding company level.
(c) Bank B’s credit risk department, which monitors Company C, has
determined that the latest developments are not significant enough
to justify a change in its internal credit risk rating.
As a consequence, Bank B does not recognise a loss allowance at an amount equal
to lifetime ECLs on the loan. However, it updates its measurement of the 12-month
ECLs for the increased risk of a default occurring in the next 12 months and for
current expectations of the credit losses that would arise
if a default were to occur.
71 April 2018 Impairment of financial instruments under IFRS 9
A numerical illustration of how a significant increase in credit risk might be
assessed is shown in Example 10:
Example 10: Assessment of a significant increase in credit risk
based on a PD approach
This example is based on the same loan presented in Example 3 above.
On 31 December 2015, Bank A originates a 10-year loan with a gross carrying
amount of $1,000,000, interest being due at the end of each year. Based on
statistical and qualitative information – including forward looking, Bank A has
assigned a BBB rating for the loan.
Based on this rating, Bank A has computed a PD term structure at origination.
Bank A’s PD term structure is estimated with the annual PD expected for each future
period. The lifetime PD is the product of each marginal PD during the considered
period:
lifetime PD
k
= 1 (1 marginal PD
i
)
n
k=i
Finally, based on the marginal PD computed for each future period, Bank A is able to
compute the forward lifetime PD, as follows:
Year
Cumulative PD
at origination
Marginal 12-
month PD
Remaining
lifetime PD
Remaining
annualised
lifetime PD
2016
2017
0.17%
0.17%
4.50%
0.46%
2018
0.49%
0.32%
4.34%
0.49%
2019
0.86%
0.37%
4.03%
0.51%
2020
1.38%
0.53%
3.67%
0.53%
2021
1.84%
0.47%
3.16%
0.53%
2022
2.37%
0.54%
2.71%
0.55%
2023
2.85%
0.49%
2.18%
0.55%
2024
3.30%
0.46%
1.70%
0.57%
2025
3.84%
0.56%
1.24%
0.62%
2026
4.50%
0.69%
0.69%
0.69%
For the first year, the remaining lifetime PD is the cumulative PD at origination. Then,
after a year, it starts decreasing, considering that the remaining period is shorter.
After 2 years it is 4.03% and after 3 years it is only 3.67%. At the end of the loan,
the remaining lifetime PD ends up at 0%.
In common with many institutions, Bank A chooses to compare an annualised lifetime
PD instead of a cumulative PD. This has the advantage that business lines and risk
analysts can easily map an annualised PD onto a rating scale. It also enables an
absolute change in annualised lifetime PD, e.g. 20bp, to be set as a ‘filter’ to exclude
small changes in lifetime PD from being assessed as significant that are considered
to be ‘noise’. For this purpose, Bank A calculates an annualised PD, using the residual
cumulative curve. The annualised lifetime PD is calculated, as follows:
when t = horizon of the lifetime PD expressed in years
2018: no significant increase in credit risk: Stage 1
On 31 December 2018 – 2 years after origination, Bank A updates the rating of its
obligor. The rating is now BB+.
72 April 2018 Impairment of financial instruments under IFRS 9
Example 10: Assessment of a significant increase in credit risk
based on a PD approach (cont’d)
A new PD term structure is estimated based on this information:
Year
Cumulative lifetime PD
2019
0.67%
2020
1.53%
2021
3.70%
2022
5.58%
2023
5.89%
2024
6.51%
2025
7.45%
2026
8.70%
Remaining annualised lifetime PD
1.13%
Forecast at origination
0.51%
Increase (multiple)
2.20
In this example, Bank A uses a significant increase in credit risk threshold of a 2.5
multiple of PD. For simplicity we ignore any qualitative or other indicators that a bank
might use to make this assessment.
Comparing the remaining annualised PD estimated at origination (0.51%) with the
remaining annualised PD at the reporting date (1.13%), the increase is still only ×2.2.
We note that, had Bank A used a cumulative lifetime PD approach, it would compare
8.70% to 4.03%, which would also be a multiple of 2.2. The significant deterioration
threshold set by Bank A is not met and therefore the loan remains in stage 1.
2019: significant increase in credit risk: stage 2
On 31 December 2019 – 3 years after origination, Bank A updates the rating of its
obligor. Its rating is now BB–. Then Bank A updates its historical information for
current economic conditions as well as reasonable and supportable forecasts of
future economic conditions.
Year
Cumulative lifetime PD
2020
1.40%
2021
3.87%
2022
8.82%
2023
12.84%
2024
16.04%
2025
18.98%
2026
21.60%
Remaining annualised lifetime PD
3.42%
Forecast at origination
0.53%
Increase (multiple)
6.41
As before, Bank A compares the remaining annualised PD estimated at origination
(0.53%) with the remaining annualised PD at the reporting date (3.42%), an increase
of 6.45 times the original PD. Had Bank A used a cumulative lifetime PD approach, the
comparison would be of 21.6% to 3.67%, a 6.41-fold increase. This time, the threshold
of significant deterioration is met and the loan is moved to stage 2.
73 April 2018 Impairment of financial instruments under IFRS 9
5.2.4 Use of behavioural factors
At its meeting on 16 September 2015, the ITG (see 1.5 above) discussed
whether the following behavioural indicators of credit risk could be used, on
their own, as a proxy to determine if there has been a significant increase in
credit risk:
•
Where a customer has made only the minimum monthly repayment for
a specified number of months
•
Where a customer has failed to make a payment on a loan with a different
lender
Or
•
Where a customer has failed to make a specified number of minimum
monthly repayments
The ITG members noted that:
•
When assessing whether there has been a significant increase in credit risk,
entities are required to consider a range of indicators rather than focusing
on only one. Furthermore, while behavioural indicators have a role to play,
the above behavioural indicators are often lagging indicators of increases
in credit risk. Consequently, they should be considered in conjunction with
other, more forward-looking information. In this regard, an entity must
consider how to source and incorporate forward-looking information into
the assessment of significant increases in credit risk and may need to do
this on a collective basis if forward-looking information is not available at
an individual financial instrument level.
•
When considering the use of behavioural indicators, an entity should:
(a)
Focus on identifying pre-delinquency behavioural indicators of
increases in credit risk, e.g., increased utilisation rates or increased
cash drawings on specific products
(b)
Only use indicators that are relevant to the risk of default occurring
(c)
Establish a link between the behavioural indicators of credit risk
and changes in the risk of default occurring since initial recognition.
(d)
Be mindful that while behavioural indicators are often predictive of
defaults in the short term, they are often less predictive of defaults
in the longer term, and, hence, might be lagging. Consequently
they may not, on their own, signal significant increases in credit
risk in a timely manner.
(e)
Consider whether the use of behavioural indicators is appropriate
for the type of product being assessed, e.g., if a loan has only back-
ended payments, behavioural indicators based on timeliness of
payment will not be appropriate.
•
An entity is required to consider all information available without undue
cost and effort and it should not be limited by the information that is
available internally. For example, an entity should consider using third-
party information from sources such as credit bureaus. However,
information that is available to entities will vary across jurisdictions.
•
When making the assessment of significant increases in credit risk,
an entity should consider the possibility of segmenting the portfolio
into groups of financial instruments with shared credit characteristics in
such a way that similar indicators of credit risk could be used to identify
increases in credit risk for specific sub-portfolios.
•
It would not be appropriate to use the above behavioural indicators
for the purposes of identifying low credit risk assets in accordance with
paragraph 5.5.10 of IFRS 9 (see section 5.2.4. below), on the basis that
such measures would not constitute a globally accepted definition of low
credit risk as required by IFRS 9.
Behavioural information
tends to be lagging
data and should be
supplemented by more
forward-looking
information.
74 April 2018 Impairment of financial instruments under IFRS 9
Other behavioural indicators, beyond those mentioned above, including items
such as the level of cash advances, changes in expected payment patterns
(e.g., moving from full payment to something less than full payment), and
higher-than-expected utilisation of the facility, were raised at the meeting.
Individually, these kinds of behaviours may not be determinative of a significant
increase in credit risk but, when observed together, they may prove to be more
indicative. By combining these indicators, an entity has the potential to transfer
assets between stage 1 and stage 2 more meaningfully.
We also note that that one of the challenges with using behavioural information
is that it depends on the starting point. That is, if the obligor’s risk of default
initially is consistent with a super-prime rating, the kind of deteriorating
behaviour noted above would likely signal a significant shift. However, if
the obligor originally had a sub-prime rating, then such behaviour might
not indicate a significant increase in risk.
As noted by the ITG, while indicators that are more lagging may show
a greater correlation with subsequent default, they are also likely to be
less forward-looking. Although a probability of default approach may seem
more sophisticated and forward looking, it is still generally fed by behavioural
information, even if it is combined, segmented and modelled in a more
sophisticated way. If the only borrower-specific information is his behaviour,
a forward looking portfolio overlay will generally be required, whether a PD
or a behavioural approach is used.
5.3 What is significant?
The assessment of whether credit risk has significantly increased depends,
critically, on an interpretation of the word ‘significant’. Some constituents
who commented on the 2013 Exposure Draft requested the IASB to quantify
the term ‘significant’, however, the IASB decided not to do so, for the following
reasons:
161
•
Specifying a fixed percentage change in the risk of default would require
all entities to use the risk of default approach. As not all entities (apart
from regulated financial institutions) use PDs as an explicit input, this would
have increased the costs and effort for those entities that do not use such
an approach
•
Defining the amount of change in the risk of a default occurring would be
arbitrary and this would depend on the type of products, maturities and
initial credit risk
The standard emphasises that the determination of the significance of the
change in the risk of a default occurring depends on:
•
The original credit risk at initial recognition: the same absolute change
in PD for a financial instrument with a lower initial credit risk will be
more significant than those with a higher initial credit risk (see 5.4.5
and Example 14).
162
•
The expected life or term structure: the risk of a default occurring for
financial instruments with similar credit risk increases the longer the
expected life of the financial instruments. Due to the relationship between
the expected life and the risk of a default occurring, an entity cannot simply
compare the absolute risk of a default occurring over time. For example, if
the risk of a default occurring for a financial instrument with an expected
life of 10 years at initial recognition is the same after five years, then this
indicates that the credit risk has increased. The standard also states that,
for financial instruments that have significant payment obligations close to
the maturity of the financial instrument (e.g., those where the principal is
only repaid at maturity), the risk of a default occurring may not necessarily
decrease as time passes. In such cases, an entity needs to consider
161
IFRS 9.BC5.171, BC5.172
162
IFRS 9.B5.5.9
The assessment of
whether credit risk has
significantly increased
depends, critically, on
an interpretation of
the word ‘significant’.
75 April 2018 Impairment of financial instruments under IFRS 9
other qualitative factors. We note, however, that while the risk of default
may decrease less quickly for an instrument with payment obligations
throughout its contractual life, normally, the risk of default will still
decrease as maturity approaches.
163
Some of these challenges are illustrated by examining the historical levels
of default associated with the credit ratings of agencies, such as Standard &
Poor’s:
•
It is apparent that the PDs increase at a geometrical, rather than an
arithmetic, rate as the credit ratings decline. Hence, the absolute increase
in the PD between two relatively low risk credit ratings is considerably less
than between two relatively higher risk ratings.
•
The relative increase in PD between each of these ratings might be
considered significant, since most involve a doubling or trebling of the PD.
In contrast, because credit rating is an art rather than a science, the smaller
changes in credit risk associated with the plus or minus notches in the
grading system are less likely to be viewed as significant.
•
In addition, as the time horizon increases, the PDs also increase across
all credit ratings (i.e., the PD increases with a longer maturity).
The majority of credit exposures that are assessed for significant credit
deterioration will not have been rated by a credit rating agency. However,
the same logic will apply when entities have developed their own PD models
and are able to classify their exposure by PD levels.
The determination of what is significant will, for the larger banks, be influenced
by the guidance issued by banking regulators (see 6.1 below).
How we see it
Given the exponential shape of the PD curve relative to ratings, some
banks consider that a bigger downgrade, as measured by the number
of grades, would be significant for a higher quality loan than for
one with a lower quality. The extent to which this is appropriate will
depend on how the different grades map to PDs. Also, the calibration
of a significant deterioration has to take into account the fact that PD
multiples for very good ratings only represent very small movements
in absolute risk, whereas the same multiple applied to bad ratings can
represent a significant change in the absolute amount of PD.
Banks have varying views on how much of an increase in PD is significant.
Some are thinking that a doubling of PD would be significant, but adding
a minimum absolute PD increase, such as 50 basis point per year, so as
to avoid very high quality assets moving to stage 2 as a result of a very
small change and to filter out ‘noise’.
Banks are also exploring various metrics to assess the effect of
different approaches to assess significant increase in credit risk and
for management information. Examples include the volume of stage 2
assets compared to the total portfolio and compared to 12-months of
lifetime expected losses, the volume of movement (back and forth)
between stages 1 and 2, the amount of assets that jump directly from
stage 1 to stage 3, the proportion of assets in stage 3 which went via
stage 2, and how long assets were in stage 2 before moving to stage 3.
163
IFRS 9.B5.5.10, B5.5.11
76 April 2018 Impairment of financial instruments under IFRS 9
5.4 Operational simplifications
When assessing significant increases in credit risk, there are a number of
operational simplifications available. These are discussed below.
5.4.1 Low credit risk operational simplification
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.
164
.
This is a change from the 2013 Exposure Draft, in which a low risk exposure
was deemed not to have suffered significant deterioration in credit risk.
165
The amendment to make the simplification optional was made in response
to requests from constituents, including regulators. The Basel Committee
guidance (see section 6.1 below) considers the use of the low credit risk
simplification a low-quality implementation of the ECL model and that the
use of this exemption should be limited, except for holdings in securities.
For low risk instruments for which the simplification is used, the entity
would recognise an allowance based on 12-month ECLs.
166
However, if
a financial instrument is not, or no longer, considered to have low credit
risk at the reporting date, it does not follow that the entity is required to
recognise lifetime ECLs. In such instances, the entity has to assess whether
there has been a significant increase in credit risk since initial recognition
which requires the recognition of lifetime ECLs.
167
The standard states that a financial instrument is considered to have low credit
risk if:
168
•
The financial instrument has 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 fulfil its
contractual cash flow obligations
164
IFRS 9.BC5.184
165
IFRS 9.BC5.181, BC5.182, BC5.183
166
IFRS 9.5.5.10
167
IFRS 9.5.5.24
168
IFRS 9.5.5.22
77 April 2018 Impairment of financial instruments under IFRS 9
A financial instrument is not considered to have low credit risk simply because it
has a low risk of loss (e.g., for a collateralised loan, if the value of the collateral
is more than the amount lent (see 4.8.11 above)) or it has lower risk of default
compared to the entity’s other financial instruments or relative to the credit
risk of the jurisdiction within which the entity operates.
169
The description of low credit risk is equivalent to investment grade quality
assets, equivalent to Standard and Poor’s rating of BBB– or better, Moody’s
rating of Baa3 or better and Fitch’s rating of BBB– or better. When applying
the low credit risk simplification, financial instruments are not required to
be externally rated. However, the IASB’s intention was to use a globally
comparable notion of low credit risk instead of a level of risk determined,
for example, by an entity or jurisdiction’s view of risk based on entity-specific
or jurisdictional factors.
170
Therefore, an entity may use its internal credit
ratings to assess low credit risk as long as this is consistent with the globally
understood definition of low credit risk (i.e. investment grade) or the market’s
expectations of what is deemed to be low credit risk, taking into consideration
the terms and conditions of the financial instruments being assessed.
171
The Basel Committee guidance (see 6.1 below) states that the investment
grade category used by ratings agencies is not considered sufficiently
homogeneous to be automatically considered low credit risk, and internationally
active and sophisticated banks are expected to rely primarily on their own credit
assessments.
In practice, entities with internal credit ratings will attempt to map their internal
rating to the external credit ratings and definitions, such as Standard & Poor’s,
Moody’s and Fitch. The description of the credit quality ratings by these major
rating agencies are illustrated below.
172
Figure 5: External credit ratings and definitions from the 3 major
rating agencies
Standard & Poor’s
Moody’s
Fitch
Investment grade would
usually refer to
categories AAA to BBB
(with BBB– being lowest
investment grade
considered by market
participants).
Investment grade would
usually refer to categories
Aaa to Baa (with Baa3 being
lowest investment grade
considered by market
participants).
Investment grade would usually
refer to categories AAA to BBB
(with BBB– being lowest
investment grade considered
by market participants).
BBB
Baa
BBB: Good credit quality
Adequate capacity to
meet financial
commitments, but more
subject to adverse
economic conditions.
Obligations rated Baa are
judged to be medium-grade
and subject to moderate
credit risk and as such may
possess certain speculative
characteristics.
Indicates that expectations of
default risk are currently low.
The capacity for payment of
financial commitments is
considered adequate but adverse
business or economic conditions
are more likely to impair this
capacity.
169
IFRS 9.B5.5.22
170
IFRS 9.BC5.188
171
IFRS 9.B5.5.23
172
IASB Agenda paper 5B, Financial Instruments: Impairment, Operational simplifications – 30dpd
and low credit risk, 28 October – 1 November 2013.
78 April 2018 Impairment of financial instruments under IFRS 9
Figure 5: External credit ratings and definitions from the 3 major
rating agencies (cont’d)
The dividing line between investment grade and speculative grade
BB
Ba
BB: Speculative
Less vulnerable in the
near-term, but faces
major on-going
uncertainties due to
adverse business,
financial and economic
conditions.
Obligations rated Ba are
judged to be speculative and
are subject to substantial
credit risk.
Indicates an elevated
vulnerability to default risk,
particularly in the event of
adverse changes in business or
economic conditions over time.
However, business or financial
flexibility exists which supports
the servicing of financial
commitments.
Examining the historical levels of default associated with the credit ratings
of agencies such as Standard & Poor’s, the PD of a BBB-rated loan is
approximately treble that of one that is rated A. Hence, many entities would
consider the increase in credit risk to be significant, if the low risk simplification
is not used.
The low credit risk simplification will not be relevant if an entity originates
or purchases a financial instrument with a credit risk which is already non-
investment grade. Similarly, this simplification will also have limited use
when the financial instrument is originated or purchased with a credit quality
that is marginally better than a non-investment grade (i.e., at the bottom of
the investment grade rating), because any credit deterioration into the non-
investment grade rating would require the entity to assess whether the increase
in credit risk has been significant.
Partly because of the Basel Committee guidance, most sophisticated banks
intend to apply the low risk simplification only to securities. It is yet to be seen
whether less sophisticated banks will use this operational simplification widely
for their loan portfolios. Investors that hold externally rated debt instruments
are more likely to rely on external rating agencies data and use the low credit
risk simplification. However, some sophisticated banks are intending not to
use it at all, preferring to use the same criteria as for other exposures (e.g.,
changes in the lifetime risk of default as the primary indicator followed by
other risk metrics such as credit scores and ratings). It is also important
to emphasise that, although ratings are forward-looking, it is sometimes
suggested that changes in credit ratings may not be reflected in a timely
matter. Therefore, entities may have to take account of expected change
in ratings in assessing whether exposures are low risk.
The following example from the standard illustrates the application of the low
credit risk simplification.
173
173
IFRS 9 IG Example 4 IE24-IE28
79 April 2018 Impairment of financial instruments under IFRS 9
Example 11: Public investment-grade bond
Company A is a large listed national logistics company. The only debt in the capital
structure is a five-year public bond with a restriction on further borrowing as the only
bond covenant. Company A reports quarterly to its shareholders. Entity B is one of
many investors in the bond. Entity B considers the bond to have low credit risk at
initial recognition in accordance with paragraph 5.5.10 of IFRS 9. This is because
the bond has a low risk of default and Company A is considered to have a strong
capacity to meet its obligations in the near term. Entity B’s expectations for the longer
term are that adverse changes in economic and business conditions may, but will
not necessarily, reduce Company A’s ability to fulfil its obligations on the bond. In
addition, at initial recognition the bond had an internal credit rating that is correlated
to a global external credit rating of investment grade.
At the reporting date, Entity B’s main credit risk concern is the continuing pressure
on the total volume of sales that has caused Company A’s operating cash flows to
decrease.
Because Entity B relies only on quarterly public information and does not have
access to private credit risk information (because it is a bond investor), its
assessment of changes in credit risk is tied to public announcements and
information, including updates on credit perspectives in press releases from
rating agencies.
Entity B applies the low credit risk simplification in paragraph 5.5.10 of IFRS 9.
Accordingly, at the reporting date, Entity B evaluates whether the bond is considered
to have low credit risk using all reasonable and supportable information that is
available without undue cost or effort. In making that evaluation, Entity B reassesses
the internal credit rating of the bond and concludes that the bond is no longer
equivalent to an investment grade rating because:
(a) The latest quarterly report of Company A revealed a quarter-on-quarter
decline in revenues of 20 per cent and in operating profit by 12 per cent.
(b) Rating agencies have reacted negatively to a profit warning by Company A and
put the credit rating under review for possible downgrade from investment
grade to non-investment grade. However, at the reporting date the external
credit risk rating was unchanged.
(c) The bond price has also declined significantly, which has resulted in a higher
yield to maturity. Entity B assesses that the bond prices have been declining
as a result of increases in Company A’s credit risk. This is because the market
environment has not changed (for example, benchmark interest rates,
liquidity, etc. are unchanged) and comparison with the bond prices of peers
shows that the reductions are probably company specific (instead of being,
for example, changes in benchmark interest rates that are not indicative of
company-specific credit risk).
While Company A currently has the capacity to meet its commitments, the large
uncertainties arising from its exposure to adverse business and economic conditions
have increased the risk of a default occurring on the bond. As a result of the factors
described above, Entity B determines that the bond does not have low credit risk
at the reporting date. As a result, Entity B needs to determine whether the increase
in credit risk since initial recognition has been significant. On the basis of its
assessment, Company B determines that the credit risk has increased significantly
since initial recognition and that a loss allowance at an amount equal to lifetime
ECLs should be recognised in accordance with paragraph 5.5.3 of IFRS 9.
Some of the challenges in assessing whether there has been a significant
increase in credit risk (including the use of the low credit risk simplification)
and estimating the ECLs, are illustrated in the following example. It illustrates
different ways of identifying a significant change in credit quality and different
input parameters for calculating ECLs for a European government bond, which
result in very different outcomes and volatility of the IFRS 9 ECL allowance.
It should also be stressed that the default rates provided by external rating
agencies are historical information. Entities need to understand the sources
80 April 2018 Impairment of financial instruments under IFRS 9
of these historical default rates and update the data for current and forward-
looking information (see section 4.9.3 above) when measuring ECLs or
assessing credit deterioration.
Example 12: Use of credit ratings and/or CDS spreads to
determine whether there have been significant increases in credit
risk and to estimate expected credit losses
Introduction
A significant challenge in applying the IFRS 9 impairment requirements to quoted
bonds is that the credit ratings assigned by agencies such as Standard & Poor’s (S&P),
and the historical experience of losses by rating grade, can differ significantly with
the view of the market, as reflected in, for instance, credit default swap (CDS) spreads
and bond spreads.
To illustrate the challenges of applying IFRS 9 to debt securities, we have examined
how the ECL could be determined for a real bond issued by a European government
on 16 September 2008 and due to mature in 2024. For three dates, we applied
the IFRS 9 calculations to this bond, which is assumed to have been acquired at
inception. In January 2009, the Standard & Poor’s credit rating of the government
was AA+, as at origination, but by January 2012, its rating was downgraded to A.
The bond was further downgraded to BBB– in March 2014 before recovery to BBB
in May 2014.
Three approaches
Shown below are three approaches:
Approach 1: Use of S&P credit ratings both to determine whether the bond
has significantly increased in credit risk and to estimate ECLs.
Approach 2: Use of S&P credit ratings to determine whether the bond has significantly
increased in credit risk and CDS spreads to estimate ECLs.
Approach 3: Use of CDS spreads both to determine whether the bond has significantly
increased in credit risk and to estimate ECLs.
Based on the historical corporate PDs from each assessed S&P credit rating (approach
1) and based on the CDS spreads (approaches 2 and 3), the loan loss percentages
were calculated below. For the calculations, an often used LGD of 60% was applied.
(Because the LGD represents a percentage of the present value of the gross carrying
amount, this example does not illustrate the effect of the time value of money).
The percentage loss allowances were, as follows:
Credit
ratings
Historical
12-month
PD based
on ratings
12-
month
PD
based
on CDS
spread
Life time
PD based
on CDS
spread
Percentage of loss allowance
Approach 1
Approach 2
Approach 3
1 January 2009
AA+
0.02%
0.44%
12.81%
–
–
–
31 January 2009
AA+
0.02%
1.84%
30.48%
0.01
1.10
18.29
31 January 2012
A
0.06%
4.96%
51,48%
0.04
2.98
30.89
31 March 2014
BBB–
0.31%
0.57%
23.01%
0.18
0.34
13.81
Approach 1
According to the credit ratings, the bond was investment grade throughout this
period. Hence, using the low risk simplification, the loss allowance would have been
based on 12-month ECLs. Using the corporate historical default rates implied by
the credit ratings and an assumption of 60% LGD to calculate the ECLs, the 12-month
allowance would have increased from 0.01% on 31 January 2009 to 0.04% three
years later, increasing to 0.18% by 31 March 2014. It should be stressed that the
historical default rates implied by credit ratings are historical rates for corporate debt
and so they would not, without adjustment, satisfy the requirements of the standard.
81 April 2018 Impairment of financial instruments under IFRS 9
Example 12: Use of credit ratings and/or CDS spreads to
determine whether there have been significant increases in credit
risk and to estimate expected credit losses (cont’d)
IFRS 9 requires the calculation of ECLs, based on current conditions and forecasts
of future conditions, to be based on reasonable and supportable information. This is
likely to include market indicators such as CDS and bond spreads, as illustrated by
Approach 2.
Approach 2
In contrast to Approach 1, using credit default swap spreads to calculate the ECLs
and the same assumption of 60% LGD to calculate the ECLs, the 12-month allowance
would have increased from 1.1% on 31 January 2009 to 2.98% three years later,
declining to 0.34% by 31 March 2014. The default rates implied by the CDSs are
significantly higher than would have been expected given the ratings of these
bonds. The loss allowances are, correspondingly, very much higher and very
volatile. It might be argued that CDS spreads are too responsive to short-term
market sentiment to calculate long-term ECLs, but it may appear difficult to find
other reasonable and supportable information to adjust these rates so as to dampen
the effects of market volatility.
Approach 3
Credit ratings are often viewed by the market as lagging indicators. For these bonds,
the ratings are difficult to reconcile with the default probabilities as assessed by
the markets. It might be argued that it is not sufficient to focus only on credit
ratings when assessing whether assets are low risk since, according to CDS spreads,
the bond was not low risk at any time in the period covered in this example, as it
showed a significant increase in 1 year PD after inception (based on CDS spreads).
The 1 year PDs increased from 0.44% on issue to 1.84% by 31 January 2009.
Assessing the bond as requiring a lifetime ECL at all three dates, based on CDS
spreads, would have given much higher loss allowances of 18.29%, 30.89% and
13.81%.
The counter-view might be that CDS spreads are too volatile to provide a sound
basis for determining significant deterioration. Perhaps the best way to make the
assessment of whether a bond has increased significantly in credit risk, is to use
more than one source of data and to take account of the qualitative indicators, as
described in the standard.
Conclusion
The calculated ECL figures differ significantly depending on the approach taken as
to how to determine a significant change in credit quality and the parameters used
for the calculation. Those based on CDS spreads are both large and very volatile,
reflecting the investor uncertainty during the period, when the possibility of default
depended more on the political will of the European Union to maintain the integrity
of the Eurozone than the economic forecasts for the particular country. As a result,
the disparity between the effect of the use of credit grades and CDSs is probably more
marked than for most other security investments. Nevertheless, the same challenges
will be found with other securities, albeit on a smaller scale.
5.4.2 Delinquency
As already described at section 5.2.2, the standard allows use of past
due information to assess whether credit risk has increased significantly,
if reasonable and supportable forward-looking information (either at an
individual or a collective level) is not available without undue cost or effort.
This is subject to the rebuttable presumption that there has been a significant
increase in credit risk if contractual payments are more than 30 days past
82 April 2018 Impairment of financial instruments under IFRS 9
due.
174
Similar to the low credit risk simplification (see section 5.4.1 above),
the Basel Committee guidance (see section 6.1 below) considers that
sophisticated banks should not use days past due information as a primary
indicator, because it is a lagging indicator, but only as a backstop measure
alongside other, earlier indicators.
How we see it
Our observation of emerging practice amongst the more sophisticated
banks is that they are following this regulatory guidance. In addition, it
is a useful measure of the effectiveness of more forward-looking primary
criteria to monitor the frequency that assets reach 30 days past due
without having already been transferred to stage 2.
Given the wording in the standard, it will be interesting to see whether any
less sophisticated banks will argue that they do not have, or are unable to
use, more forward-looking indicators (either at an individual or a collective
level) to supplement past due status.
5.4.3 12-month risk as an approximation for change in lifetime risk
In determining whether there has been a significant increase in credit risk,
an entity must assess the change in the risk of default occurring over the
expected life of the financial instrument. Despite this, the standard states
that, ‘... changes in the risk of a default occurring over the next 12 months
may be a reasonable approximation ... unless circumstances indicate that
a lifetime assessment is necessary’.
175
The IASB observed in its Basis for Conclusions that changes in the risk of
a default occurring within the next 12 months generally should be a reasonable
approximation of changes in the risk of a default occurring over the remaining
life of a financial instrument and thus would not be inconsistent with the
requirements. Also, some entities use a 12-month PD measure for prudential
regulatory requirements and these entities can continue to use their existing
systems and methodologies as a starting point for determining significant
increases in credit risk, thus reducing the costs of implementation.
176
However, for some financial instruments, or in some circumstances, the use
of changes in the risk of default occurring over the next 12 months may not
be appropriate to determine whether lifetime ECLs should be recognised. For
a financial instrument with a maturity longer than 12 months, the standard
gives the following examples:
177
•
The financial instrument only has significant payment obligations beyond
the next 12 months
•
Changes in relevant macroeconomic or other credit-related factors occur
that are not adequately reflected in the risk of a default occurring in the
next 12 months
Or
174
IFRS 9 5.5.11
175
IFRS 9.B5.5.13
176
IFRS 9.BC5.178
177
IFRS 9.B5.5.14
The standard permits the
use of a 12-month risk
of a default occurring
when determining
whether credit risk has
increased significantly
since initial recognition,
only if a change in the
12-month risk of default
can be shown to be a
reasonable approximation
of a change in the lifetime
risk.
83 April 2018 Impairment of financial instruments under IFRS 9
•
Changes in credit-related factors only have an impact on the credit risk
of the financial instrument (or have a more pronounced effect) beyond
12 months
On 16 September 2015, the ITG members discussed the use of changes in
the 12-month risk of default as a surrogate for changes in lifetime risk and
commented, as follows:
•
An entity would be expected to complete a robust analysis up front in order
to support the conclusion that changes in the 12-month risk of a default
occurring was a reasonable approximation for the assessment of changes
in the lifetime risk of default occurring.
•
The level of initial analysis required would depend on the specific type
of financial instrument being considered. Consequently in some cases,
a qualitative analysis would suffice, whereas in less clear-cut cases,
a quantitative analysis may be necessary. Also, it may be appropriate to
segregate portfolios (e.g., by maturity) in order to facilitate the analysis
for groups of similar financial instruments.
•
An entity would need to be satisfied on an ongoing basis that the use
of changes in the 12-month risk of a default occurring continued to be
a reasonable approximation for changes in the lifetime risk of a default
occurring.
At the meeting, the ITG members also discussed:
•
The appropriate type of review that should be undertaken on an ongoing
basis. While a quantitative review would not necessarily be required,
it would depend on the specific facts and circumstances. One way of
approaching an ongoing review would be as follows:
(a) Identify the key factors that would affect the appropriateness of
using changes in the 12-month risk of a default occurring as an
approximation of changes in the lifetime risk of default occurring
(b) Monitor these factors on an ongoing basis as part of a qualitative
review of circumstances
(c) Consider whether any changes in those factors indicated that
changes in the 12-month risk of a default occurring were no longer
an appropriate proxy for changes in a lifetime risk of default occurring
•
If it were determined that changes in the 12-month risk of a default
occurring were no longer a reasonable approximation for the assessment
of changes in the lifetime risk of a default occurring, an entity would be
required to determine an appropriate approach to capture changes in
the lifetime risk of a default occurring.
•
It is important to emphasise that the guidance which permits an entity to
use changes in the 12-month risk of a default as an approximation for the
lifetime risk of default, is only relevant for the assessment of significant
increases in credit risk and does not relate to the measurement of ECLs.
When an entity is required to measure lifetime ECLs, that measurement
must always reflect the lifetime risk of a default occurring.
•
IFRS 9 does not prescribe how an entity should determine whether the use
of changes in the 12-month risk of a default was an appropriate proxy for
assessing changes in the lifetime risk of a default. However, it was noted
that entities are required to disclose how they make the assessment of
significant increases in credit risk, in accordance with IFRS 7.
84 April 2018 Impairment of financial instruments under IFRS 9
How we see it
Most of the sophisticated banks currently intend to use the lifetime risk
of default rather than the 12-month risk of default or the Basel risk of
default for assessing whether there has been a significant increase in
credit risk. Movements in a 12-month risk of default are, for most products
and conditions, strongly correlated with movements in the lifetime risk.
However, these banks appreciate that 12-month PDs may need to be
adjusted or calibrated to reflect the longer-term macroeconomic outlook.
Also, there are products such as interest-only mortgages and those
with an introductory period in which no repayments are required, where
additional procedures may need to be implemented in order to ensure
that they are transferred to stage 2 appropriately.
5.4.4 Assessment at the counterparty level
As indicated by Example 7 in the Implementation Guidance of IFRS 9,
assessment of significant deterioration in credit risk can be made at the level
of the counterparty rather than the individual financial instrument. Such
assessment at the counterparty level is only allowed if the outcome would
not differ from the outcome if the financial instruments had been individually
assessed.
178
In certain circumstances, assessment at the counterparty
level would not be consistent with the impairment requirements. Both these
situations are illustrated in the example below, based on Example 7 in the
Implementation Guidance for the standard.
179
Example 13: Counterparty assessment of credit risk
Scenario 1
In 2011 Bank A granted a loan of $10,000 with a contractual term of 15 years to
Company Q when the company had an internal credit risk rating of 4 on a scale
of 1 (lowest credit risk) to 10 (highest credit risk). The risk of a default occurring
increases exponentially as the credit risk rating deteriorates so, for example, the
difference between credit risk rating grades 1 and 2 is smaller than the difference
between credit risk rating grades 2 and 3. In 2015, when Company Q had an internal
credit risk rating of 6, Bank A issued another loan to Company Q for $5,000 with
a contractual term of 10 years. In 2018, Company Q fails to retain its contract with
a major customer and correspondingly experiences a large decline in its revenue.
Bank A considers that as a result of losing the contract, Company Q will have a
significantly reduced ability to meet its loan obligations and changes its internal
credit risk rating to 8.
Bank A assesses credit risk on a counterparty level for credit risk management
purposes and determines that the increase in Company Q’s credit risk is significant.
Although Bank A did not perform an individual assessment of changes in the
credit risk on each loan since its initial recognition, assessing the credit risk on a
counterparty level and recognising lifetime ECLs on all loans granted to Company Q,
meets the objective of the impairment requirements, as stated in paragraph 5.5.4
of IFRS 9. This is because, even since the most recent loan was originated, its credit
risk has increased significantly. The counterparty assessment would therefore achieve
the same result as assessing the change in credit risk for each loan individually.
Scenario 2
Bank A granted a loan of $150,000 with a contractual term of 20 years to Company X
in 2011 when the company had an internal credit risk rating of 4. During 2015,
economic conditions deteriorate and demand for Company X’s products has declined
178
IFRS 9.BC5.168.
179
IFRS 9 IG Example 7 IE43-IE47
Assessment of significant
deterioration in credit
risk at the counterparty
level is only allowed
if the outcome would
not be different to the
outcome if the financial
instruments had been
individually assessed.
85 April 2018 Impairment of financial instruments under IFRS 9
Example 13: Counterparty assessment of credit risk (cont’d)
significantly. As a result of the reduced cash flows from lower sales, Company X
could not make full payment of its loan instalment to Bank A. Bank A re-assesses
Company X’s internal credit risk rating, and determines it to be 7 at the reporting
date. Bank A considered the change in credit risk on the loan, including considering
the change in the internal credit risk rating, and determines that there has been
a significant increase in credit risk and recognises lifetime ECLs on the loan of
$150,000.
Despite the recent downgrade of the internal credit risk rating, Bank A grants another
loan of $50,000 to Company X in 2017 with a contractual term of 5 years, taking into
consideration the higher credit risk at that date.
The fact that Company X’s credit risk (assessed on a counterparty basis) has
previously been assessed to have increased significantly, does not result in lifetime
ECLs being recognised on the new loan. This is because the credit risk on the new
loan has not increased significantly since the loan was initially recognised. If Bank A
only assessed credit risk on a counterparty level, without considering whether the
conclusion about changes in credit risk applies to all individual financial instruments
provided to the same customer, the objective in paragraph 5.5.4 of IFRS 9 would not
be met.
How we see it
Most banks manage their credit exposures on a counterparty basis and
would be keen to use their existing risk management processes where they
can. This is particularly the case for those banks that are seeking to use
processes such as the use of watch lists to make the assessment. However,
this will be challenging as the standard only allows use of a counterparty
basis when it can be demonstrated that it would make no difference
from making the assessment at an individual instrument level. It may be
necessary for these banks to add procedures to track increase in the risk
of default at the instrument level in order to comply with the standard.
5.4.5 Determining maximum initial credit risk for a portfolio
The IFRS 9 credit risk assessment that determines whether a financial
instrument should attract a lifetime ECL allowance, or only a 12-month ECL
allowance, is based on whether there has been a relative increase in credit
risk. One of the challenges identified by some constituents in responding to
the 2013 ED is that many credit risk systems monitor absolute levels of risk,
without tracking the history of individual loans (see section 5.1 above). To help
address this concern, the standard contains an approach that turns a relative
system into an absolute one, by segmenting the portfolio sufficiently by loan
quality at origination.
As indicated by Illustrative Example 6 in the Implementation Guidance of IFRS 9
on which Example 14 below is based, an entity can determine the maximum
initial credit risk accepted for portfolios with similar credit risks on initial
recognition.
180
Thereby, an entity may be able to establish an absolute
threshold for recognising lifetime ECLs.
180
IFRS 9 IG Example 6 IE40-IE42
An entity can determine
the maximum initial
credit risk accepted for
portfolios with similar
credit risks on initial
recognition. Thereby,
an entity may be able
to establish an ‘absolute’
threshold for recognising
lifetime expected credit
losses.
86 April 2018 Impairment of financial instruments under IFRS 9
Example 14: Comparison to maximum initial credit risk
Bank A has two portfolios of automobile loans with similar terms and conditions
in Region W. Bank A’s policy on financing decisions for each loan is based on an
internal credit rating system that considers a customer’s credit history, payment
behaviour on other products with Bank A and other factors, and assigns an internal
credit risk rating from 1 (lowest credit risk) to 10 (highest credit risk) to each loan
on origination. The risk of a default occurring increases exponentially as the credit risk
rating deteriorates so, for example, the difference between credit risk rating grades
1 and 2 is smaller than the difference between credit risk rating grades 2 and 3.
Loans in Portfolio 1 were only offered to existing customers with a similar internal
credit risk rating and, at initial recognition, all loans were rated 3 or 4 on the internal
rating scale. Bank A determines that the maximum initial credit risk rating at initial
recognition it would accept for Portfolio 1 is an internal rating of 4. Loans in Portfolio
2 were offered to customers that responded to an advertisement for automobile
loans and the internal credit risk ratings of these customers range between 4 and 7 on
the internal rating scale. Bank A never originates an automobile loan with an internal
credit risk rating worse than 7 (i.e., with an internal rating of 8-10).
For the purposes of assessing whether there have been significant increases in credit
risk, Bank A determines that all loans in Portfolio 1 had a similar initial credit risk.
It determines that, given the risk of default reflected in its internal risk rating grades,
a change in internal rating from 3 to 4 would not represent a significant increase in
credit risk, but that there has been a significant increase in credit risk on any loan
in this portfolio that has an internal rating worse than 5. This means that Bank A
does not have to know the initial credit rating of each loan in the portfolio to assess
the change in credit risk since initial recognition. It only has to determine whether
the credit risk is worse than 5 at the reporting date to determine whether lifetime
ECLs should be recognised in accordance with paragraph 5.5.3 of IFRS 9.
However, determining the maximum initial credit risk accepted at initial recognition
for Portfolio 2 at an internal credit risk rating of 7, would not meet the objective of
the requirements as stated in paragraph 5.5.4 of IFRS 9. This is because Bank A
determines that significant increases in credit risk not only arise when credit risk
increases above the level at which an entity would originate new financial assets
(i.e., when the internal rating is worse than 7). Although Bank A never originates
an automobile loan with an internal credit rating worse than 7, the initial credit risk
on loans in Portfolio 2 is not of sufficiently similar credit risk at initial recognition
to apply the approach used for Portfolio 1. This means that Bank A cannot simply
compare the credit risk at the reporting date with the lowest credit quality at initial
recognition (for example, by comparing the internal credit risk rating of loans in
Portfolio 2 with an internal credit risk rating of 7) to determine whether credit risk
has increased significantly because the initial credit quality of loans in the portfolio
is too diverse. For example, if a loan initially had a credit risk rating of 4 the credit risk
on the loan may have increased significantly if its internal credit risk rating changes
to 6.
At its meeting on 16 September 2015, the ITG (see section1.5 above)
discussed how to identify a significant increase in credit risk for a portfolio
of retail loans when identical pricing and contractual terms are applied to
customers across broad credit quality bands. The question was influenced
by the operational simplifications described above which allows an entity to
assess if there has been a significant increase in credit risk by determining
the maximum initial credit risk accepted for portfolios with similar credit risks
on original recognition, and by reviewing which exposures now exceed this limit.
The ITG discussed an example of a retail loan portfolio (Portfolio A) comprising
customers who had been assigned initial credit grades between 1 and 5 (based
on a 10-grade rating scale where 1 is the highest credit quality) and had been
87 April 2018 Impairment of financial instruments under IFRS 9
issued loans with the same contractual terms and pricing. The question was
whether it would be appropriate to make the determination of significant
increases in credit risk by using a single threshold approach such as that
outlined for Portfolio 1 in Illustrative Example 6 of IFRS 9, on the basis that
the exposures in Portfolio A could be considered to have a similar initial credit
risk, or whether there were other more appropriate approaches such as, for
example, defining a significant increase in credit risk as a specific number of
notch increases in credit grade.
The ITG members observed that:
•
When assessing whether there has been a significant increase in credit risk,
it would not be appropriate for the entity to consider only factors such as
pricing and contractual terms. In this regard, while the concept of economic
loss was considered in developing the IFRS 9 model, the standard requires
an assessment of changes in credit risk based on a wide range of factors
including internal and external indicators of credit risk, changes to
contractual terms, actual and expected performance/behaviours
and forecasts of future conditions.
•
Credit grading systems were not necessarily designed with the
requirements of IFRS 9 in mind, and, thus, it should not be assumed
that they will always be an appropriate means of identifying significant
increases in credit risk. The appropriateness of using internal credit
grading systems as a means of assessing changes in credit risk since
initial recognition depends on whether the credit grades are reviewed
with sufficient frequency, include all reasonable and supportable
information and reflect the risk of default over the expected life of
the financial instrument. As credit grading systems vary, care needs
to be taken when referring to movements in credit grades and how this
reflects an increased risk of default occurring. In addition, the assessment
of whether a change in credit risk grade represents a significant increase in
credit risk in accordance with IFRS 9 depends on the initial credit risk of the
financial instrument being assessed. Because the relationship between
credit grades and changes in the risk of default occurring differs between
credit grading systems (e.g., in some cases, the changes in the risk of a
default occurring may increase exponentially between grades whereas in
others it may not), this requires particular consideration.
•
Consequently, the impairment model is based on an assessment of changes
in credit risk since initial recognition, rather than the identification of
a specific level of credit risk at the reporting date and a smaller absolute
change in the risk of default occurring will be more significant for an asset
that is of high quality on initial recognition than for one that is of low
quality.
•
In Illustrative Example 6 in IFRS 9, the assessment of significant increases
in credit risk of Portfolio 1 was made using a form of absolute approach.
However, it was pointed out that this approach was still consistent with
the objective of identifying significant increases in credit risk since initial
recognition. In particular, only loans with an initial credit grade of 3 or 4
were included in Portfolio 1 and furthermore, the entity had concluded
that a movement from credit grade 3 to 4 did not represent a significant
increase in credit risk. Consequently, using a single threshold of credit
grade 5 as a means of identifying a significant increase in credit risk since
initial recognition served to capture changes in credit risk in a manner that
achieved the objective of the impairment requirements.
88 April 2018 Impairment of financial instruments under IFRS 9
•
In contrast, in the fact pattern discussed, Portfolio A contained loans with
initial credit grades ranging between 1 and 5. Questions were raised as
to whether such a broad range of credit grades could be considered to
represent a similar initial credit risk and the ITG members noted that, in
order to conclude that the assessment could be based on whether loans
had a credit rating worse than 5, the entity would need to have determined
that movements between credit grades 1 and 5 did not represent
a significant increase in credit risk.
•
Information available at an individual financial instrument level and/or
built into a credit risk grading system may not incorporate forward-
looking information, as required by IFRS 9. Consequently, the assessment
of significant increases in credit risk may need to be supplemented by
a collective assessment to capture forward-looking information. However,
a collective assessment should not obscure significant increases in credit
risk at an individual financial instrument level. In this regard, portfolio
segmentation is important and entities should ensure that sub-portfolios
are not defined too widely.
5.5 Collective assessment
Banks have hundreds of thousands, or even millions, of small exposures to
retail customers and small businesses. Much of the information available to
monitor them is based on whether payments are past due and behavioural
information that is mostly historical rather than forward looking. As a result
such exposures tend to be managed on an aggregated basis, combining past
due and behavioural data with historical statistical experience and sometimes
macroeconomic indicators, such as interest rates and unemployment levels,
that tend to correlate with future defaults. Also, even when exposures are
managed on an individual basis, as is the case for most commercial loans,
the information used to manage them may not be sufficiently forward looking
to comply with the standard.
To address these concerns, the standard introduces the idea of making
a collective assessment for financial assets, to determine if there has been
a significant increase in credit risk, if an entity cannot make the assessment
adequately on an individual instrument level. This exercise must consider
comprehensive information that incorporates not only past due data but
other relevant credit information, such as forward-looking macro-economic
information. The objective is to approximate the result of using comprehensive
credit information that incorporates forward-looking information at an
individual instrument level.
181
Hence, even if a financial asset is normally
managed on an individual basis, it should also be assessed collectively (i.e.,
based on macroeconomic indicators), if the entity does not have sufficient
forward-looking information at the individual level to make the determination.
The way that this might work is not very different from the IAS 39 requirement
to assess an asset collectively for impairment if it has already been assessed
individually and found not to be impaired.
181
IFRS 9.B5.5.4
89 April 2018 Impairment of financial instruments under IFRS 9
How we see it
Some kind of collective adjustment or overlay will be needed for many retail
lending portfolios, given that most customer-specific information will not be
forward looking. In contrast, for commercial loans, the lender will typically
have access to much more information and a forward-looking approach
may already have been built into loan grading systems. Nevertheless, we
are aware of some banks that consider that they might need to introduce
an additional overlay for commercial loans so as to be more responsive to
emerging macroeconomic and other risk developments. Other banks intend
to achieve this by using their existing watch list approaches to supplement
using their credit grading system when assessing whether there has been
a significant increase in credit risk. This is because watch list systems tend
to be more reactive to changing circumstances than formal credit gradings.
Any one bank is likely to employ a variety of methods, depending on its
products, systems and data.
It is worth noting that the language describing when a collective apporach is
required is not entirely consistent within the standard. Paragraph B5.5.1 states
that ‘it may be necessary to perform the assessment’ on a collective basis,
which is consistent with the requirement in paragraph 5.5.11, that ‘an entity
cannot rely solely on past due information if reasonable and supportable
forward-looking information is available without undue cost or effort’. However,
paragraph B5.5.4 states that if, ‘an entity does not have reasonable and
supportable information that is available without undue cost or effort to
measure lifetime ECLs on an individual instrument basis ... lifetime credit losses
shall be recognised on a collective basis’ (emphasis added for each quotation).
Banking regulators will probably ensure that this ‘shall be’ wording will be
applied, at least for more sophisticated banks (see sections 1.6 above and
6.1 below).This raises a second concern: once significant deterioration has
been identified for a portfolio, whether the entire portfolio would have to be
measured using lifetime ECLs. This outcome would result in sudden, massive
increases in provisions as soon as conditions begin to decline. Consequently,
the Board, in finalising the standard, also had to devise a method by which
only a segment or portion of the portfolio would be changed to lifetime ECLs.
Illustrative Example 5 in the Implementation Guidance for the standard
illustrates how an entity may assess whether its individual assessment should be
complemented with a collective one whenever the information at individual level
is not sufficiently comprehensive and up-to-date. The following examples have
been adapted from that guidance.
5.5.1 Example of individual assessment of changes in credit risk
As a benchmark, Scenario 1 (an individual assessment) illustrates a situation
where a bank has sufficient information at individual exposure level to identify
a significant deterioration of credit quality.
Example 15: Individual assessment in relation to responsiveness
to changes in credit risk
The bank assesses each of its mortgage loans on a monthly basis by means of
an automated behavioural scoring process based on current and historical past due
statuses, levels of customer indebtedness, loan-to-value (LTV) measures, customer
behaviour on other financial instruments with the bank, the loan size and the time
since the origination of the loan. It is said that historical data indicates a strong
correlation between the value of residential property and the default rates for
mortgages.
The IASB has sought
to make it clear that
financial assets
can (and should) be
assessed collectively
for significant credit
risk deterioration, if
the entity cannot make
the assessment on an
individual instrument
basis.
90 April 2018 Impairment of financial instruments under IFRS 9
Example 15: Individual assessment in relation to responsiveness
to changes in credit risk (cont’d)
The bank updates the LTV measures on a regular basis through an automated
process that re-estimates property values using recent sales in each post code
area and reasonable and supportable forward-looking information that is available
without undue cost or effort. Therefore, an increased risk of a default occurring due
to an expected decline in residential property value adjusts the behavioural scores
and the Bank is, therefore, able to identify significant increases in credit risk on
individual customers before a mortgage becomes past due if there has been
a deterioration in the behavioural score.
The example concludes that if the bank is unable to update behavioural scores
to reflect the expected declines in property prices, it would use reasonable and
supportable information that is available without undue cost or effort to undertake
a collective assessment to determine the loans on which there has been a significant
increase in credit risk since initial recognition and recognize lifetime ECLs for those
loans.
It should be noted that, in this example, the main source of forward-looking
information is expected future property prices. No account would appear
to be taken of other economic data, such as future levels of employment
or interest rates. We assume that the Board took this approach to make the
example simple, but it implies, in this particular example, that future property
prices are considered to provide a sufficiently good guide to future defaults that
it is not necessary to take account of other data as well.
5.5.2 Basis of aggregation for collective assessment
Next, the standard sets out how financial instruments may be grouped together
in order to determine whether there has been a significant increase in credit
risk. Any instruments assessed collectively must possess shared credit risk
characteristics. It is not permitted to aggregate exposures that have different
risks and, in so doing, obscure significant increases in risk that may arise on
a sub-set of the portfolio. Examples of shared credit risk characteristics given
in the standard include, but are not limited to:
182
•
Instrument type
•
Credit risk ratings
•
Collateral type
•
Date of initial recognition
•
Remaining term to maturity
•
Industry
•
Geographical location of the borrower
•
The value of collateral relative to the asset (the loan-to-value or LTV ratio),
if this would have an impact on the risk of a default occurring
The standard also states that the basis of aggregation of financial instruments
to assess whether there have been changes in credit risk on a collective basis
may have to change over time, as new information on groups of, or individual,
financial instruments becomes available.
183
182
IFRS 9.B5.5.5
183
IFRS 9.B5.5.6
The objective of
collective assesment is
to approximate the result
of using comprehensive
credit information that
incorporates forward-
looking information at
an individual instrument
level.
91 April 2018 Impairment of financial instruments under IFRS 9
How we see it
• As has been stressed earlier, the assessment of significant deterioration
is intended to reflect the risk of default, not the risk of loss, hence,
collateral should normally be ignored for the assessment. The standard
nonetheless explains that the value of collateral relative to the financial
asset would be relevant to the collective assessment if it has an impact
on the risk of a default occurring. It cites, as an example, non-recourse
loans in certain jurisdictions. The question of when such an arrangement
would always meet the IFRS 9 classification and measurement
characteristics of the asset test is beyond the scope of this chapter. LTV
or a house price index may be a useful indicator of significant collective
deterioration in a wider range of circumstances than just where the
loans are non-recourse. First, house prices are themselves a useful
barometer of the economy and, so, higher LTVs and lower indices
correlate with declining economic conditions. Second, loans that were
originally advanced at higher LTVs may reflect more aggressive lending
practices, with the consequence that such loans may exhibit a higher
PD if economic conditions decline. Third, a borrower in trouble with a
lower LTV will likely sell his house to redeem the mortgage rather than
defaulting on the mortgage (and, conversely, a borrower with a high
LTV will have less incentive not to default).
• By date of original recognition, we assume that the Board did not
intend that loans should be assessed in separate groups for each year of
origination, but that vintages may be aggregated into groups that share
similar credit risk characteristics. Loan products and lending practices,
including the extent of due diligence, and key ratios, such as the LTV
and loan to income, change over time, often reflecting the economic
conditions at the time of origination. The consequence is that loans from
particular years are inherently more risky than others. For some banks,
this might mean isolating those loans advanced just prior to the financial
crisis from those originated earlier or in the subsequent, more careful
lending environment. Also, there is a phenomenon termed seasoning,
which describes how loans that been serviced adequately for a number
of years, over a business cycle, are statistically less likely to default in
future, suggesting that older loans should be assessed separately.
• Although the examples in the standard refer to regions, as the
geographical location of borrowers, the groupings could be much larger,
such as by country, or much smaller, if there are particular issues
associated with particular towns. Hence, the choice of geographical
groupings will depend very much on the environment in which a bank
operates.
• Other ways that loans might be grouped according to shared credit
risk characteristics could include by credit score, by payment history,
whether previously restructured or subject to forbearance but
subsequently restored to a 12-month ECL allowance, and manner of
employment (as featured in Illustrative Example 5 in the Implementation
Guidance for the standard under the bottom up assessment discussed
in Example 16 below).
• The requirement that financial instruments that are assessed together
must share similar credit risk characteristics means that a bank may
have a substantial number of portfolios. Even a relatively small bank
might have six different products (taking into account terms to maturity
and types of collateral), three regions and three different vintage groups
92 April 2018 Impairment of financial instruments under IFRS 9
which, multiplied out, would give fifty four different assessment groups.
A larger, global bank might need to monitor many more different
portfolios. However, a balance will need to be struck between ensuring
that portfolios are small enough to have sufficient homogeneity and yet
not so small that there is too little historical data for losses to be reliably
estimated.
• Also, the requirement that groupings may have to be amended over
time means that there must processes to reassess whether loans
continue to share similar credit risk characteristics. Yet, in practice,
there will need to be a sufficient level of stability in the construction
of portfolios to allow enough historical data to be gathered for reliable
estimation of losses.
Finally, paragraph B5.5.6 of IFRS 9 adds that, ‘if an entity is not able to
group financial instruments for which the credit risk is considered to have
increased significantly since original recognition based on shared credit risk
characteristics, the entity should recognise lifetime ECLs on a portion of the
financial assets for which credit risk is deemed to have increased significantly’.
As clarified by the IASB in its webcast on forward-looking information in July
2106, it is possible that a bank is aware of differences in sensitivities of credit
risk to a change in a particular parameter, but is unable to group the assets on
the basis of such sensitivity. In such instances, the bank may determine that the
expected forward-looking scenario would result in significant increases in credit
risk for a certain proportion of its portfolio.
5.5.3 Example of collective assessment (‘bottom up’ and ‘top down’
approach)
The main standard does not amplify how a collective assessment would be
made, but Illustrative Example 5 in the Implementation Guidance of IFRS 9
provides two scenarios that explore the approach.
184
Example 16: Collective assessment in relation to responsiveness
to changes in credit risk (‘bottom up’ approach)
Region Two of Illustrative Example 5 in the Implementation Guidance for the standard
introduces the so-called bottom up method. It deals with a mining community
within a region that faces unemployment risk due to a decline in coal exports and,
consequently, anticipated future mine closures. Although most of the loans are not
yet 30 days past due and, further, the borrowers are not yet unemployed, the bank
re-segments its mortgage portfolio so as to separate loans to customers employed in
the mining industry (based on information in the original mortgage application form).
For these loans (plus any others that are more than 30 days past due), Bank ABC
recognises lifetime ECLs, while it continues to recognise 12-month ECLs for
the other mortgage loans in the region. Any new loans to borrowers who rely
on the coal industry would also attract only a 12-month allowance, until they
also demonstrate a significant increase in credit risk.
The bottom up method is described as an example of how to assess credit
deterioration by using information that is more forward-looking than past
due status. But this example also illustrates that collectively assessed groups
may need to change over time, to ensure that they share similar credit risk
characteristics. Once the coal mining industry begins to decline, those loans
connected with it would no longer share the same risk characteristics as other
184
IFRS 9 IG Example 5 IE29-IE39.
93 April 2018 Impairment of financial instruments under IFRS 9
loans to borrowers in the region, and so would need to be assessed separately.
We also note that this example assumes that macroeconomic factors can be
linked to the ECLs of a very specific portfolio. Further, in practice, most banks
may not have the data to achieve this level of segmentation.
As already described above (possible criteria for grouping of financial assets
with similar credit risk characteristics), the bottom up approach could be
applied to sub-portfolios differentiated by type of instrument, risk rating, type
of collateral, date of initial recognition, remaining term to maturity, industry,
geographical location of the borrower, or the LTV ratio. A good example of
this approach might be for exposures to borrowers that are expected to suffer
major economic difficulties due to war or political upheaval, or borrowers with
the weakest credit scores, who are expected to be more sensitive to a change
in a relevant macroeconomic factor. In addition, as underwriting standards may
vary or change, the portfolio might be sub-divided so as to reflect this. Note
that the coal mines closures are, as yet, only anticipated, hence, this example
helps show how the standard is intended to look much further forward than the
consequent unemployment that would probably trigger an IAS 39 impairment
provision. The need to look forward is also illustrated in the next example.
Example 17: Collective assessment in relation to responsiveness
to changes in credit risk (‘top down’ approach)
For Region Three of Illustrative Example 5 in the Implementation Guidance for the
standard, Bank ABC anticipates an increase in defaults following an expected rise
in interest rates. We are told that, historically, an increase in interest rates has
been a lead indicator of future defaults on floating-rate mortgages in the region.
The bank regards the portfolio of variable rate mortgage loans in that region to be
homogenous and it is incapable of identifying particular sub portfolios on the basis
of shared credit risk characteristics. Hence, it uses what is described as a top down
method.
Based on historical data, the bank estimates that a 200 basis points rise in interest
rates will cause a significant increase in credit risk on 20 per cent of the mortgages.
As a result, presumably because the bank expects a 200 basis points rise in rates, it
recognises lifetime ECLs on 20 per cent of the portfolio (along with those loans that
are more than 30 days past due) and 12-month ECLs on the remainder of mortgages
in the region.
The challenge posed by the top down method is how to calculate the percentage
of loans that have significantly deteriorated. That a rise in interest rates will
likely lead to a significant deterioration in credit risk for some floating-rate
borrowers, is not controversial. But working out whether the proportion of
significantly affected borrowers makes up 5 per cent, 20 per cent or 35 per
cent of the portfolio would appear to be more of an art than science, and no
two banks are likely to arrive at the same figure.
The IASB brought some useful clarification on this example in its July 2016
webcast on forward-looking information:
•
First, it clarified that one financial instrument cannot exist in stage 1 and
in stage 2 at the same time. Therefore, the Board in the above example
did not mean that each asset in the portfolio is to be regarded as 20% in
stage 2 and 80% in stage 1. Instead, 20% of the assets are in stage 2,
even if the bank does not yet know which.
•
This allocation is intended to reflect that some assets in the portfolio
will respond more adversely to a given change to the macroeconomic
factor (e.g., unemployment rate) than others. Therefore, some assets
94 April 2018 Impairment of financial instruments under IFRS 9
in the portfolio may be considered to have significantly increased in
credit risk while others have not. Judgment is required to determine how
much of the portfolio should move to stage 2. An entity may, for example,
determine that given the range of possible scenarios, 20% of the portfolio
moves to stage 2 considering the different level of sensitivity of the assets
in the portfolio to the different relevant credit risk drivers.
•
As further explained in the next section on using multiple scenarios for
the staging assessment (see section 5.7 below), it is important to note that
the 20% is not the probability of occurrence of the more adverse scenario.
Rather, it reflects the proportion of the portfolio deemed to have already
significantly deteriorated based on the most recent probability-weighted
average PD. This is due to the heightened sensitivity of this proportion of
the portfolio to certain macroeconomic factors.
A further issue with the top down approach is the question of what the lender
should do if it subsequently finds that differences in risk characteristics emerge
within the portfolio, such that certain assets need to be measured using lifetime
ECLs using the bottom up approach. A similar question arises if individual assets
subsequently need to be measured using lifetime ECLs, for instance, because
they become 30 days past due. In practice, it is likely that banks, at each
reporting date, will first allocate exposures to stage 2 based on an individual
assessment and then apply a collective approach to the remaining stage 1
exposures. They are unlikely to ‘roll-forward’ the collective allowance.
Presumably the proportion of the portfolio ECLs in stage 2 can be measured
once again using 12-month ECLs if economic conditions are expected to
improve. However, any assets that are 30 days past due will continue to
be treated as stage 2.
185
How we see it
Because of these and similar difficulties, we are not currently aware of any
banks who intend to use the top down approach in the manner set out in
the Illustrative Example. Banks prefer to know which loans are measured
using lifetime ECLs, rather than a notional percentage of the population.
In practice, the methods that are being explored by banks are closer to
a mixture of the bottom up and top down approaches, as described in
Examples 16 and 17 above. Macroeconomic indicators are assessed,
as in the top down approach, but the effect is determined by assessing
the effect on particular exposures. One possible method is to determine
the expected migration of loans through a bank’s risk classification system,
by recalibrating the probabilities of default based on forward-looking
data. This could be used to forecast how many additional loans will get
downgraded as well as the associated ECLs. Another is to focus on more
vulnerable categories of lending, such as interest-only mortgages, secured
loans with high loan-to-value ratios, or property development loans,
and assess how these might respond to the economic outlook. The more
information about customers that a lender possesses, the more this might
look like the illustrated bottom up approach. It is likely that banks will use
different approaches for different portfolios, depending on how they are
managed and what data is available.
185
IFRS 9.B5.5.19
95 April 2018 Impairment of financial instruments under IFRS 9
All of the examples in the illustrative examples simplify the fact pattern
to focus on just one driver of credit losses, whereas in reality there will
be many, and it may not be possible to find a historical precedent for the
combination of economic indicators that may now be present. Further, to
delve into the past to predict the future requires a level of data that banks
may lack. The example in the standard bases the percentage on historical
experience, but it is more than 20 years since most developed countries
last saw a 200 basis points rise in interest rates, and products and lending
practices were then very different, as was the level of interest rates before
they began to rise and the extent of the increase. Hence, the past may not
be a reliable guide to the future. In practice, banks will need to determine
the main macroeconomic variables that correlate with credit losses and
focus on modelling these key drivers of loss. The banks can make use of
work that has already been carried out for stress testing. Also, it should be
stressed that banks will generally use one single model to estimate forward-
looking PDs for both for the assessment of significant increases in credit risk
and the measurement of ECLs (see section 4.9.3 above).
The example of an anticipated increase in interest rates is very topical,
given that rates in many countries are expected to rise in future from the
all-time low levels that have been experienced since the financial crisis. This
gives rise to an observation that is relevant to any ECL model: banks and
(hopefully) borrowers have presumably known that new variable loans made
since the crisis would likely increase in rate as the economy improves. If
the increase was anticipated at the time of origination, expectation of a rise
in interest rate should not be viewed as a significant deterioration in credit
risk. Yet, there is a concern that rising rates will bring difficulty for many
borrowers who have over stretched themselves, implying that the inevitable
rise was not fully factored into lending decisions. With any forward-looking
approach it is necessary to understand what risks were already taken into
account when loans are first made, to assess whether there has been
a significant increase in risk.
5.6 Determining the credit risk at initial recognition of
an identical group of financial assets
In practice, entities may hold a portfolio of debt securities that are identical
and cannot be distinguished individually (e.g., all securities have the same
international securities identification number (ISIN)) and over the lifetime of
the portfolio, entities may acquire additional securities or sell some of those
previously acquired. In such instances, entities have to determine the credit
risk at initial recognition of those securities that remain in the homogeneous
portfolio at the reporting date.
IFRS 9 contains no specific guidance on how to calculate the cost of financial
assets for derecognition purposes when they are part of a homogenous
portfolio. Under IAS 39, which is also silent on this topic, entities choose
between the following cost allocation methods for available-for-sale securities:
the average cost method, the first-in-first-out (FIFO) method or the specific
identification method. Specific identification can be applied if the entity is
able to identify the specific items sold and their costs. For example, a specific
security may be identified as sold by linking the date, amount and cost of
securities bought with the sale transaction, provided that there is no other
evidence suggesting that the actual security sold was not the one identified
under this method.
96 April 2018 Impairment of financial instruments under IFRS 9
For IFRS 9, the question arises whether entities can continue to apply one of
the above methods for debt instruments, not only for determining the cost of
the security at derecognition, but also for determining their initial credit risk.
We believe that:
•
The method used for recognising and measuring impairment losses should
normally be the same as that used for determining the cost allocation
method on derecognition.
•
Either a FIFO approach or a specific identification method, as described
above, constitute acceptable accounting policy choices to be applied
consistently.
•
However, it would not normally be appropriate to use the weighted-
average method to determine the credit risk at initial recognition, as
averaging the different levels of initial credit risk of debt securities
purchased at different dates would result in an identical initial credit
risk for each item. It, therefore, would create bias when assessing
whether the credit risk of debt securities has increased significantly.
5.7 Multiple scenarios for the assessment of significant
increases in credit risk
At its December 2015 meeting, the ITG discussed not only the need to consider
multiple scenarios for the measurement of ECLs (see section 4.6 above), but
also for the purposes of assessing whether exposures should be measured on
a lifetime loss basis.
Similar to the measurement of ECLs, the ITG members noted that where there
is a non-linear relationship between the different forward looking scenarios
and the associated risks of default, using a single scenario would not meet the
objectives of the standard. Consequently, in such cases, an entity would need
to consider more than one forward looking scenario. Further, there should be
consistency, to the extent relevant, between the information used to measure
ECLs and that used to assess significant increases in credit risk. An example
of when the information might not be relevant is the value of collateral. It may
be necessary to calculate the effect of multiple scenarios to value collateral to
measure ECLs, but this information may not be relevant to assessing significant
changes in credit risk unless the value has an effect on the probability of default
occurring.
186
As with the measurement of ECLs, the ITG members noted that IFRS 9 does
not prescribe particular methods of assessing for significant increases in
credit risk. Consequently, various methods could be applied, depending
on facts and circumstances and these may include both quantitative and
qualitative approaches. An entity should not restrict itself by considering only
quantitative approaches when deciding how to incorporate multiple forward-
looking scenarios. Whichever approach is taken, it should be consistent with
IFRS 9, considering reasonable and supportable information that is available
without undue cost and effort. Once again, this is an area of judgement and,
so, appropriate disclosures would need to be provided to comply with the
requirements of IFRS 7 (see section 14 below).
A further issue was raised at the ITG meeting, which was not referred to
in the minutes, but was addressed in the 25 July 2016 IASB webcast. If a
number of scenarios are applied to an individual asset, in some of which, there
is no significant increase in credit risk and in others there is, is it possible that
186
IASB Transition Resource Group for Impairment of Financial Instruments, Meeting Summary,
Paragraphs 58 and 59, 11 December 2015.
Where there is a material
non-linear relationship
between different
macroeconomic
scenarios and the risk of
default, it is necessary,
to consider multiple
scenarios for the staging
analysis.
97 April 2018 Impairment of financial instruments under IFRS 9
it could be measured partly based on 12 month losses and partly on lifetime
losses? It was not the intention of the IASB that an asset should be regarded
as being in more than one stage at the same time. For staging as well as for
measurement, IFRS 9 applies to the unit of account, which is the individual
financial instrument. The financial asset cannot be considered to have partly
significantly deteriorated and partly not. Hence, for instance, if the staging
assessment is based on a mechanistic approach which considers the change
in the lifetime probability of default, the entity should use the multiple scenario
probability-weighted lifetime probability of default to assess whether there has
been a significant increase in credit risk. The asset should then be measured
using the weighted 12-month probability of default if it is considered to be in
stage 1, or the weighted lifetime probability of default if it is considered to be
in stage 2.
However, as described in section 5.5.3 above, the webcast also noted that, for
a collectively assessed portfolio of assets, a proportion of the portfolio only may
be deemed to have significantly deteriorated while the rest of the portfolio has
not, due to differences in sensitivities of credit risk to a change in a particular
parameter.
The IASB also illustrated how multiple scenarios can be reflected in a non-
PD-based approach, using the example of a scorecard system. If the entity
determines that there is non-linearity in the effect of the scenarios on the
credit risk of the customers, one possibility is to look at the scorecard inputs
and to determine which of these inputs have a non-linear relationship with
the macroeconomic parameters. The entity then adjusts the scorecard, for
example, using a scaling factor to reflect the impact of non-linearity, assesses
whether there has been a significant increase in credit risk and measures ECL
on the basis of the adjusted scorecard.
The approach set out in this discussion is broadly the same as ‘the top down’
approach to collective assessments illustrated by Example 17.
It is important to note that the ITG did not state that it is always necessary to
use multiple scenarios and probability-weighted lifetime probabilities of default
to assess significant increases in credit risk.
What it did state is that:
•
It is necessary to consider more than one scenario if there is non-linearity
in the possible distribution of losses
•
Qualitative approaches may be included as well as quantitative ones, so
that, for instance, it might be possible to take account of non-linearities
by scaling the output from score cards
•
The assessment should be based on reasonable and supportable
information that is available without undue cost or effort (see section 4.9.1
above)
Nevertheless, the ITG did state that there should be consistency, to the extent
relevant, between the forward-looking information used for measurement
and for the assessment of significant increases in credit risk. There would not
always be a direct mapping of the relevant information, because, in some cases,
information might have an impact on the measurement of ECLs but not on the
assessment of significant increases in credit risk (and vice versa). Also, various
methods of assessing for significant increases in credit risk could be applied,
depending on the particular facts and circumstances, and an entity should not
restrict itself by considering only quantitative approaches when considering
how to incorporate multiple forward-looking scenarios.
98 April 2018 Impairment of financial instruments under IFRS 9
In the July 2016 webcast, the IASB also stressed the importance of adequate
disclosures. Because there is no one right approach and because this area
involves a high level of judgement, disclosures are very important to enable
users of financial statements to understand how entities’ credit risk is affected
by forward-looking scenarios and how they have affected the application
of the ECL model. It would also be useful to disclose if relevant forward
looking information has not been reflected in the assessment of significant
deterioration on the basis that it is not reasonable and supportable.
In practice, many banks that use multiple scenarios of lifetime probabilities
of default to measure assets in stage 2, also intend to use them for assessing
if there has been a significant increase in credit risk. Moreover, as with
measurement, banks will need to consider regulators’ expectations (see
section 6.1 below).
6 Other matters and issues in relation to
the expected credit loss calculations
This section discusses other matters and issues that are relevant to applying
the IFRS 9 impairment requirements.
6.1 Basel guidance on accounting for expected credit losses
In December 2015, the Basel Committee published the final version of its
Guidance on Credit Risk and Accounting for Expected Credit Losses (sometimes
referred to as ‘G-CRAECL’, but in this publication, as ‘the Basel guidance’ or
just ‘the guidance’) (see section 1.6 above). The guidance deals with lending
exposures, and not debt securities, and does not address the consequent
capital requirements.
The guidance was originally drafted for internationally active banks and more
sophisticated banks in the business of lending. The final version does not limit
its scope but allows less complex banks to apply, ‘a proportionate approach’
that is commensurate with the size, nature and complexity of their lending
exposures. It also extends this notion to individual portfolios of more complex
banks. It follows that determining what is proportionate will be a key judgement
to be made, which is likely to be guided in some jurisdictions by banking
regulators. The guidance issued in June 2016 by the GPPC (see section 6.2
below) will also be relevant in making this determination. The final version
of the guidance acknowledges that due consideration may also be given to
materiality.
The main section of the Basel Committee’s guidance is intended to be applicable
in all jurisdictions (i.e., for banks reporting under US GAAP as well as for banks
reporting under IFRS) and contains 11 supervisory principles. The guidance is
supplemented by an appendix that outlines additional supervisory requirements
specific to jurisdictions applying the IFRS 9 ECL model.
It is important to stress that the guidance is not intended to conflict with IFRS 9
(and, indeed, this has been confirmed by the IASB), but it goes further than
IFRS 9 and, in particular, removes some of the simplifications that are available
in the standard. It also insists that any approximation to what would be
regarded as an ‘ideal’ implementation of ECL accounting should be designed
and implemented so as to avoid ‘bias’. The term ‘avoidance of bias’ is used
several times in the guidance and we understand it to have its normal
accounting meaning of neutrality. Hence, for instance, if a bank were ever
dependent on past-due information to assess whether an exposure should
be measured on a lifetime ECL basis, it is guided to ‘pay particular attention
The Basel Committee
guidance is designed for
internationally active
banks, but is intended to
be applied by all banks
using ‘a proportionate
approach’.
99 April 2018 Impairment of financial instruments under IFRS 9
to its measurement of the 12-month allowance to ensure that ECLs are
appropriately captured in accordance with the measurement objective of
IFRS 9.’
187
Perhaps one of the most significant pieces of guidance provided by the Basel
Committee relates to the important requirement in IFRS 9 that ECLs should
be measured using ‘reasonable and supportable information’. The Committee
accepts that in certain circumstances, information relevant to the assessment
and measurement of credit risk may not be reasonable and supportable and
should therefore be excluded from the ECL assessment and measurement
process. But, given that credit risk management is a core competence of banks,
‘these circumstances would be exceptional in nature’.
188
This attitude pervades
the guidance. It also states that management is expected ‘to apply its credit
judgement to consider future scenarios’ and ‘[t]he Committee does not view
the unbiased consideration of forward looking information as speculative’.
189
The guidance, therefore, establishes a high hurdle for when it is not possible
for an internationally active bank to estimate the effects of forward looking
information. It is possible that banking regulators would expect banks to make
an estimate of the effects of events with an uncertain binary outcome that is
highly significant, such as the result of a referendum as discussed by the ITG
in September 2015 (see 4.9.3 above).
A connected piece of the guidance relates to another important principle
in IFRS 9, that reasonable and supportable information should be available
‘without undue cost or effort’. The guidance states that banks are not
expected to read this ‘restrictively’. It goes on to say that, ‘Since the
objective of the IFRS 9 model is to deliver fundamental improvements in
the measurement of credit losses ... this will potentially require costly upfront
investment in new systems and processes’. Such costs ‘should therefore not
be considered undue’.
190
Much of the guidance relates to systems and controls and so is outside the
scope of this publication. The requirements of the main section that relate
to accounting include:
•
There should be commonality in the processes, systems, tools and data
used to assess credit risk and to measure ECLs for accounting and for
regulatory capital purposes.
191
•
When a bank’s individual assessment of exposures does not adequately
consider forward-looking information, it is appropriate to group lending
exposures with shared credit risk characteristics to estimate the impact
of forward-looking information, including macroeconomic factors (see 5.5
above).
192
The grouping of lending exposures into portfolios with shared
credit risk characteristics must be re-evaluated regularly (including re-
segmentation in light of relevant new information or changes in the bank’s
187
Basel Committee on Banking Supervision, Guidance on credit risk and accounting for expected
credit losses, Paragraph A55, December 2015.
188
Basel Committee on Banking Supervision, Guidance on credit risk and accounting for expected
credit losses, Paragraph 22, December 2015.
189
Basel Committee on Banking Supervision, Guidance on credit risk and accounting for expected
credit losses, Paragraph 21, December 2015.
190
Basel Committee on Banking Supervision, Guidance on credit risk and accounting for expected
credit losses, Paragraph A47, December 2015.
191
Basel Committee on Banking Supervision, Guidance on credit risk and accounting for expected
credit losses, Paragraph 69, December 2015.
192
Basel Committee on Banking Supervision, Guidance on credit risk and accounting for expected
credit losses, Paragraph 57, December 2015.
100 April 2018 Impairment of financial instruments under IFRS 9
expectations). Groupings must be granular enough to assess changes in
credit risk and changes in a part of the portfolio must not be masked by
the performance of the portfolio as a whole.
193
•
‘Adjustments’ may be used to address events, circumstances or risk factors
that are not fully considered in credit rating and modelling processes.
But the Committee expects that such adjustments will be temporary. If
the reason for an adjustment is not expected to be temporary then the
processes should be updated to incorporate that risk driver. The guidance
goes on to say that adjustments require judgement and create the potential
for bias. Therefore, they should be subject to appropriate governance
processes.
194
•
The ‘consideration of forward-looking information and macroeconomic
factors is considered essential to the proper implementation of an ECL
model. It cannot be avoided on the basis that the banks consider the
costs to be excessive or unnecessary or because there is uncertainty
in formulating forward looking scenarios’. However, the Committee
recognises that an ECL is ‘an estimate and thus may not perfectly predict
actual outcomes. Accordingly, the need to incorporate such information
is likely to increase the inherent degree of subjectivity in ECL estimates,
compared with impairment measured using incurred loss approaches’.
Also, the Basel Committee recognises that it may not always be possible
to demonstrate a strong link in formal statistical terms between certain
types of information and the credit risk drivers. Consequently, a bank’s
experienced credit judgement will be crucial in establishing the appropriate
level for the individual or collective allowance.
195
•
Although the final version of the guidance notes less about disclosures
than the draft version, given the publication of the Enhanced Disclosure
Task Force (EDTF) recommendations, disclosure remains one of the key
principles (see 14 below).
The guidance is supplemented by an appendix that outlines additional
supervisory requirements specific to jurisdictions applying the IFRS 9 ECL
model. The key requirements are outlined below:
•
A bank’s definition of default adopted for accounting purposes should be
guided by the definition used for regulatory purposes, which includes both
a qualitative ‘unlikeliness to pay’ criterion and an objective 90-days-past-
due criterion, described by the Committee as a ‘backstop’.
•
The IFRS 9 requirement to assess whether exposures have significantly
increased in credit risk ‘is demanding in its requirements for data, analysis
and use of experienced credit judgement’. The determination should be
made ‘on a timely and holistic basis’, considering a wide range of current
information. It is critical that banks have processes in place to ensure that
financial instruments, whether assessed individually or collectively, are
moved from the 12-month to the lifetime ECL measurement as soon as
credit risk has increased significantly. Credit losses very often begin to
deteriorate a considerable period of time before an actual delinquency
occurs and delinquency data are generally backward-looking. Therefore,
‘the Committee believes that they will seldom on their own be appropriate
193
Basel Committee on Banking Supervision, Guidance on credit risk and accounting for expected
credit losses, Paragraphs 46 - 49, December 2015.
194
Basel Committee on Banking Supervision, Guidance on credit risk and accounting for expected
credit losses, Paragraphs 50, 51 and 58, December 2015.
195
Basel Committee on Banking Supervision, Guidance on credit risk and accounting for expected
credit losses, Paragraphs 64 and 65, December 2015.
Delinquency data alone
will seldom be sufficient
to inform a bank’s
staging assessment.
101 April 2018 Impairment of financial instruments under IFRS 9
in the implementation of an ECL approach by a bank.’ Instead, banks need
to consider the linkages between macroeconomic factors and borrower
attributes, using historical information to identify the main risk drivers,
and current and forecast conditions and experienced credit judgement
to determine loss expectations. This will apply not only to collective
assessments of portfolios, but also for assessments of individual loans.
The guidance gives the example of a commercial property loan, for
which the bank should assess the sensitivity of the property market to
the macroeconomic environment and use information such as interest
rates or vacancy rates to make the assessment.
196
•
In assessing whether there has been a significant increase in credit risk,
banks should not rely solely on quantitative analysis. The guidance draws
banks’ attention to the list of qualitative indicators set out in paragraph
B5.5.17 of the standard. Particular consideration should be given to
a list of conditions, including an increased credit spread for a particular
loan, a decision to strengthen collateral and/or covenant requirements,
a downgrade by a credit rating agency or within the bank’s internal credit
rating system, a deterioration in future cash flows, or an expectation
of forbearance or restructuring Also, the guidance stresses that the
sensitivity of the risk of a default occurring to rating downgrades increases
strongly as rating quality declines. Therefore, the widths of credit risk
grades need to be set appropriately, so that significant increases in
credit risk are not masked. Further, ‘if a decision is made to intensify
the monitoring of a borrower or class of borrowers, it is unlikely that
such action would have been taken ... had the increase in credit risk
not been perceived as significant.
197
•
Exposures that are transferred to stage 2 and that are subsequently
renegotiated or modified, but not derecognised, should not be moved
back to stage 1 until there is sufficient evidence that the credit risk
over the remaining life is no longer significantly higher than on
initial recognition. ‘Typically, a customer would need to demonstrate
consistently good payment behaviour over a period of time before
the credit risk is considered to have decreased.
198
•
IFRS 9 includes a number of practical expedients (see section 5.4 above).
However, as banks are in the business of lending and it is unlikely that
obtaining relevant information will involve undue cost or effort, the Basel
Committee expects their limited use by internationally active banks. For
instance:
• The long-term benefit of a high-quality implementation of an ECL
model that takes into account all reasonable and supportable
information far outweighs the associated costs.
• The use of the low credit risk simplification is considered a low-
quality implementation of the ECL model and its use should be
limited (except for holdings in debt securities, which are out of
scope of the guidance). Also, the reference to an investment grade
rating in the standard is only given as an example of a low credit
risk exposure. An investment grade rating given by a rating agenda
196
Basel Committee on Banking Supervision, Guidance on credit risk and accounting for expected
credit losses, Paragraphs A15 to A21, December 2015.
197
Basel Committee on Banking Supervision, Guidance on credit risk and accounting for expected
credit losses, Paragraphs A23 to A30, December 2015.
198
Basel Committee on Banking Supervision, Guidance on credit risk and accounting for expected
credit losses, Paragraphs A44, December 2015.
102 April 2018 Impairment of financial instruments under IFRS 9
cannot automatically be considered low credit risk because banks
are expected to rely primarily on their own credit assessments.
• Delinquency is a lagging indicator. Therefore, the Committee
does not expect banks not to use the more-than-30-days-past-
due rebuttable presumption as a primary indicator of a significant
increase in credit risk. Banks may only use the rebuttable presumption
as a backstop measure, alongside other earlier indicators, while
any rebuttal of the presumption would have to be accompanied by
a thorough analysis to show that 30 days past due is not correlated
with a significant increase in credit risk.
199
6.2 Global Public Policy Committee (GPPC) guidance
On 17 June 2016, the GPPC published The implementation of IFRS 9
impairment by banks
–
Considerations for those charged with governance
of systemically important banks (the GPPC guidance). The GPPC is
the Global Public Policy Committee of representatives of the six largest
accounting networks. This publication was issued to promote the high-
quality implementation of the accounting for ECLs in accordance with IFRS
and to help those charged with governance to identify the elements of a high-
quality implementation. It was designed to complement other guidance such as
that issued by the Basel Committee (see 6.1 above) and the EDTF (see section
14). It does not purport to amend or interpret the requirements of IFRS 9
in any way. The first half of the GPCC guidance sets out key areas of focus
for those charged with governance. This includes governance and controls,
transition issues and ten questions that those charged with governance might
wish to discuss. The second half of the guidance sets out a sophisticated
approach to implementing each aspect of the requirements of IFRS 9, along
with considerations for a simpler approach and actions that would not be
compliant. Where relevant to understanding the accounting requirements
of IFRS 9, this guidance is reflected in this chapter.
The GPPC guidance regards determination of the level of sophistication of
the approach to be used as one of the key areas of focus for those charged
with governance. Consequently, it provides guidance on how to make this
determination for particular portfolios. It sets out factors to consider at the
level of the entity, such as the extent of systemic risk that the bank poses,
whether it is listed or a public interest entity, the size of the balance sheet
and off-balance sheet credit exposures, and the level and volatility of historical
credit losses. Portfolio-level factors include the entity’s size relative to the
total balance sheet and its complexity, the sophistication of other lending-
related modelling methodologies, the extent of available data, the level of
historical losses and the level and volatility of losses expected in the future.
The document stresses that a simpler approach is not necessarily a lower
quality approach if it is applied to an appropriate portfolio.
Also, on 28 July 2017, the GPPC issued a second paper, The Auditor’s
Response to the Risks of Material Misstatement Posed by Estimates of Expected
Credit Losses under IFRS 9. This paper was written in an effort to assist audit
committees in their oversight of the bank’s auditors with regard to auditing
ECLs. It is addressed primarily to the audit committees of systemically-
important banks (SIBs) because of the relative importance of SIBs to capital
markets and global financial stability but it relevant for other banks as well.
It should be read in conjunction with the initial guidance published in 2016.
199
Basel Committee on Banking Supervision, Guidance on credit risk and accounting for expected
credit losses, Paragraphs A45 to A55, December 2015.
The GPPC guidance aims
to help those charged
with governance to
identify the elements
of a high-quality
implementation of
IFRS 9.
103 April 2018 Impairment of financial instruments under IFRS 9
6.3 Measurement dates of expected credit losses
6.3.1 Date of derecognition and date of initial recognition
Impairment must be assessed and measured at the reporting date. IFRS 9 also
requires a derecognition gain or loss to be measured relative to the carrying
amount at the date of derecognition. This necessitates an assessment and
measurement of ECLs for that particular asset as at the date of derecognition,
as was confirmed by the discussions at the April 2015 ITG meeting. Essentially,
the calculation of derecognition gains or losses is a two-step process:
•
Step 1: ECLs are remeasured at the date of derecognition and presented
in the separate impairment line item in the statement of profit or loss,
as per paragraph 82(ba) of IAS 1 Presentation of Financial Statements. As
mentioned at 4.8.2 above, if the asset is impaired and the sale of the asset
is one of the possible methods of recovery, this scenario should be included
in measuring ECLs. Otherwise, even if the financial asset is about to be sold,
the change in ECL estimate should still reflect the reporting entity’s view
rather than the market’s view of credit losses based upon the remaining
contractual life of the financial asset. Also, the residual life of the asset
should not be deemed to be nil because of the imminent sale and
impairment losses that have not materialised should not be mechanically
reversed to reflect the fact that the reporting entity will no longer be
holding the debt security. This is consistent with examples 13 and 14
of IFRS 9. In particular, a footnote to the last journal entry in example 14
explains that the loss on sale includes the accumulated impairment amount.
•
Step 2: Gains or losses on derecognition are calculated taking into account
all ECLs for financial assets measured at amortised cost and all cumulative
gains or losses previously recognised in other comprehensive income
including those related to ECLs for financial assets measured at fair value
through other comprehensive income. Unlike the requirement to present
gains and losses arising from the derecognition of financial assets
measured at amortised cost as a separate line item in the statement
of profit or loss as per paragraph 82(aa) of IAS 1, there is no specific
presentation requirement for financial assets measured at fair value
through other comprehensive income.
A similar issue is whether impairment needs to be measured at the date that
an asset is modified (see section 7 below).
At the April 2015 meeting, the ITG also discussed a more difficult question,
whether impairment must be measured as at the date of initial recognition
for foreign currency monetary assets. The significance of this is whether
subsequent gains and losses arising from foreign currency retranslation
in the first accounting period should be calculated based on the initial gross
amortised cost or a net amount, after deducting an impairment allowance.
This would affect the allocation of subsequent gains and losses of the asset
in this period to impairment or to foreign currency retranslation, so that it
would be reported in different lines of the profit or loss account.
Differing views were expressed:
•
A few ITG members supported the view that while IFRS 9 does not
expressly require ECLs to be measured at the date of initial recognition,
the requirements of other IFRSs, e.g., IAS 21, may result in an entity
measuring ECLs at the date of initial recognition. Also, Illustrative
Example 14 in IFRS 9 implies the need to include ECLs on initial recognition
in the measurement of foreign exchange gains and losses in respect of
a foreign currency-denominated asset (see Example 20 in section 8.2
104 April 2018 Impairment of financial instruments under IFRS 9
below). However, these members questioned the frequency with which
an entity needed to perform that calculation and pointed out that
considerations of materiality would be a key factor in making this decision.
•
Some other ITG members were of the view that an entity is required
to measure a financial asset at its fair value upon initial recognition
and that consequently measuring ECLs at initial recognition would be
inconsistent with that requirement
.
200
IFRS 9 includes impairment as
part of the subsequent measurement of a financial asset and, as such,
only requires an entity to begin measuring ECLs at the first reporting
date after initial recognition (or on derecognition if that occurs earlier).
201
While the requirements of other IFRSs should be applied to the loss
allowance at that point, the application of those requirements should
not result in an entity having to measure ECLs at a date earlier than
that specifically required by IFRS 9.
The ITG also noted that the illustrative examples are non-authoritative and
illustrate only one way of applying the requirements of IFRS 9. Measuring
a 12-month expected loss using point in time, forward-looking information,
every time that a foreign currency exposure is first recognised would not
be feasible. Given that there was no consensus on this issue, we expect
that there may be diversity in practice.
6.3.2 Trade date and settlement date accounting
For financial assets measured at amortised cost or at fair value through
other comprehensive income, IFRS 9 requires entities to use the trade date
as the date of initial recognition for the purposes of applying the impairment
requirements.
202
This means that entities that use settlement date accounting
for regular way purchases of debt securities may have to recognise a loss
allowance for securities which they have purchased but not yet recognised,
and, correspondingly, no loss allowance for securities that they have sold
but not yet derecognised.
Irrespective of the accounting policy choice for trade date accounting versus
settlement date accounting, the recognition of the loss allowance on the
trade date ensures that entities recognise the loss allowance at the same
time; otherwise entities could choose settlement date accounting to delay
recognising the loss allowance until the settlement date. The effect of this
is similar to accounting for fair value changes for financial assets measured
at fair value through other comprehensive income and those measured at fair
value through profit or loss when settlement date accounting is applied (i.e., a
measurement change needs to be recognised in profit or loss and the statement
of financial position, even if the related assets that are being measured are
only recognised slightly later). It is also consistent with the treatment of ECLs
in loans, where an ECL is calculated in respect of a loan commitment between
the date that the commitment is made and the loan is drawn down.
For settlement date accounting, the recognition of a loss allowance for
an asset that has not yet been recognised raises the question of how that loss
allowance should be presented in the statement of financial position. The time
between the trade date and the settlement date is somewhat similar to a loan
commitment in that the accounting is off balance sheet, which suggests
presentation of the loss allowance as a provision.
In practice, some entities tend to opt for settlement date accounting for
regular way securities recorded at amortised cost, because they do not
200
IFRS 9.5.1.1
201
IFRS 9.3.2.12, 9.5.5.3, 9.5.5.5, 9.5.5.13
202
IFRS 9.5.7.4
105 April 2018 Impairment of financial instruments under IFRS 9
need the additional systems capabilities to account for the securities on trade
date (i.e., they do not need to account for them until the settlement date).
The change from the IAS 39 incurred loss model to the IFRS 9 ECL model
means that the settlement date accounting simplification for financial assets
measured at amortised cost would lose much of its benefit from an operational
perspective.
6.4 Interaction between the initial measurement of debt
instruments acquired in a business combination and
the impairment model of IFRS 9
Consistent with IFRS 9 and IFRS 13, IFRS 3 Business Combinations requires
financial assets acquired in a business combination to be measured by the
acquirer on initial recognition at their fair value.
203
IFRS 3 contains application
guidance explaining that an acquirer should not recognise a separate valuation
allowance (i.e., loss allowance for ECLs) in respect of loans and receivables
acquired in a business combination for contractual cash flows that are deemed
to be uncollectible at the acquisition date. This is because the effects of
uncertainty about future cash flows are included in the fair value measure
.
204
Consequently, the accounting for impairment of debt instruments measured at
amortised cost or fair value through other comprehensive income under IFRS 9
does not affect the accounting for the business combination. At the acquisition
date, the acquired debt instruments are measured at their acquisition-date fair
value, in accordance with IFRS 3. No loss allowance is recognised as part of
the initial measurement of debt instruments that are acquired in a business
combination.
Subsequent accounting for debt instruments acquired in a business combination
after their initial recognition is in the scope of IFRS 9. The impairment
requirements in IFRS 9 are part of the subsequent measurement of those
debt instruments.
205
At the first reporting date after the business combination,
following the guidance in IFRS 9, a loss allowance is recognised.
206
This will
result in an impairment loss that is recognised in profit or loss (rather than an
adjustment to goodwill), just as would be the case if the entity were to originate
those assets or acquire them as a portfolio, rather than acquire them through
a business combination.
207
Despite the colloquial reference to a ‘day one’ loss that results from the ECL
impairment model in IFRS 9, it is important to understand that the recognition
of a loss allowance for newly acquired (whether purchased or originated) debt
instruments that are in the scope of the impairment requirements of IFRS 9
is a matter of subsequent measurement of those financial instruments. This
means that the acquirer recognises the loss allowance for all debt instruments
acquired in a business combination (that are subject to impairment accounting)
in the reporting period that includes the business combination but not as part
of that business combination, and with a corresponding impairment loss in
profit or loss.
The only exception to this is the specific accounting for purchased or originated
credit-impaired financial assets which applies to the extent that the portfolio
includes financial assets which are credit-impaired at the acquisition date (i.e.,
the EIR is determined using a cash flow estimate that includes all ECLs and
no allowance is made for ECLs). A financial asset is credit-impaired when one
203
IFRS 3.18, IFRS 3.36
204
IFRS 3.B41
205
IFRS 9.5.5, 9.5.2.1, 9.5.2.2
206
IFRS 9.5.5.3, 9.5.5.5
207
IFRS 9.5.5.8
In addition to recording
the acquired assets and
liabilities at fair value,
the acquirer in a business
combination will need to
record an expense for
12m ECLs.
106 April 2018 Impairment of financial instruments under IFRS 9
or more events that have a detrimental impact on the estimated future cash
flows of that financial asset have occurred (see section 3.1 above).
6.5 Interaction between expected credit losses calculations
and fair value hedge accounting
Previously, the implementation guidance of IAS 39 made it clear that a fair
value hedge adjustment would be included in the carrying amount of a financial
asset that is subject to the impairment requirements. Otherwise, a part of its
carrying amount would not have a loss allowance or the loss allowance would
be overstated (in the case of a negative fair value hedge adjustment). This
guidance stated that the effect of fair value hedge accounting is to adjust
the EIR, which affects the rate used to discount expected future cash flows.
208
The rationale given in the example is that the original interest rate before the
hedge becomes irrelevant once the carrying amount of the loan is adjusted
for any changes in its fair value attributable to interest rate movements.
Similarly, for a financial asset that becomes credit-impaired, IFRS 9 requires
impairment to be measured by reference to the gross carrying amount of
the asset, which would include the fair value hedge adjustment. Therefore,
for a credit-impaired financial asset in stage 3, the EIR would be adjusted to
reflect any fair value hedge adjustment.
209
However, whereas under IAS 39, most assets that are impaired would not
generally be those for which fair value hedge accounting has been undertaken,
under the new ECL impairment model an allowance is required for assets in
stages 1 and 2, in addition to assets in stage 3. Hence, if the discount rate
were to be adjusted whenever fair value hedge is applied, then all fair value
hedge adjustments would need to be taken into account in calculating ECLs.
This would give rise to significant operational challenges.
IFRS 9 is not explicit on this matter, but two points in the standard would
seem to be relevant. First, unlike IAS 39, except for credit-impaired assets,
the ECL requirements are not based on an asset’s ‘carrying amount’, but on
the contractual cash flows that are expected to be lost. Second, implementation
guidance E4.4 in IAS 39, which stated that a fair value hedge adjusts the EIR,
was not carried forward into the new standard. We understand that removing
this guidance was not intended to change the accounting treatment in this
respect. However, another requirement of IAS 39, carried forward into IFRS 9,
is that a fair value hedge adjustment is only required to be amortised when
the hedged item ceases to be adjusted for changes in fair value attributable
to the risk being hedged, which can be read to imply that until then there is no
need to adjust the EIR, and hence, the rate used to discount ECLs.
210
How we see it
We believe the requirement is not clear, so at least until it is clarified,
there is an accounting policy choice on the matter. One approach would
be to adjust the EIR whenever a fair value hedge adjustment is made
and, hence, change the interest rate used to discount expected losses.
The other would not take into account the fair value hedge adjustment
until the EIR is adjusted to amortise the fair value hedge adjustment.
211
Such an adjustment to the EIR is permitted to commence at any time,
but would, at the latest, be required when hedge accounting ceases or
when the financial asset becomes credit impaired, i.e., moved to stage 3.
208
IAS 39.E.4.4
209
IFRS 9.B5.5.33
210
IFRS 9.6.5.10
211
IFRS 9.6.5.8
107 April 2018 Impairment of financial instruments under IFRS 9
7 Modified financial assets
If the contractual cash flows on a financial asset are renegotiated or modified,
the holder needs to assess whether the financial asset should be derecognised.
In summary, an entity should derecognise a financial asset if the cash flows
are extinguished or if the terms of the instrument have substantially changed.
7.1 Accounting treatment if modified financial assets are
derecognised
In some circumstances, the renegotiation or modification of the contractual
cash flows of a financial asset can lead to the derecognition of the existing
financial asset and subsequently, the recognition of a new financial asset.
212
This means that the entity is starting afresh and the date of the modification
will also be the date of initial recognition of the new financial asset at its fair
value. Typically, the entity will recognise a loss allowance based on 12-month
ECLs at each reporting date unless the requirements for the recognition of
lifetime ECLs are met. However, in what the standard describes as ‘some
unusual circumstances’ following a modification that results in derecognition
of the original financial asset, there may be evidence that the new financial
asset is credit-impaired on initial recognition (see section 3.3 above). Thus,
the financial asset should be recognised as an originated credit-impaired
financial asset. In practice, we believe that more restructured financial assets
will be treated as originated credit-impaired than the Board seems to have
envisaged.
213
7.2 Accounting treatment if modified financial assets are not
derecognised
In other circumstances, the renegotiation or modification of the contractual
cash flows of a financial asset does not lead to the derecognition of the existing
financial asset as per IFRS 9. In such situations, the entity will:
•
Continue with its current accounting treatment for the existing asset that
has been modified
•
Recognise a modification gain or loss in profit or loss by recalculating
the gross carrying amount of the financial asset as the present value
of the renegotiated or modified contractual cash flows, discounted at
the financial asset’s original EIR (or the credit-adjusted EIR for purchased
or originated credit-impaired financial assets). Any costs or fees incurred
adjust the carrying amount of the modified financial asset and are
amortised over the remaining term of the modified financial asset (see
section 3.1 above)
214
•
Assess whether there has been a significant increase in the credit risk of
the financial instrument, by comparing the risk of a default occurring at
the reporting date (based on the modified contractual terms) and the risk of
a default occurring at initial recognition (based on the original, unmodified
contractual terms). A financial asset that has been renegotiated or modified
is not automatically considered to have lower credit risk. The assessment
should consider the credit risk over the expected life of the asset based
on historical and forward-looking information, including information about
the circumstances that led to the modification. Evidence that the criteria
for the recognition of lifetime ECLs are subsequently no longer met may
include a history of up-to-date and timely payment in subsequent periods.
212
IFRS 9.B5.5.25
213
IFRS 9.B5.5.26
214
IFRS 9.5.4.3, Appendix A, IAS 1.82(a)
If the contractual cash
flows on a financial asset
are renegotiated or
modified, the holder
needs to assess whether
the financial asset should
be derecognised.
108 April 2018 Impairment of financial instruments under IFRS 9
This means a minimum period of observation will often be necessary before
a financial asset may qualify to return to stage 1
215
•
Make the appropriate quantitative and qualitative disclosures required for
renegotiated or modified assets to enable users of financial statements to
understand the nature and effect of such modifications (including the effect
on the measurement of ECLs) and how the entity monitors its assets that
have been modified (see 14 below)
216
As highlighted above, IFRS 9 introduces explicit guidance on measuring
financial assets that have been modified but not derecognised. Under IAS 39,
there is no clear guidance on the treatment of modification gains or losses in
profit or loss. For entities that have recognised the modification gain or loss
over the remaining life of the financial asset by adjusting the EIR prospectively
rather than an adjustment to the carrying amount, there will be a need on
transition to IFRS 9 to re-assess as at the time of modification, the change in
carrying value of the financial asset using the original EIR. The difference in
the carrying amounts after taking into account the subsequent amortisation
will be recorded in retained earnings on transition.
Reductions in the carrying value will be partially offset by an increase in
amortisation in the period between the date of modification and the date
of transition, as the original EIR will be used to amortise the modified assets
during this period.
The example below has been adapted from Example 11 of the Implementation
Guidance in IFRS 9 to illustrate the accounting treatment of a loan that is
modified.
217
Example 18: Modification of contractual cash flow
Bank A originates a five-year loan that requires the repayment of the outstanding
contractual amount in full at maturity. Its contractual par amount is €1,000 with
an interest rate of 5 per cent, payable annually. The EIR is 5 per cent. At the end
of the first reporting period in Year 1, Bank A recognises a loss allowance at
an amount equal to 12-month ECLs because there has not been a significant
increase in credit risk since initial recognition. A loss allowance balance of €20
is recognised. In Year 2, Bank A determines that the credit risk on the loan has
increased significantly since initial recognition. As a result, Bank A recognises
lifetime ECLs on the loan. The loss allowance balance is €150.
At the end of Year 3, following significant financial difficulty of the borrower, Bank A
modifies the contractual cash flows on the loan. It forgoes interest payments and
extends the contractual term of the loan by one year so that the remaining term
at the date of the modification is three years. The modification does not result in
derecognition of the loan by Bank A.
As a result of that modification, Bank A recalculates the gross carrying amount
of the financial asset as the present value of the modified contractual cash flows
discounted at the loan’s original EIR of 5 per cent. The difference between this
recalculated gross carrying amount and the gross carrying amount before the
modification is recognised as a modification gain or loss. Bank A recognises
the modification loss (calculated as €136) against the gross carrying amount
of the loan, reducing it to €864, and a modification loss of €136 in profit or loss.
215
IFRS 9.5.5.12, B5.5.27
216
IFRS 7.35F(f), B8B, 35J
217
IFRS 9 IG Example 11 IE66-IE73
109 April 2018 Impairment of financial instruments under IFRS 9
Example 18: Modification of contractual cash flow (cont’d)
Bank A also remeasures the loss allowance, taking into account the modified
contractual cash flows and evaluates whether the loss allowance for the loan
should continue to be measured at an amount equal to lifetime ECLs. Bank A
compares the current credit risk (taking into consideration the modified cash
flows) to the credit risk (on the original unmodified cash flows) at initial recognition.
Bank A determines that the loan is not credit-impaired at the reporting date, but
that credit risk has still significantly increased compared with the credit risk at
initial recognition. It continues to measure the loss allowance at an amount equal
to lifetime ECLs, which are €110 at the reporting date.
At each subsequent reporting date, Bank A continues to evaluate whether there
has been a significant increase in credit risk by comparing the loan’s credit risk at
initial recognition (based on the original, unmodified cash flows) with the credit risk
at the reporting date (based on the modified cash flows).
Two reporting periods after the loan modification (Year 5), the borrower has
outperformed its business plan significantly compared to the expectations at
the modification date. In addition, the outlook for the business is more positive
than previously envisaged. An assessment of all reasonable and supportable
information that is available without undue cost or effort indicates that the overall
credit risk on the loan has decreased and that the risk of a default occurring over
the expected life of the loan has decreased, so Bank A adjusts the borrower’s
internal credit rating at the end of the reporting period.
Given the positive overall development, Bank A re-assesses the situation and
concludes that the credit risk of the loan has decreased and there is no longer
a significant increase in credit risk since initial recognition. As a result, Bank A
once again measures the loss allowance at an amount equal to 12-month ECLs.
Year
Beginning
gross
carrying
amount
Impairment
(loss)/gain
Modification
(loss)/gain
Interest
revenue
Cash
flows
Ending
gross
carrying
amount
Loss
allowance
Ending
amortised
cost
amount
A
B
C
D Gross: A
× 5%
E
F = A + C
+ D – E
G
H = F – G
1
€1,000
(€20)
€50
€50
€1,000
€20
€980
2
€1,000
(€130)
€50
€50
€1,000
€150
€850
3
€1,000
€40
(€136)
€50
€50
€864
€110
€754
4
€864
€24
€43
€907
€86
€821
5
€907
€72
€45
€952
€14
€938
6
€952
€14
€48
€1,000
€0
€0
€0
At its meeting on 22 April 2015, the ITG (see section 1.5 above) discussed
the measurement of ECLs in respect of a modified financial asset where the
modification does not result in derecognition, but the cash flows have been
renegotiated to be consistent with those previously expected to be paid.
218
The ITG noted that IFRS 9 is clear that an entity is required to calculate a new
gross carrying amount and the gain or loss on modification taken to profit
or loss should be based on the renegotiated or modified contractual cash
flows and excludes ECLs unless it is a purchased or originated credit-impaired
financial asset.
219
Consequently, an entity must calculate the gain or loss
on modification as a first step before going on to consider the revised ECL
218
Transition Resource Group for Impairment of Financial Instruments, Agenda ref 8,
Measurement of expected credit losses in respect of a modified financial asset , 22 April
2015.
219
IFRS 9.5.4.3, Appendix A
110 April 2018 Impairment of financial instruments under IFRS 9
allowance required on the modified financial asset. Thereafter, the entity is
required to continue to apply the impairment requirements to the modified
financial asset in the same way as it would for other unmodified financial
instruments, taking into account the revised contractual terms.
220
The revised
ECL cannot be assumed to be nil as, in accordance with paragraph 5.5.18
of IFRS 9, an entity is required to consider the possibility that a credit loss
occurs, even if the likelihood of that credit loss occurring is very low.
221
The ITG also discussed the appropriate presentation and disclosure
requirements pertaining to modifications. These are discussed further in
section 14.
We note that if an entity has no reasonable expectations of recovering a portion
of the financial asset, which is subsequently forgiven, then this amount should
arguably be written off, as a partial derecognition. The gross carrying amount
would be reduced directly before a modification gain or loss is calculated.
222
This will mean that the loss will be recorded as an impairment loss, rather than
as a loss on modification, and presented differently in the profit or loss account.
8 Financial assets measured at fair value
through other comprehensive income
For financial assets measured at fair value through other comprehensive
income, the ECLs do not reduce the carrying amount in the statement of
financial position, which remains at fair value. Instead, an amount equal to
the allowance that would arise if the asset were measured at amortised cost
is recognised in other comprehensive income as the ‘accumulated impairment
amount’.
223
8.1 Accounting treatment for debt instruments measured at
fair value through other comprehensive income
The accounting treatment and journal entries for debt instruments measured at
fair value through other comprehensive income are illustrated in the following
example, based on Illustrative Example 13 in the Implementation Guidance for
the standard.
224
Example 19: Debt instrument measured at fair value through
other comprehensive income
An entity purchases a debt instrument with a fair value of £1,000 on 15 December
2018 and measures the debt instrument at fair value through other comprehensive
income (FVOCI). The instrument has an interest rate of 5 per cent over the
contractual term of 10 years, and has a 5 per cent EIR. At initial recognition the
entity determines that the asset is not purchased or originated credit-impaired.
Debit
Credit
Financial asset – FVOCI
£1,000
Cash
£1,000
(To recognise the debt instrument measured at its fair value)
220
IFRS 9.5.5.12
221
IFRS 9.5.5.18
222
IFRS 9.5.4.4, B5.4.9
223
IFRS 9.4.1.2A, 5.5.2, Appendix A
224
IFRS 9 IG Example 13, IE78-IE81
For debt instruments
measured at FVOCI,
ECLs do not reduce
the carrying amount in
the statement of financial
position, which remains
at fair value. Instead,
an amount equal to the
allowance that would
arise if the asset was
measured at amortised
cost, is recognised in other
comprehensive income .
111 April 2018 Impairment of financial instruments under IFRS 9
Example 19: Debt instrument measured at fair value through
other comprehensive income (cont’d)
On 31 December 2018 (the reporting date), the fair value of the debt instrument has
decreased to £950 as a result of changes in market interest rates. The entity
determines that there has not been a significant increase in credit risk since initial
recognition and that ECLs should be measured at an amount equal to 12-month ECLs,
which amounts to £30. For simplicity, journal entries for the receipt of interest
revenue are not provided.
Debit
Credit
Impairment loss (profit or
loss)
£30
Other comprehensive
income
(a)
£20
Financial asset – FVOCI
£50
(To recognise 12-month ECLs and other fair value changes on the debt instrument)
(a) The cumulative loss in other comprehensive income at the reporting date was
£20. That amount consists of the total fair value change of £50 (i.e., £1,000 –
£950) offset by the change in the accumulated impairment amount representing
12-month ECLs that was recognised (£30).
Disclosure would be provided about the accumulated impairment amount of £30.
On 1 January 2019, the entity decides to sell the debt instrument for £950, which
is its fair value at that date.
Debit
Credit
Cash
£950
Financial asset – FVOCI
£950
Loss (profit or loss)
£20
Other comprehensive income
£20
(To derecognise the fair value through other comprehensive income asset and recycle
amounts accumulated in other comprehensive income to profit or loss, i.e. £20).
This means that, in contrast to financial assets measured at amortised cost,
there is no separate allowance. Instead, impairment gains or losses are
accounted for as an adjustment of the revaluation reserve accumulated
in other comprehensive income, with a corresponding charge to profit or
loss (which is then reflected in retained earnings).
As explained in section 6.3.1 above, IFRS 9 requires a derecognition gain
or loss to be measured relative to the carrying amount at the date of
derecognition. This necessitates an assessment and measurement of
ECLs for that particular asset as at the date of derecognition.
8.2 Interaction between foreign currency translation, fair
value hedge accounting and impairment
The above example is relatively straightforward. A more complicated one,
based on a foreign currency denominated financial asset which is also the
subject of an interest rate hedge, is provided below. It is based on Illustrative
Example 14 in the Implementation Guidance for the standard, but has been
adjusted so as to include the effect of discounting in the measurement of
ECLs (see section 4.7 above).
225
Note that we do not address the additional
complexities that will arise from the consideration of taxation, including
deferred tax.
225
IFRS 9.IE82-IE102
112 April 2018 Impairment of financial instruments under IFRS 9
Example 20: Interaction between the fair value through other
comprehensive income measurement category and foreign
currency denomination, fair value hedge accounting and
impairment
The example assumes the following fact pattern and that, on initial recognition, ECLs
are included when measuring foreign exchange gains and losses (see section 6.3.1
above):
•
An entity purchases a bond denominated in a foreign currency (FC) for its
fair value of FC100,000 on 1 January 2018.
•
The bond is held within a business model whose objective is achieved by
both collecting contractual cash flows and selling financial assets and has
contractual cash flows which are solely payments of principal and interest
on the principal amount outstanding. Therefore, the entity classifies the bond
as measured at fair value through other comprehensive income.
•
The bond has five years remaining to maturity and a fixed coupon of 5 per cent
over its contractual life on the contractual par amount of FC100,000.
•
The entity hedges the bond for its interest rate related fair value risk. The fair
value of the corresponding interest rate swap at the date of initial recognition
is nil.
•
On initial recognition, the bond has a 5 per cent EIR which results in a gross
carrying amount that equals the fair value at initial recognition.
•
The entity’s functional currency is its local currency (LC).
•
As at 1 January 2018, the exchange rate is FC1 to LC1.
•
At initial recognition, the entity determines that the bond is not purchased
credit-impaired. The entity applies a 12-month PD for its impairment calculation
and assumes that payment default occurs at the end of the reporting period
(i.e., after 12 months). In particular, the entity estimates the PD over the next
12 months at 2 per cent and the LGD at FC60,000, resulting in an (undiscounted)
expected cash shortfall of FC1,200. The discounted expected cash shortfall is
FC1,143 at 5 per cent EIR (see the example below for the detailed calculation).
•
For simplicity, amounts for interest revenue are not provided. It is assumed that
interest accrued is received in the period. Differences of 1 in the calculations and
reconciliations are due to rounding.
The entity hedges its risk exposures using the following risk management strategy:
(a) for fixed interest rate risk (in FC) the entity decides to link its interest receipts
in FC to current variable interest rates in FC. Consequently, the entity uses
interest rate swaps denominated in FC under which it pays fixed interest and
receives variable interest in FC; and
(b) for foreign exchange (FX) risk, the entity decides not to hedge against any
variability in LC arising from changes in foreign exchange rates.
The entity designates the following hedging relationship: a fair value hedge of
the bond in FC as the hedged item with changes in benchmark interest rate risk in
FC as the hedged risk. The entity enters into a swap that pays fixed and receives
variable interest in FC on the same day and designates the swap as the hedging
instrument. The tenor of the swap matches that of the hedged item (i.e., five
years). This example assumes that all qualifying criteria for hedge accounting
are met (see paragraph 6.4.1 of IFRS 9). The description of the designation is
solely for the purpose of understanding this example (i.e., it is not an example of
the complete formal documentation required in accordance with paragraph 6.4.1
of IFRS 9).
113 April 2018 Impairment of financial instruments under IFRS 9
Example 20: Interaction between the fair value through other
comprehensive income measurement category and foreign
currency denomination, fair value hedge accounting and
impairment (cont’d)
This example assumes that no hedge ineffectiveness arises in the hedging
relationship. This assumption is made in order to better focus on illustrating
the accounting mechanics in a situation that entails measurement at fair value
through other comprehensive income of a foreign currency financial instrument
that is designated in a fair value hedge relationship, and also to focus on the
recognition of impairment gains or losses on such an instrument.
The entity decided not to amortise the fair value hedge adjustment to profit or
loss before the hedge ceases or the asset is credit-impaired. Consequently, in
this example, there is no adjustment to the EIR due to fair value hedge accounting.
However, such an adjustment to the EIR would at the latest be required when the
entity ceases to apply hedge accounting or when the asset becomes credit-impaired,
i.e., moved to stage 3 (See section 6.5 above).
Situation as per 1 January 2018
The table below illustrates the amounts recognised in the financial statements
as per 1 January 2018, as well as the shadow amortised cost calculation for the
bond, based on the fact pattern described above (debits are shown as positive
numbers and credits as negative numbers):
Financial Statements
Shadow Calculation
FC
LC
FC
LC
Statement of financial
position
Bond (FV)
100,000
100,000
Gross
carrying
amount
100,000
100,000
Swap (FV)
–
–
Loss
allowance
(1,143)
(1,143)
Amortised
cost
98,857
98,857
Statement of
profit or loss
Impairment
1,143
1,143
FV hedge
adjustment
–
–
FV hedge
(bond)
–
–
Adjusted
gross
carrying amt.
100,000
100,000
FX gain/loss
(bond)
–
–
Adjusted
amortised
cost
98,857
98,857
FV hedge
(swap)
–
–
FX gain/loss
(swap)
–
–
Statement of OCI
FV changes
–
–
Impairment
offset
(1,143)
(1,143)
FV hedge
adjustment
–
–
114 April 2018 Impairment of financial instruments under IFRS 9
Example 20: Interaction between the fair value through other
comprehensive income measurement category and foreign
currency denomination, fair value hedge accounting and
impairment (cont’d)
As per 1 January 2018, the entity recognises the bond and the swap at their initial
fair values of LC100,000 and nil, respectively. The loss allowance
of FC1,143 is recognised in profit or loss. The amount is calculated as the
difference between all contractual cash flows that are due to the entity in
accordance with the contract and all the cash flows that the entity expects to
receive (i.e., all cash shortfalls), discounted at the original effective interest
of 5 per cent, and weighted by the probability of the scenario occurring. To keep
the example simple, it is assumed that default on the bond occurs one year after
the date of the initial recognition, at which point the recoverable amount of the
bond is received. This means that in the case of a default the entity expects cash
flows of FC45,000 (which is the principal of FC100,000 plus one year of interest of
FC5,000 less the LGD of FC60,000). The latter
loss is discounted by the 5 per cent EIR and weighted by the 2 per cent PD
to arrive at the loss allowance. The table below shows the ECL calculation:
1 January
2018
(values in
FC)
Year 1
Year 2
Year 3
Year 4
Year 5
Contractual
cash flows
5,000
5,000
5,000
5,000
105,000
Expected
cash flows
45,000
Expected
cash
shortfalls
40,000
(5,000)
(5,000)
(5,000)
(105,000)
NPV at 5%
(57,143)
PD
2%
ECL
(1,143)
In accordance with paragraph 16A of IFRS 7, the loss allowance for financial
assets measured at fair value through other comprehensive income is not
presented separately as a reduction of the carrying amount of the financial
asset. As a consequence, the offsetting entry to the impairment loss of LC1,143
is recorded in other comprehensive income in the same period.
Situation as at 31 December 2018
As of 31 December 2018 (the reporting date), the entity observes the following
facts:
•
The fair value of the bond has decreased from FC100,000 to FC96,370, mainly
because of an increase in market interest rates.
•
The fair value of the swap has increased to FC1,837.
•
In addition, as at 31 December 2018, the entity determines that there has been
no change to the credit risk on the bond since initial recognition. The entity
still estimates the PD over the next 12 months at 2 per cent and the LGD at
FC60,000, resulting in an (undiscounted) expected shortfall of FC1,200.
•
As at 31 December 2018, the exchange rate is FC1 to LC1.4.
115 April 2018 Impairment of financial instruments under IFRS 9
Example 20: Interaction between the fair value through other
comprehensive income measurement category and foreign
currency denomination, fair value hedge accounting and
impairment (cont’d)
The table below illustrates the amounts recognised in the financial statements
between 1 January 2018 (after the entries for the impairment loss of FC1,143 at
1 January, shown above) and 31 December 2018, as well as the shadow amortised
cost calculation for the bond (debits are shown as positive numbers and credits as
negative numbers)
Financial statements
Shadow calculation
FC
LC
FC
LC
Statement of financial
position
Bond (FV)
96,370
134,918
Gross
carrying
amount
100,000
140,000
Swap (FV)
1,837
2,572
Loss
allowance
(1,143)
(1,600)
Amortised
cost
98,857
138,400
Statement of
profit or loss
Impairment
–
–
FV hedge
adjustment
(1,837)
(2,572)
FV hedge
(bond)
1,837
2,572
Adjusted
gross
carrying
amount
98,163
137,428
FX gain/loss
(bond)
(39,543)
Adjusted
amortised
cost
97,020
135,828
FV hedge
(swap)
(1,837)
(2,572)
FX gain/loss
(swap)
–
–
Statement of OCI
FV changes
3,630
4,625
Impairment
offset
–
–
FV hedge
adjustment
(1,837)
(2,572)
Because the entity has maintained the expected cash shortfall pattern and its
probability of occurring, the change in estimate is just the effect of deferral by
a year of the expected date of default, which exactly offsets the unwinding of
the discount.
The bond is a monetary asset. Consequently, the entity recognises the changes
arising from movements in foreign exchange rates in profit or loss in accordance
with paragraphs 23(a) and 28 of IAS 21 and recognises other changes in
accordance with IFRS 9. For the purposes of applying paragraph 28 of IAS 21,
the asset is treated as an asset measured at amortised cost in the foreign
currency.
The change in the fair value of the bond since 1 January 2018 amounts to
LC34,918 and is recognised as a fair value adjustment to the carrying amount
of the bond on the entity’s statement of financial position.
The gain of LC39,543 due to the changes in foreign exchange rates is recognised
in profit or loss. It consists of the impact of the change in the exchange rates
during 2018:
•
On the original gross carrying amount of the bond, amounting to LC40,000
•
Offset by the loss allowance of the bond, amounting to LC457 (i.e., the difference
of FC1,143 translated at the exchange rate as at 1 January 2018 of FC1 to LC1
and FC1,143 translated at the exchange rate as at 31 December 2018 of FC1 to
LC1.4)
116 April 2018 Impairment of financial instruments under IFRS 9
Example 20: Interaction between the fair value through other
comprehensive income measurement category and foreign
currency denomination, fair value hedge accounting and
impairment (cont’d)
The difference between the change in fair value (LC34,918) and the gain recognised
in profit or loss that is due to the changes in foreign exchange rates (LC39,543) is
recognised in OCI. That difference amounts to LC4,625.
A gain of LC2,572 (FC1,837) on the swap is recognised in profit or loss and,
because it is assumed that there is no hedge ineffectiveness, this amount coincides
with the loss on the hedged item. Illustrative Example 14 of IFRS 9 seems to
suggest that the hedging gain or loss of a debt instrument at fair value through
other comprehensive income is recycled from other comprehensive income in
the same period but, since paragraph 6.5.8(b) of IFRS 9 requires the hedging gain
or loss on the hedged item to be recognised in profit or loss and the offsetting
entry is to OCI, this is not strictly ‘recycling’
Situation as at 31 December 2019
As of 31 December 2019 (the reporting date), the entity observes the following
facts:
•
The fair value of the bond has further decreased from FC96,370 to FC87,114.
•
The fair value of the swap has increased to FC2,092.
•
Based on adverse macroeconomic developments in the industry in which
the bond issuer operates, the entity assumes a significant increase in credit
risk since initial recognition, and recognises the lifetime ECL for the bond.
•
The entity updates its impairment estimate and now estimates the lifetime PD
at 20 per cent and the LGD at FC48,500, resulting in (undiscounted) expected
cash shortfalls of FC9,700. (For simplicity, this example assumes that payment
default will happen on maturity when the entire face value becomes due).
•
As at 31 December 2019, the exchange rate is FC1 to LC1.25.
The table below illustrates the amounts recognised in the financial statements
between 31 December 2018 and 31 December 2019, as well as the shadow
amortised cost calculation for the bond (debits are shown as positive numbers
and credits as negative numbers):
Financial statements
Shadow calculation
FC
LC
FC
LC
Statement of financial
position
Bond (FV)
87,114
108,893
Gross
carrying
amount
100,000
125,000
Swap (FV)
2,092
2,615
Loss
allowance
(8,379)
(10,474)
Amortised
cost
91,621
114,526
Statement of
profit or loss
Impairment
7,236
9,045
FV hedge
adjustment
(2,092)
(2,615)
FV hedge
(bond)
255
319
Adj. gross
carrying amt.
97,908
122,385
FX gain/loss
(bond)
14,553
Adj.
amortised
cost
89,529
111,911
FV hedge
(swap)
(255)
(319)
FX gain/loss
(swap)
276
Statement of OCI
FV changes
9,256
11,472
Impairment
offset
(7,236)
(9,045)
FV hedge
adjustment
(255)
(319)
117 April 2018 Impairment of financial instruments under IFRS 9
Example 20: Interaction between the fair value through other
comprehensive income measurement category and foreign
currency denomination, fair value hedge accounting and
impairment (cont’d)
The table below illustrates the ECL calculation:
31 December 2019
(values in FC)
Year 3
Year 4
Year 5
Contractual cash flows
5,000
5,000
105,000
Expected cash flows
5,000
5,000
56,500
Expected cash shortfalls
–
–
(48,500)
NPV at 5%
(41,896)
PD
20%
ECL
(8,379)
Again, the table above shows how the ECL is calculated as the net present value
of the cash shortfalls, i.e., the difference between contractual and expected
cash flows on each relevant date multiplied by the PD. The offsetting entry of
the impairment loss FC7,236 (LC9,045) is recorded in other comprehensive
income in the same period.
The change in the fair value of the bond since 31 December 2018 amounts to
a decrease of LC26,026 and is recognised as a fair value adjustment to the
carrying amount of the bond on the entity’s statement of financial position.
The loss of LC14,553 due to the changes in foreign exchange rates is recognised
in profit or loss. It consists of the impact of the change in the exchange rates
during 2019:
•
On the original gross carrying amount of the bond, amounting to a loss
of LC15,000;
•
On the loss allowance of the bond, amounting to a gain of LC171;
•
On the fair value hedge adjustment, amounting to a gain of LC276.
The difference between the change in fair value (decrease of LC26,026) and the
loss recognised in profit or loss that is due to the changes in foreign exchange
rates (–LC14,553) is recognised in OCI.
A gain of LC319 (FC255) on the swap is recognised in profit or loss and, because
it is assumed that there is no hedge ineffectiveness, this amount coincides with
the loss on the hedged item.
Situation as at 1 January 2020
On 1 January 2020, the entity decides to sell the bond for FC87,114, which is its
fair value at that date and also closes out the swap at its fair value. For simplicity,
all amounts, including the foreign exchange rate, are assumed to be the same as
at 31 December 2019.
Upon derecognition, the entity reclassifies the cumulative amount recognised
in OCI of (LC3,018) ((FC2,415)) to profit or loss. This amount is equal to the
difference between the fair value and the adjusted amortised cost amount
of the bond, including the fair value hedge adjustment at the time of its
derecognition. The table below presents a reconciliation of those amounts.
118 April 2018 Impairment of financial instruments under IFRS 9
Example 20: Interaction between the fair value through other
comprehensive income measurement category and foreign
currency denomination, fair value hedge accounting and
impairment (cont’d)
Reconciliation of loss on derecognition (values in LC) to cumulative OCI
Fair value per
1 January
2020
108,893
Adjusted
amortised cost
per 1 January
2020
111,911
Loss
(3,018)
Cum. OCI
1 January
2018
31 December
2018
31 December
2019
FV changes
16,097
–
4,625
11,472
Impairment
(10,188)
(1,143)
–
(9,045)
FV hedge
adjustment
(2,891)
–
(2,572)
(319)
Total OCI to
be
reclassified
3,018
This table presents the amount that has not yet been recycled and, therefore, must
be reclassified to profit or loss on derecognition.
119 April 2018 Impairment of financial instruments under IFRS 9
9 Trade receivables, contract assets and
lease receivables
The standard provides some operational simplifications for trade receivables,
contract assets and lease receivables. These are the requirement or policy
choice to apply the simplified approach that does not require entities to track
changes in credit risk (see section 3.2 above) and the practical expedient to
calculate ECLs on tradaawe receivables using a provision matrix (see 9.1
below).
9.1 Trade receivables and contract assets
It is a requirement for entities to apply the simplified approach for trade
receivables or contract assets that do not contain a significant financing
component. However, entities have a policy choice to apply either the general
approach (see section 3.1 above) or the simplified approach separately to
trade receivables and contract assets that do contain a significant financing
component (see section 3.2 above).
226
Also, entities are allowed to use practical expedients when measuring ECLs, as
long as the approach reflects a probability-weighted outcome, the time value
of money and reasonable and supportable information that is available without
undue cost or effort at the reporting date about past events, current conditions
and forecasts of future economic conditions.
227
One of the approaches suggested in the standard is the use of a provision
matrix as a practical expedient for measuring ECLs on trade receivables. For
instance, the provision rates might be based on days past due (e.g., 1 per cent
if not past due, 2 per cent if less than 30 days past due, etc.) for groupings
of various customer segments that have similar loss patterns. The grouping
may be based on geographical region, product type, customer rating, type
of collateral or whether covered by trade credit insurance, and the type of
customer (such as wholesale or retail). To calibrate the matrix, the entity
would adjust its historical credit loss experience with forward-looking
information.
228
In practice, many corporates use a provision matrix to calculate their
current impairment allowances. However, in order to comply with the IFRS 9
requirements, corporates would need to consider how current and forward-
looking information might affect their customers’ historical default rates and,
consequently, how the information would affect their current expectations and
estimates of ECLs. The use of the provision matrix is illustrated in the following
example:
229
Example 21: Provision matrix
Company M, a manufacturer, has a portfolio of trade receivables of €30 million
in 2018 and operates only in one geographical region. The customer base consists
of a large number of small clients and the trade receivables are categorised by
common risk characteristics that are representative of the customers’ abilities
to pay all amounts due in accordance with the contractual terms. The trade
receivables do not have a significant financing component in accordance with
IFRS 15. In accordance with paragraph 5.5.15 of IFRS 9, the loss allowance for
such trade receivables is always measured at an amount equal to lifetime ECLs.
226
IFRS 9.5.5.15(a)
227
IFRS 9.5.5.17, B5.5.35
228
IFRS 9.B5.5.35
229
IFRS 9 IG Example 12, IE74-IE77
The standard provides
some operational
simplifications for trade
receivables, contract
assets and lease
receivables.
120 April 2018 Impairment of financial instruments under IFRS 9
Example 21: Provision matrix (cont’d)
To determine the ECLs for the portfolio, Company M uses a provision matrix. The
provision matrix is based on its historical observed loss rates over the expected
life of the trade receivables and is adjusted for forward-looking estimates. At every
reporting date, the historical observed loss rates are updated and changes in the
forward-looking estimates are analysed. In this case, it is forecast that economic
conditions will deteriorate over the next year.
On that basis, Company M estimates the following provision matrix:
Current
1-30 days
past due
31-60 days
past due
61-90 days
past due
More than
90 days
past due
Loss rate
0.3%
1.6%
3.6%
6.6%
10.6%
The trade receivables from the large number of small customers amount
to €30 million and are measured using the provision matrix.
Gross carrying amount
Lifetime ECL allowance
(Gross carrying amount ×
lifetime ECL rate)
Current
€15,000,000
€45,000
1-30 days past due
€7,500,000
€120,000
31-60 days past
due
€4,000,000
€144,000
61-90 days past
due
€2,500,000
€165,000
More than 90 days
past due
€1,000,000
€106,000
€30,000,000
€580,000
It should be noted that this example, like many in the standard, ignores the need to
consider explicitly the time value of money, presumably in this case because the effect
is considered immaterial.
9.2 Lease receivables
For lease receivables, entities have a policy choice to apply either the general
approach (see section 3.1 above) or the simplified approach (see section 3.2
above) separately to finance and operating lease receivables.
230
When measuring ECLs for lease receivables, an entity should:
•
Use the cash flows that are used in measuring the lease receivables
in accordance with IAS 17 or IFRS 16 (when applied)
231
•
Discount the ECLs using the same discount rate used in the
measurement of the lease receivables in accordance with IAS 17
or IFRS 16 (when applied)
232
There has been some discussion on whether the unguaranteed residual
value (URV) of the asset subject to a finance lease should be included in the
calculation of ECLs under IFRS 9. The URV is part of the gross investment in
the finance lease, together with the minimum lease payments receivable by
the lessor. Changes to URV arise from fluctuations in the price that could be
received for the leased asset at the end of the lease term. Paragraph 2.1(b) of
IFRS 9 scopes out rights and obligations under leases to which IAS 17 applies,
except for the impairment of finance lease receivables (i.e., net investments
230
IFRS 9.5.5.15(b)
231
IFRS 9.B5.5.34
232
IFRS 9.B5.5.46, IAS 17.4
For lease receivables,
entities have a policy
choice to apply either
the general approach or
the simplified approach.
121 April 2018 Impairment of financial instruments under IFRS 9
in finance leases) and operating lease receivables recognised by a lessor
(see section 2 above). Furthermore, IAS 17 does not provide guidance on
impairment of lease receivables as this is subject to IFRS 9. However, IAS 17
and IFRS 16 (when applied) provide guidance on measurement of the URV,
which means that such measurement is within the scope of IAS 17 or IFRS16
(when applied) rather than the impairment requirements of IFRS 9.
233
How we see it
The URV of the asset underlying a finance lease should be excluded from
the calculation of ECLs under IFRS 9. This means that the collateral that
is taken into account in measuring ECLs should exclude any amounts
attributed to URV and recorded on the lessor’s statement of financial
position.
10 Loan commitments and written financial
guarantee contracts
The description of ‘loan commitment’ and the definition of ‘financial guarantee
contract’ remain unchanged from IAS 39. Loan commitments are described in
IFRS 9 as ‘firm commitments to provide credit under pre-specified terms and
conditions’, while a financial guarantee contract is defined as ‘a contract that
requires the issuer to make specified payments to reimburse the holder for
a loss it incurs because a specified debtor fails to make payment when due
in accordance with the original or modified terms of a debt instrument’.
234
The IFRS 9 impairment requirements apply to loan commitments and financial
guarantee contracts that are not measured at fair value through profit or loss
under IFRS 9, with some exceptions (see section 2 above).
The ITG (seesection 1.5 above) discussed in April 2015 whether the impairment
requirements in IFRS 9 must also be applied to other commitments to extend
credit such as:
•
A commitment (on inception of a finance lease) to commence a finance
lease at a date in the future (i.e., a commitment to transfer the right to use
an asset at the lease commencement date in return for a payment or series
of payments in the future)
•
A commitment by a retailer through the issue of a store account to provide
a customer with credit when the customer buys goods or services from the
retailer in the future
The ITG appeared to agree with the IASB’s staff analysis that the impairment
requirements of IFRS 9 apply to an agreement that contains a commitment
to extend credit by virtue of paragraph 2.1(g) if:
•
The agreement meets the description of a loan commitment
235
•
The agreement meets the definition of a financial instrument
236
And
•
None of the specific exemptions from the requirements of IFRS 9 apply
237
233
IAS 17.41, IFRS 16.77
234
IFRS 9.BCZ2.2, Appendix A, IAS 39.9, BC15
235
IFRS 9.BCZ2.2
236
IAS 32.11
237
IFRS 9.2.1
The IFRS 9 impairment
requirements apply to
loan commitments and
financial guarantee
contracts that are not
measured at fair value
through profit or loss
under IFRS 9.
122 April 2018 Impairment of financial instruments under IFRS 9
The IASB staff paper stated that some contracts, such as irrevocable finance
lease agreements, might clearly contain a firm commitment at inception to
provide credit under pre-specified terms and conditions. However, other cases
might not be so clear cut, depending upon the specific terms of the agreement
and other facts and circumstances (e.g., if the issuer of a store account has
the discretion to refuse to sell products or services to a customer with a store
card and, hence, can avoid extending credit).
238
In the examples discussed above, the finance lease and store account do
not meet the definition of a financial instrument until the contractual right
to receive cash is established, that is likely to be at the commencement of
the lease term or when goods or services are sold.
239
Only lease receivables
are scoped into the IFRS 9 impairment requirements (see section 9.2 above).
240
Consequently, there is no need to make provision for ECLs, in accordance with
IFRS 9, until a financial lease receivable or a financial asset within the scope
of IFRS 9 is recognised.
The application of the model to financial guarantees and loan commitments
warrants some further specification regarding some of the key elements,
such as the determination of the credit quality on initial recognition, cash
shortfalls and the EIR to be used in the ECL calculations. These specifications
are summarised in the table below, which also highlights the differences in
recognising and measuring ECLs for financial assets measured at amortised
cost or at fair value through other comprehensive income, loan commitments
and financial guarantee contracts.
Figures 6: Summary of the application of the ECL model to loan
commitments and financial guarantee contacts
Financial assets
measured at
amortised cost
or at fair value
through other
comprehensive
income
Loan
commitments
Financial
guarantee
contracts
Date of initial
recognition in
applying the
impairment
requirements (see
sections 6.3.1
above and 6.2.1
below)
Trade date.
241
Date that an entity
becomes a party
to the irrevocable
commitment.
242
Date that an entity
becomes a party
to the irrevocable
commitment.
243
238
Transition Resource Group for Impairment of Financial Instruments, Agenda ref 3, Loan
Commitments – Scope, 22 April 2015.
239
IAS 32.11, AG20
240
IFRS 9.2.1(b)
241
IFRS 9.5.7.4
242
IFRS 9.5.5.6
243
IFRS 9.5.5.6
123 April 2018 Impairment of financial instruments under IFRS 9
Figures 6: Summary of the application of the ECL model to loan
commitments and financial guarantee contacts (cont’d)
Period over which
to estimate ECLs
(see 4.5 above)
The expected
life up to the
maximum
contractual
period (including
extension options
at the discretion
of the borrower)
over which the
entity is exposed
to credit risk and
not a longer
period.
244
The expected life
up to the
maximum
contractual
period over which
an entity has
a present
contractual
obligation to
extend credit.
245
However, for
revolving credit
facilities (see
section 11 below),
this period extends
beyond the
contractual period
over which the
entity is exposed
to credit risk and
the ECLs would
not be mitigated
by credit risk
management
actions.
246
The expected
life up to the
maximum
contractual
period over which
an entity has
a present
contractual
obligation to
extend credit.
247
Cash shortfalls in
measuring ECLs
(see section 4.2
above)
Cash shortfalls
between the cash
flows that are due
to an entity in
accordance with
the contract and
the cash flows
that the entity
expects to
receive.
248
Cash shortfalls
between the
contractual cash
flows that are due
to the entity if the
holder of the loan
commitment
draws down the
loan and the cash
flows that the
entity expects to
receive if the loan
is drawn down.
249
Cash shortfalls
are the expected
payments to
reimburse the
holder for a credit
loss that it incurs
less any amounts
that the entity
(issuer) expects to
receive from the
holder, the debtor
or any other
party.
250
EIR used in
discounting ECLs
(see section 4.7
above)
The EIR is
determined or
approximated at
initial recognition
of the financial
instrument.
251
The EIR of the
resulting asset
will be applied
and if this is not
determinable,
then the current
rate representing
the risk of the
cash flows is
used.
252
The current rate
representing the
risk of the cash
flows is used.
253
Assessment of
significant
increases in
credit risk (see
section 5 above)
An entity
considers changes
in the risk of a
default occurring
on the financial
asset.
254
An entity
considers changes
in the risk of a
default occurring
on the loan to
which a loan
commitment
relates.
255
An entity
considers the
changes in
the risk that the
specified debtor
will default on
the contract.
256
244
IFRS 9.5.5.19
245
IFRS 9.B5.5.38
246
IFRS 9.5.5.20, B5.5.39, B5.5.40
247
IFRS 9.B5.5.38
248
IFRS 9.B5.5.28
249
IFRS 9.B5.5.30
250
IFRS 9.B5.5.32
251
IFRS 9.B5.5.44
252
IFRS 9.B5.5.47, B5.5.48
253
IFRS 9.B5.5.48
254
IFRS 9.5.5.9
255
IFRS 9.B5.5.8
256
IFRS 9.B5.5.8
124 April 2018 Impairment of financial instruments under IFRS 9
At its meeting in April 2015, the ITG (see section 1.5 above) also discussed the
measurement of ECLs for an issued financial guarantee contract that requires
the holder to pay further premiums in the future. Some members of the ITG
agreed with the staff’s analysis that the issuer of a financial guarantee contract
should exclude future premium receipts due from the holder when measuring
ECLs in respect of the expected cash outflows payable under the guarantee.
257
When estimating the cash shortfalls, the amounts that the entity expects to
receive from the holder should relate only to recoveries or reimbursements
of claims for losses and would not include receipts of premiums.
258
Moreover,
the expected cash outflows under the guarantee depend upon the risk of default
of the guaranteed asset, while the expected future premiums receipts are
subject to the risk of default by the holder of the guarantee. Hence, these
risks of default should be considered separately. This means that the ECL
measurement should be carried out gross of any premiums receivable in
the future.
In addition, an ITG member noted that the terms of a financial guarantee
contract may affect the period of exposure to credit risk on the guarantee,
for example, if the guarantee were contingent or cancellable. This should
be taken into consideration when measuring the ECLs of the guarantee.
IFRS 9 requires that financial guarantees and off-market loan commitments
should be measured at the “higher of” the amount intially recognised less
cumulative amortisation, and the ECL.
259
Consequently, the timing of premium
payments and, hence, the amount intially required, can result in no ECL
provision being recognised required on initial recognition.
For a financial guarantee contract issued to an unrelated party in a stand-alone
arm’s length transaction, premiums that are received in full at inception will
likely be the same as the fair value of the guarantee at initial recognition.
In such circumstances, it is likely that no ECLs will need to be recognised
immediately after initial recognition, as the initial fair value will normally
exceed the lifetime ECLs. However, a financial guarantee contract for which
premiums are receivable over the life of the guarantee will have a nil fair value
at initial recognition. In such circumstances, the subsequent measurement of
the financial guarantee contract is likely to be based on the ECL allowance. This
is illustrated in the example below:
Example 22: Determining the initial and subsequent measurement
of a financial guarantee contract where premiums are receivable
upfront or over the life of the guarantee
Scenario 1: On 1 January 2018, Bank A issues a 5 year financial guarantee of
a loan with a nominal value of £2,000,000 with 5% interest, with the full premium
of £100,000 receivable upfront at contract inception. This premium is recognised
on a straight line basis over the life of the guarantee. As at 31 December 2020 and
2021, Bank A assesses that there has been a significant increase in credit risk of
the financial guarantee contract and, as at 31 December 2022, the debtor defaults
and fails to make payments in accordance with the terms of the debt instrument.
The lifetime ECLs estimated as at 31 December 2018 and 2019 are £75,000 and
£55,000, respectively, with a significant increase in 2020 and 2021 to £200,000
and £500,000, respectively, and for the guaranteed amount of £2,100,000,
including accrued interest in 2022 when the debtor defaults. The 12-month ECLs are
£18,000 and £25,000 as at 31 December 2018 and 2019.
257
Transition Resource Group for Impairment of Financial Instruments, Agenda ref 6, Measurement
of expected credit losses for an issued financial guarantee contract, 22 April 2015.
258
IFRS 9.B5.5.32
259
IFRS 9.4.2.1(c), 4.2.1(d)
125 April 2018 Impairment of financial instruments under IFRS 9
Example 22: Determining the initial and subsequent measurement
of a financial guarantee contract where premiums are receivable
upfront or over the life of the guarantee (cont’d)
Scenario 2: Same facts as in Scenario 1, except that Bank B issues a 5 year financial
guarantee of a loan with a nominal value of £2,00,000, with premiums receivable
over the life of the guarantee of £20,000 each year, payable on 31 December 2018,
2019, 2020, 2021 and 2022, i.e., a total of £100,000. The fair value of the
guarantee is nil at origination. If a claim is paid out under the financial guarantee
contract, Bank B will lose the right to receive future premiums.
31 Dec
2018
31 Dec
2019
31 Dec 2020
31 Dec
2021
31 Dec 2022
Scenario 1: Full
premium
receivable at
inception
Initial fair value
is £100,000
Fair value less
cumulative
income
recognised*
£80,000
£60,000
£40,000
£20,000
–
ECLs
£18,000
£25,000
£200,000
£500,000
£2,100,000
Recorded value:
higher of (a) or
(b) in
accordance
with
IFRS 9.4.2.1(c)
£80,000
£60,000
£200,000
£500,000
£2,100,000
Scenario 2:
Premium
receivable over
the life
of contract
Initial fair value
is £0 in
accordance
with
IFRS 9.5.1.1
£20,000
£20,000
£20,000
£20,000
£20,000
(a) Fair value
less
cumulative
income
recognised*
–
–
–
–
–
(b) ECLs
£18,000
£25,000
£200,000
£500,000
£2,100,000
Recorded value:
higher of (a) or
(b) in
accordance
with
IFRS 9.4.2.1(c)
£18,000
£25,000
£200,000
£500,000
£2,100,000
* Based on the assumption of a straight-line amortisation of premiums received
over the life of the financial guarantee.
Before there has been a significant increase in credit risk in 2018 and 2019, in
Scenario 1, the measurement of the financial guarantee is based on the fair value,
less cumulative income recognised in accordance with IFRS 15, whilst, in Scenario 2,
126 April 2018 Impairment of financial instruments under IFRS 9
Example 22: Determining the initial and subsequent measurement
of a financial guarantee contract where premiums are receivable
upfront or over the life of the guarantee (cont’d)
the measurement is based on the ECL allowance. However, once there has been
a significant increase in credit risk, the measurement of the financial guarantee is
based on the ECL allowance in both scenarios. Consequently, the timing of receipt
of premiums may have a significant effect on the measurement of the guarantee
particularly when there has not been a significant increase in credit risk.
Although the accounting treatment in Scenario 2 in the example above may seem
counterintuitive, in that the guarantor must initially recognise ECLs even though it
expects to receive future premium income, it is consistent with the impairment of
loans for which risk premiums are also received over the life of the loan. Also, in
practice, it is relatively unusual for guarantors not to receive premiums upfront
when issuing a financial guarantee contract.
Normal loan commitments issued at market interest rates are excluded from
the scope of IFRS 9 except for impairment and derecognition.
260
Unlike
off-market loan commitments, i.e., loan commitments provided at below-
market interest rates, and financial guarantee contracts (see above), normal
loan commitments are not subject to the ‘higher of’ test for subsequent
measurement.
261
The consequence is that an ECL is required for all normal
loan commitments, whether or not any fees are paid upfront. This is consistent
with the general requirement to provide for 12-month ECLs for any new loans
that have not experienced significant increases in credit risk since initial
recognition.
Another question that arises in practice is whether loan commitments and
financial guarantee contracts can ever be accounted for as purchased or
originated credit-impaired. The definition of ‘purchased or originated credit-
impaired’ in IFRS 9 refers only to financial assets, not financial instruments
(consistent with the definition of credit-impaired) but loan commitments
and financial guarantees are not financial assets. So, if such an instrument
is entered into when default is highly likely or has already occurred, and the
potential loss is reflected in the price, how should the ECLs be measured, so
as to avoid double counting the loss? This issue could be particularly relevant
in the context of business combinations, where an entity may acquire loan
commitments or financial guarantee contracts that are already credit-impaired.
For financial guarantees, the ‘higher of’ test avoids the double-counting, as the
fair value of the guarantee recognised as a liability on initial recognition will be
higher than lifetime expected losses. For loan commitments, one view could be
to consider they are at below-market interest rates on initial recognition (as the
terms were fixed at a time where the loan commitment was not credit-impaired)
and apply the ‘higher of’ test. Alternatively, one may consider that the guidance
for financial assets may be applied by analogy to loans commitments. This
would make sense as the standard treats loans that are drawn from a loan
commitment as a continuation of the same financial instrument. For disclosure
purposes, we believe such loan commitments and financial guarantees should
also be reported as credit-impaired.
260
IFRS 9.2.1(g), 2.3
261
IFRS 9.2.3(c), 4.2.1(d)
127 April 2018 Impairment of financial instruments under IFRS 9
11 Revolving credit facilities
The 2013 ED specified that the maximum period over which ECLs are to
be calculated should be limited to the contractual period over which the
entity is exposed to credit risk.
262
This would mean that the allowance for
commitments that can be withdrawn at short notice by a lender, such as
overdrafts and credit card facilities, would be limited to the ECLs that would
arise over the notice period, which might be only one day. However, banks
will not normally exercise their right to cancel the commitment until there
is already evidence of significant deterioration, which exposes them to risk
over a considerably longer period. Banks and banking regulators raised
concerns over this issue and the IASB responded by introducing an exception
for revolving credit facilities and setting out further guidance as well as
an example addressing such arrangements.
In outline, the revolving facility exception requires the issuer of such a facility
to calculate ECLs based on the period over which they expect, in practice, to
be exposed to credit risk. However, the words of the exception are not very
clear and it has been discussed at all three ITG meetings. The IASB staff
have also produced a webcast on the topic.
11.1 Scope of the exception
The guidance relates to financial instruments that ‘include both a loan and an
undrawn commitment component and for which the entity’s contractual ability
to demand repayment and cancel the commitment does not limit the entity’s
exposure to credit losses to the contractual notice period’.
263
Despite the use
of the word ‘both’, the ITG agreed, in April 2015, that this guidance applies
even if the facility has yet to be drawn down. It also applies if the facility has
been completely drawn down, as it is the nature of revolving facilities that the
drawn down component is periodically paid off before further amounts will be
drawn down again in future.
The standard also describes three characteristics generally associated with
such instruments:
264
•
They usually have no fixed term or repayment structure and usually have
a short contractual cancellation period
•
The contractual ability to cancel the contract is not enforced in day-to-day
management, but only when the lender is aware of an increase in credit
risk at the facility level
•
They are managed on a collective basis
Products that are generally agreed to be in the scope of the exception include
most credit card facilities and most retail overdrafts. However, even with these,
some caution needs to be applied, since we understand that there are credit
card facilities which do not enable the issuer to demand repayment and cancel
the facility, and as such, would be out of scope.
What is less clear is the treatment of corporate overdrafts and similar facilities.
It is relevant that all the ITG discussions as well as the webcast referred
to credit cards and retail customers and not corporate exposures. The
problem is partly that the guidance for the standard describes management
on a collective basis as a characteristic that revolving facilities in the scope
of the exception ‘generally have’, rather than a required feature, as listed in
262
Exposure Draft – Financial Instruments: Expected Credit Losses, March 2013, para. 17.
263
IFRS 9.5.5.20
264
IFRS 9.B5.5.39
The section contains
special rules for
revolving credit facilities,
such as overdrafts and
credit cards.
Whether the revolving
facilities exception
applies to corporate
facilities depends on the
facts and circumstances
and requires judgement.
128 April 2018 Impairment of financial instruments under IFRS 9
paragraph 5.5.20 of IFRS 9
.
265
Some banks consider this is still a determining
feature and that many of their corporate facilities are outside the scope of the
exception because they are managed on an individual basis. Banks normally
have a closer business relationship with their larger corporate customers than
with most retail customers, and more data to manage the credit risk, such as
access to regular management information. Other banks consider that facilities
that are individually managed are still in the scope of the exception, notably
because individual credit reviews are generally performed only on an annual
basis (unless a significant event occurs). In addition, it is unclear exactly what
is meant by ‘managed on a collective basis’ and where to draw the line between
large corporates and smaller entities. It should be noted that, if a corporate
facility is not deemed to be a revolving facility, but can be cancelled at short
notice, the ECLs will be limited to those that arise over the notice period.
At its December 2015 meeting, the ITG discussed whether:
•
Multi-purpose credit facilities, which have the ability to be drawn down in
a number of different ways (e.g., as a revolving overdraft, a variable or
fixed-rate loan (with or without a fixed term) or an amortising loan such
as a mortgage) would fall within the scope exception
•
The general characteristics identified in paragraph B5.5.39 of IFRS 9
should be considered to be required characteristics, or merely examples
of typical characteristics
•
The existence of a fixed term of the loan once drawn down would prevent
a facility from falling within the scope exception
The ITG commented that:
•
The supporting application guidance in paragraph B5.5.39 of IFRS 9
reinforces the features described in paragraph 5.5.20 of IFRS 9 by setting
out general characteristics which, while not determinative, are consistent
with those features.
•
The Basis for Conclusions of IFRS 9 provides further context around the
type of financial instruments that the Board envisaged would fall within
the scope exception. In particular, the exception was intended to be limited
in nature and it was introduced in order to address specific concerns raised
by respondents in relation to revolving credit facilities that were managed
on a collective basis. Also, it was understood that these types of financial
instruments included both a loan and an undrawn commitment component
and that they were managed, and ECLs were estimated, on a facility level;
i.e., the drawn and undrawn exposure were viewed as one single cash flow
from the borrower.
266
•
Consequently, both the drawn and undrawn components of these facilities
were understood to have similar short contractual maturities, i.e.,
the lender had both the ability to withdraw the undrawn commitment
component and demand repayment of the drawn component at short
notice.
•
An immediately revocable facility which has a fixed maturity (e.g., 5 years)
would be consistent with the type of facility within the scope exception
because the fixed term feature does not negate the lender’s contractual
right to cancel the undrawn component at any time. In contrast, an
immediately revocable facility that has no fixed maturity, but when drawn,
can take the form of a loan with a fixed maturity (i.e., once it has been
265
IFRS 9.B5.5.39
266
IFRS 9.BC5.254-BC5.261
129 April 2018 Impairment of financial instruments under IFRS 9
drawn, the lender no longer has the right to demand immediate repayment
at its discretion) would not be consistent with the type of facility envisaged
to be within the scope exception. This is because the fixed-term feature
does negate the lender’s contractual right to demand repayment of the
undrawn component. However, regarding this characteristic, the ITG
members also highlighted the following:
(a) An entity would first need to establish the unit of account to which the
requirements of IFRS 9 should be applied. In this regard, they noted
that, even if there was only one legal contract supporting a particular
multi-purpose credit facility, there might be more than one unit of
account to consider
(b) If the fixed-term feature was for a shorter period, judgement would be
required in order to determine whether such a fixed-term feature would
prevent a particular financial instrument from falling within the scope
exception (e.g., whether the borrower could consider the exposure
on the drawn and undrawn components to be one single cash flow).
•
IFRS 7 requires an entity to explain, among other things, the assumptions
used to measure ECLs. Within the context of multi-purpose credit facilities,
such disclosures are likely to be important in order to meet the disclosure
objectives (see section 14 below).
While, according to the ITG, the drawn and undrawn exposures are viewed as
‘one single cash flow from the borrower’, the standard’s Basis for Conclusions
is slightly clearer.
267
It states that the loan and undrawn commitment ‘
are managed, and ECLs are estimated on a facility level. In other words,
there is only one set of cash flows from the borrower that relates to both
components’. Hence, the drawn and undrawn elements of a revolving facility
within the scope of the exception would normally be viewed as only one unit of
account. The ITG discussion seems to suggest that a new unit of account would
be recognised if a borrower chose to draw down on a multi-purpose facility in
the form of a term loan, because this is the point where this specific drawn
portion ceases to share the key characteristic of a revolving facility, i.e., the
entity’s contractual ability to demand repayment and cancel the commitment.
At its December 2015 meeting, the ITG discussed charge cards and how ECLs
on future drawdowns should be measured if there is no specified credit limit
in the contract. The ITG members considered a specific fact pattern where the
bank has the ability to approve each transaction at the time of sale based on
the customer’s perceived spending capacity using statistical models and inputs
such as spending history and known income.
The ITG members noted that, because the bank has the right to refuse each
transaction at its discretion, and on the assumption that the bank actually
exercises that right in practice, then:
•
The contractual credit limit should be considered to be zero and
consequently future drawdowns would not be taken into account.
•
The facility described would not fall within the scope exception because
there would be no undrawn commitment component (i.e., there is no
firm commitment to extend credit).
However, the ITG members noted that their discussions focused on the very
specific fact pattern presented and observed that the conclusion could differ
in other situations.
267
IFRS 9.BC5.259
130 April 2018 Impairment of financial instruments under IFRS 9
11.2 The period over which to measure expected credit losses
According to the standard, ‘for such financial instruments, and only those
financial instruments, the entity shall measure ECLs over the period that
the entity is exposed to credit risk and ECLs would not be mitigated by credit
risk management actions, even if that period extends beyond the maximum
contractual period’.
268
In order to calculate the period for which ECLs are
assessed, ‘an entity should consider factors such as historical information
and experience about:
(a) The period over which the entity was exposed to credit risk on similar
financial instruments
(b) The length of time for related defaults to occur on similar financial
instruments following a significant increase in credit risk
(c) The credit risk management actions that an entity expects to take
once the credit risk on the financial instrument has increased, such
as the reduction or removal of undrawn limits.’
269
This wording in the standard is not easy to interpret or apply.
This following example illustrates the calculation of impairment for revolving
credit facilities, based on Illustrative Example 10 in the Implementation
Guidance for the standard.
270
For the sake of clarity, the assumptions and
calculations have been adapted from the IASB example as it is not explicit
on the source of the parameters and how they are computed. The example
has also been expanded to show the calculation of the loss allowances.
However, to simplify the example, we have continued to ignore the need
to discount ECLs or whether the credit conversion factor would change if
an exposure has significantly deteriorated in credit risk.
Example 23: Revolving credit facilities
Bank A provides credit cards with a one day cancellation right and manages
the drawn and undrawn commitment on each card together, as a facility. Bank A
sub-divides the credit card portfolio by segregating those amounts for which
a significant increase in credit risk was identified at the individual facility level
from the remainder of the portfolio. The remainder of this example only illustrates
the calculation of ECLs for the sub-portfolio, for which a significant increase in
credit risk was not identified at the individual facility level. At the reporting date,
the outstanding balance on the sub-portfolio is £6,000,000 and the undrawn facility
is £4,000,000. The Bank determines the sub-portfolio’s expected life as 30 months
(using the guidance set out above) and that the credit risk on 25 per cent of the sub-
portfolio has increased significantly since initial origination, making up £1,500,000
of the outstanding balance and £1,000,000 of the undrawn commitment (see the
calculation of the exposure in the table below).
To calculate its EAD, Bank A adds the amounts that are drawn at the reporting date
and additional draw-downs that are expected in the case that a customer defaults. For
those expected additional draw-downs, Bank A uses a credit conversion factor that
represents the estimate of what percentage of that part of committed credit facilities
that is unused at the reporting date would be drawn by a customer before he defaults.
Using its credit models, the bank determines this credit conversion factor as 95 per
cent. The EAD on the portion of facilities measured on a lifetime ECL basis is therefore
£2,450,000, made up of the drawn balance of £1,500,000 and £950,000 of
expected further draw-downs before the customers default. For the remainder of the
facilities, the EAD that is measured on a 12-month ECL basis is £7,350,000, being
the remaining drawn balance of £4,500,000 plus additional expected draw-downs for
customers defaulting over the next 12 months of £2,850,000 (see the calculation for
the EAD in the table below).
Bank A has estimated that the PD for the next 12 months is 5 per cent, and
30 per cent for the next 30 months. The estimate for the LGD on the credit cards
in the sub-portfolio is 90 per cent. That results in lifetime ECLs of £661,500 and
12-month ECLs of £330,750 (see calculation for ECLs in the table below).
For the presentation in the statement of financial position, the ECLs against the
drawn amount of £607,500 would be recognised as an allowance against the credit
card receivables and the remainder of the ECLs that relates to the undrawn facilities
of £384,750 would be recognised as a liability (see table below).
268
IFRS 9.5.5.20
269
IFRS 9.B5.5.40
270
IFRS 9 IG Example 10 IE58-IE65
131 April 2018 Impairment of financial instruments under IFRS 9
Example 23: Revolving credit facilities (cont’d)
Determination made at facility
level
Drawn
Undrawn
Total
Facility
£6,000,000
£4,000,000
£10,000,000
Exposure
Subject to lifetime
ECLs (25% of the
facility has been
determined
to have significantly
increased in credit
risk)
25%
£1,500,000
£1,000,000
Subject to 12-month
ECLs (the remaining
75%
of the facility)
75%
£4,500,000
£3,000,000
£7,500,000
Credit conversion
factor (CCF)
A uniform CCF is used
irrespective of
deterioration, which
reflects that the CCF
is contingent on
default which
is the same reference
point for a 12-month
and lifetime ECL
calculation
95%
EAD
EAD for undrawn
balances is calculated
as exposure × CCF
Subject to lifetime
ECLs
£1,500,000
£950,000
£2,450,000
Subject to 12-month
ECLs
£4,500,000
£2,850,000
£7,350,000
PD
Exposures subject to
lifetime ECLs
30%
Exposures subject to
12-month ECLs
5%
LGD
90%
ECLs
(EAD × PD × LGD)
Exposures subject to
lifetime ECLs
£405,000
£256,500
£661,500
Exposures subject to
12-month ECLs
£202,500
£128,250
£330,750
£607,500
presented as loss
allowance against
assets
£384,750 presented as
provision
£992,250
132 April 2018 Impairment of financial instruments under IFRS 9
In the above calculations, we have used the same credit conversion factor, of
95%, for calculating the EAD, irrespective of whether it is an input for 12-month
or lifetime ECLs. This is based on an assumption that the extent of future draw-
downs in the event that the customer defaults does not differ depending on
whether, at the reporting date, there had been a significant increase in credit
risk. In practice, for many credit cards, the exposure in the event of default
reaches close to the credit limit and may even exceed it. However, as discussed
further below, the standard does not permit the use of a credit conversion
factor of more than 100%. For this reason, the use of a conventional credit
conversion factor model for estimating the EAD may need to be adjusted to
comply with the standard.
We make the following observations:
•
Example 10 of the standard (on which our Example 23 above is based),
does not explain how the entity has concluded that 25% of the portfolio
has significantly increased in credit risk. Collective assessment is discussed
in section 5.5 above.
•
Example 10 in the standard also does not show how the 30-month period
was calculated.
The ITG in April 2015, discussed how to determine the appropriate period when
measuring ECLs for a portfolio of revolving credit card exposures in stages 1, 2
and 3 and commented that:
•
An entity’s ability to segment and stratify the portfolio into different
sections of exposures in accordance with how those exposures are being
managed will be relevant. For example, an entity may be able to identify
exposures with specific attributes that are considered more likely to default
and, consequently, would have shorter average lives than those that are
expected to continue performing (see 5.5 above).
•
While IFRS 9 requires a period in excess of the maximum contractual
period to be used when measuring ECLs, the fundamental aim was still
to determine the period over which the entity is exposed to credit risk
and an entity must consider all three factors set out in paragraph B5.5.40.
Consequently, expected defaults or potential credit risk management
actions such as reduction or removal of undrawn limits could result
in a shorter period of exposure than that indicated by the historical
behavioural life of the facility. That is, the time horizon is not the period
over which the lender expects the facility to be used, but the period
over which the lender is, in practice, exposed to credit risk.
At its December 2015 meeting, the ITG continued the discussion on how
an entity should determine the maximum period to consider when measuring
ECLs for revolving credit facilities. This divided into two sub-questions: when
does this period start and when does it end?
With respect to the starting-point, the ITG members observed that the
requirements of paragraph B5.5.40 of IFRS 9 do not alter the starting point
of the maximum period to consider when measuring ECLs and consequently,
the appropriate starting-point should be the reporting date.
With respect to the ending-point, ITG members focused on which credit risk
management actions an entity should take into account and noted that:
•
An entity should consider:
(a) Only credit risk management actions that it expects to take rather than
all credit risk management actions that it is legally and operationally
able to take.
The period over which
an entity is exposed to
a revolving facility is
limited by the credit
mitigation actions it
expects to take and
whereby it will terminate
or limit the credit
exposure.
133 April 2018 Impairment of financial instruments under IFRS 9
(b) Only those credit risk management actions that serve to mitigate credit
risk and, consequently, actions that do not mitigate credit risk such
as the reinstatement of previously curtailed credit limits should not
be considered.
(c) All credit risk management actions that it expects to take and that
serve to either terminate or limit the credit risk exposure in some way.
•
An entity’s expected actions must be based on reasonable and supportable
information. In this regard, consideration should be given to an entity’s
normal credit risk mitigation process, past practice and future intentions.
•
The ending-point could be limited by the expected timing of the entity’s next
review process, but only if the entity’s normal business practice is to take
credit risk mitigation actions as part of this review process. Consequently,
it may not always be appropriate to use the timing of the entity’s next
review process as a basis for determining the ending-point.
•
In respect of assets in stage 2, the probability of assets curing and
defaulting would need to be taken into account when determining
the maximum period to consider when measuring ECLs.
•
It was noted that a distinction should be made between credit risk
management actions such as the reinstatement of a previously curtailed
credit limit (that should not be taken into account) and considering how
a particular stage 2 exposure that has not yet been subject to any credit
risk mitigation actions will develop. For example, an entity may have
determined that there has been a significant increase in credit risk since
initial recognition in respect of a particular exposure, but may not yet have
taken any specific credit risk mitigation actions such as the curtailment
or termination of the credit limit. In this case, consideration should be
given to the possibility that the exposure may cure rather than default.
In contrast, if an entity had taken credit risk mitigation action in respect
of that exposure such as the curtailment of the credit limit, it would not be
appropriate to take into consideration the possibility that the exposure may
subsequently cure, resulting in a reinstatement of the previously curtailed
credit limit when determining the maximum exposure period. In this regard,
appropriate portfolio segmentation is crucial, in particular, in relation to
financial assets in stage 2.
•
There is only one maximum exposure period to consider, which applies
equally to both the drawn and undrawn components of a revolving credit
facility, which is consistent with the way in which the facility is managed.
Nevertheless, in measuring ECLs, credit risk mitigation actions may affect
the drawn and undrawn components differently. For example, when an
entity cancels the undrawn component, the possibility of any future
drawdowns is removed, whereas when an entity demands repayment
of the drawn component the recovery period associated with that
drawn exposure still needs to be considered in measuring ECLs.
•
Ultimately, the estimation of the maximum period to consider would
require judgement and the disclosure requirements of IFRS 7 (such as
those explaining inputs, assumptions and estimation techniques in relation
to ECLs) would be important (see 14 below).
In May 2017 the IASB issued a webcast, IFRS 9 Impairment: The expected
life of revolving facilities. Like other IASB webcasts, this sets out the views
of the speakers rather than the Board, but it will, nevertheless, be regarded
as important educational material.
134 April 2018 Impairment of financial instruments under IFRS 9
The webcast used the example of a portfolio of 100 similar facilities, 30 of
which are expected to significantly increase in credit risk by the next credit
review and, at the next credit review, based on past experience, five of these
facilities will be cut. The key messages provided were:
•
The entity should assume that the expected life of the portfolio will be
limited by the period to the next credit review only for those five facilities.
This is because the expected life can only be reduced to the next review
date to the extent that mitigation actions are expected to occur.
•
It is not necessary to know in advance which five facilities will be cut.
•
The expected life of the other 95 facilities will be bounded by when they
are expected to default or the point at which the facility is no longer used
by the customer.
•
Meanwhile, the expected life for the five facilities may be shorter than
the time to the next review if they are expected to default.
•
As discussed at the ITG, it will be necessary to segment the portfolio
appropriately into groups of loans with similar credit and payment
expectations in order to determine its expected life. If a facility is more
likely to default, then it is also more likely to be subject to risk mitigation
action.
•
If the entity expects, based on past experience, to cut the facility only in
part, by reducing the limit, then the life of the facility will be cut only for
the portion of the facility that is expected to be withdrawn.
This example only looks forward to what it expects to happen by the time
of the next credit review. Presumably it would be appropriate to extend the
analysis, to look beyond this to subsequent reviews and further reductions
in facilities expected in the future, to help determine the expected life of the
remaining 95 facilities in the portfolio. This is illustrated by Example 24 below.
A second example in the webcast compared two entities: entity A only cancels
undrawn facilities that deteriorate to a risk classification of 20, while entity B
cancels any facility as soon as it deteriorates to a classification of 15 (and
so lower risk than grade 20). It was concluded that, all else being equal, the
expected life for entity A’s portfolio will be longer than for entity B’s portfolio.
It should be stressed that estimating the expected life of a revolving
facility is of relevance mostly for those facilities that are measured using
lifetime credit losses. The allowance for those assets in stage 1 will be
calculated based only on losses associated with default in the next twelve
months, which is likely to be the period used to measure ECLs unless the
entity’s risk mitigation activities indicate that a shorter period should be
used.
135 April 2018 Impairment of financial instruments under IFRS 9
How we see it
To recap, it would seem that a periodic credit review should normally
be taken into account when assessing the period over which to measure
losses to the extent that it is expected to result in actual limit reduction or
withdrawal. Hence, for example, if, normally, 20% of facilities are withdrawn
based on an annual review, then for 20% of the outstanding facilities, the
period to measure losses should be limited by the timing of this next review.
For the other 80% of the facilities, three things may happen: they may
someday default, the facility may someday be reduced or withdrawn, or the
borrower may someday cease to use the card. For the 80% it is necessary
to model each of these possibilities, which means that the period over which
to measure ECLs may extend for a number of years into the future. In this
view, the standard’s requirement for any facilities measured using lifetime
ECLs can be simply summarised as ‘how much do you expect to lose’?
The length of the period over which losses are measured is of secondary
importance except that it is necessary to know when defaults are expected
to occur, in order to determine the appropriate discounting.
The application of this approach is illustrated in the following example.
Example 24: Estimating the life of revolving credit facilities
Of 1,000 facilities in stage 2 the entity estimates that each year:
•
10% will default every year in the first three years, but this reduces to 2%
thereafter, as those facilities that do not default in the first three years
are expected to have become significantly lower risk.
•
8% of holders will cease to use their card every year in the first three
years, but this increases to 15% thereafter once their financial position
has improved.
•
15% of facilities will be withdrawn each year, as credit risk mitigation,
over the first three years. After that period, it is assumed that the credit
risk is significantly reduced and none of the facilities are reduced
thereafter.
No. of facilities in Stage 2
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Balance
brought
forward
1,000
670
448
301
250
207
172
Defaults
(100)
(67)
(45)
(6)
(5)
(4)
(3)
Cease to
use card
(80)
(54)
(35)
(45)
(38)
(31)
(26)
Facility
withdrawn
(150)
(101)
(67)
–
–
–
–
Balance
carried
forward
670
448
301
250
207
172
143
136 April 2018 Impairment of financial instruments under IFRS 9
In this example, it is apparent that while the level of defaults quickly declines,
a small portion of the portfolio has a very long life. The consequence is that
the ECL could be very significant. However, the example does not take account
of the time value of money. Given the high interest rate charged on credit
cards, the manner in which interest is included in the estimation of cash flows
and losses are discounted will have a major impact upon the ECL measurement
(see section 11.4 below).
One method that we have observed being applied to make this calculation work
is to track a portfolio of stage 2 facilities over a number of years and note how
long it takes for the default rate to reduce to an immaterial level.
A further issue is the extent to which the period over which to measure
ECLs is restricted by the normal derecognition principles of IFRS 9 and
what could constitute a derecognition of the facility. In particular, it is
unclear whether the existence of a contractual life and/or the lender’s
ability to revise the terms and conditions of the facility based on periodic
credit reviews as thorough as that on origination, would be regarded
as triggers for derecognition and so would also limit the life for ECL
measurement.
In April 2015, the ITG discussed how to determine the date of initial recognition
of a revolving credit facility for the purposes of the assessment of significant
increases in credit risk. The challenge presented was how to determine when
changes are sufficiently significant to result in a derecognition of the original
facility and recognition of a new facility. The ITG members discussed some of
the factors that might be taken into consideration in making that judgement,
such as issuing a new card, revising credit limits or conducting credit reviews.
It was noted that judgement would be required in making this assessment and
that it would depend on the specific facts and circumstances. However, the
following observations were made:
(a) In some circumstances issuing a new card may be indicative that the
original facility has been derecognised, but, in other cases, this may be
a purely operational process and thus would not indicate that a new facility
has been issued
(b) Credit reviews in themselves may not indicate that a new facility has been
issued
Although this discussion was on how to determine the reference date for
assessing if there has been a significant increase in credit risk, the notion that
it depends on the derecognition of one facility and the recognition of a new
one would, presumably, be equally relevant for assessing the period over which
to measure ECLs. This is especially relevant for corporate overdraft facilities
which are considered to be in the scope of the exception (see 11.1 above). If,
for instance:
i) The facility has a clearly agreed contractual life of one year (in addition
to a short cancellation notice period)
ii) The bank goes through a thorough credit process each year, similar
to that on original application and using detailed financial and other
information specific to the customer, before deciding whether to
continue with the facility, increase it, reduce it or withdraw it
iii) The bank will at that time revise the terms and conditions of the facility
to reflect the up-to-date credit quality of the borrower
iv) The bank derecognises the facility and recognises a new one, giving
the associated required disclosures
It is less clear how
the rules for revolving
facilities interact
which those for
derecognition.
137 April 2018 Impairment of financial instruments under IFRS 9
Intuitively, it would seem that the bank is only exposed to credit risk for
the period of a year.
This is consistent with the Basis of Conclusions which confirms the general
principle that, ‘if an entity decides to renew or extend its commitment to extend
credit, it will be a new instrument for which the entity has the opportunity
to revise the terms and conditions.’
271
Also, while paragraph BC5.261, by
starting with the word ‘however’, makes it clear that the revolving facilities
amendment was an exception to this principle, it does not explicitly state that
it is an exception to the entire principle. On one hand, it states that ‘the entity’s
contractual ability to demand repayment and cancel the undrawn commitment
does not limit the entity’s exposure’ (emphasis added), remaining silent on
an entity’s ability to renew or extend credit. On the other hand, some believe
that an ability to withdraw or cancel is, in substance, sufficiently similar to
an ability to renew or extend, and that they should be treated the same.
They also consider that the IASB webcast has made it clear that only expected
reductions and withdrawals of facilities can be reflected in the assessment
of the risk horizon. Consequently, a decision to maintain the facility, even if
based on fully revised terms and conditions, would not be considered a risk
management decision that shortens the life of the facility.
There are also differences of view as to whether a revolving facility can be
derecognised (and so the expected derecognition can be reflected in the ECL
horizon) if the lender carries out an annual thorough periodic credit review
at least equivalent to that when the facility was first granted. At this point,
the lender may revise the terms and conditions, but there is no contractual
limit to the life of the facility, or if there is a contractual limit to the life of
the facility but no thorough credit review at the point of renewal. In the first
case, the contract allows for a periodic credit review equivalent to that on
origination, to be performed on an individual rather than a collective basis
and with an opportunity to revise the terms and conditions if the credit quality
has changed, some believe that this could lead to derecognition of the facility
and recognition of a new one. As a result, ECLs would only be measured over
the period until the next periodic review. In the second case, the facility has
a clearly agreed contractual life, but its renewal is relatively automatic without
a thorough review. Some believe that IFRS 9 is clear that a financial instrument
is derecognised if it expires and therefore a thorough credit review is not
required.
It will be important for banks to disclose the basis on which they have made
their calculations.
It should be stressed that this issue is of relevance mostly for those facilities
that are measured using lifetime credit losses. The allowance for those assets
in stage 1 will be calculated based only on losses associated with default in
the next twelve months.
11.3 Exposure at default (EAD)
To measure ECLs on revolving facilities, such as credit cards, it will be
necessary to estimate several components that make up the EAD:
•
The credit conversion factor, to determine the portion of the facility that
is drawn down in any period (limited, for facilities in stage 1 to the next
twelve months)
•
The speed at which drawn down facilities are paid off
271
IFRS 9.BC5.260
138 April 2018 Impairment of financial instruments under IFRS 9
•
The level of interest expected to be charged in the future on those facilities
that are drawn down
These components will all need to be estimated based on past experience
and future expectations, for sections of the portfolio that are segmented
so that they have similar credit characteristics (see section 5.5.2 above).
The estimation of interest is addressed further in section 11.4 below.
At its meeting on 16 September 2015, the ITG (see section 1.5 above)
discussed how an entity should estimate future drawdowns on undrawn lines
of credit when an entity has a history of allowing customers to exceed their
contractually set credit limits on overdrafts and other revolving credit facilities.
The ITG members noted that:
•
The exception for some types of revolving credit facilities set out in
paragraph 5.5.20 of IFRS 9 relates to the contractual commitment period
and does not address the contractual credit limit. The standard was clear
in this regard. Consequently, it would not be appropriate to analogise this
specific exception to the contractual credit limit.
•
Some members of the ITG pointed out that, in practice, the tenor and
amount of revolving credit facilities are inextricably linked, because banks
not only extend credit for a period in excess of their maximum contractual
commitment period, but also allow customers to make drawdowns in
excess of the maximum contractually agreed credit limit as notified to
the customer. Consequently, if amounts in excess of the maximum
contractually agreed credit limits are not taken into account, there
would be a potential disconnect between the accounting and credit
risk management view.
•
However, it was concluded that IFRS 9 limits the estimation of future
drawdowns to the contractually agreed credit limit
11.4 Time value of money
The time value of money is important in measuring ECLs for revolving facilities
since interest rates (when interest is charged) are high. Hence, it is important
that any interest that is expected to be charged on drawn balances is included
in the EAD and that an appropriate rate is used to discount ECLs. An additional
complexity is introduced by credit cards, because they typically have a grace
period in which no interest is charged as long as the amount drawn down is
repaid within a specified period of time.
The standard is silent on this topic, however, the ITG discussion on the use of
floating-rates of interest to measure ECLs in December 2015 (see section 4.7
above) established a useful principle that there should be consistency between
the rate used to recognise interest revenue, the rate used to project future
cash flows (including shortfalls) and the rate used to discount those cash flows.
While the high rates charged by a credit card issuer are sometimes fixed in
the contract, the fact that the rate charged (nil or the high rate) depends on
how quickly the customer repays the amount drawn, means that the rate can
be thought of as ‘floating’, even if it does not vary with a benchmark rate of
interest. This is important since, otherwise, it would be necessary to assess
the EIR on original recognition and keep this fixed unless the facility is
derecognised, ignoring any changes in customer behaviour.
Applying this principle, for a credit card customer that is a ‘transactor’,
that is, one who repays any amount drawn down within the specified
short period and so is charged no interest, it would not be appropriate to
discount expected losses. On the other hand, for a credit card customer
The EAD on revolving
facilities is limited to
the contractual limit.
The time value of money
may have a major impact
on the measurement of
ECLs for revolving
facilities.
139 April 2018 Impairment of financial instruments under IFRS 9
who is a ‘revolver’ and who only pays off the minimum amounts permitted
by the issuer (in effect, using the card to borrow money), the high rate of
interest should be included in the forecast cash flows and in the discount
rate.
However, any transactor who goes on to default is likely to begin paying off
less than the full amount for a period of time before they default. To estimate
the expected losses for this scenario, it will be necessary to include any interest
that will be charged in this period. A consistent discount rate will then be
a blended rate of nil for the period over which the customer is expected to
pay no interest and the high rate over the period in which they will pay.
According to the guidance for ‘normal’ loan commitments, the expected
credit losses on a loan commitment must be discounted using the
effective interest rate, or an approximation thereof, that will be
applied when recognising the financial asset resulting from the loan
commitment.
272
Applying this approach, the losses on the currently
undrawn portion of a revolving facility should be discounted based on
the rate that is likely to be charged if it is drawn down. If it is expected
that interest will be charged at the high rate – which is likely for most
facilities that are already ‘revolvers’ – then the discount rate is likely
to be the high rate. This approach is consistent with a view expressed
at the ITG meeting that the drawn and undrawn balances should be
viewed as one unit of account and so discounted at the same rate. If
it is projected that a transactor will at some stage become a revolver
before it defaults, then it may be appropriate to calculate a blended
discount rate.
Because the choice of interest rate used to project cash flows and to discount
losses will depend on expectations of the borrower’s behaviour, it will need
to be made separately for segments of the portfolio with similar credit and
payment characteristics.
How we see it
In practice, it is likely that credit card issuers will often adopt procedures to
discount their ECLs that may be less sophisticated than set out above, due
to operational constraints and because the objective of the standard is to
discount ECLs at an approximation of the EIR.
273
However, it is necessary
to understand what is theoretically required by IFRS 9 in order to be able
to assess whether a pragmatic approach is a reasonable approximation.
11.5 Determining significant increase in credit risk
As already mentioned at section 11.2 above, at its April 2015 meeting,
the ITG discussed the starting reference date when assessing significant
increases in credit risk for a portfolio of revolving credit facilities. There
will typically be a diverse customer base, ranging from long-standing
customers who have been with the bank for many years, to new customers
who have only recently opened an account. The general rule in IFRS 9
is that the starting reference date is the date of original recognition.
Consequently, the date of initial recognition for this purpose is the date
the facility was issued and it should only be changed if there has been
a derecognition of the original facility. As discussed at section 11.2
above, it is not altogether clear what would qualify as a derecognition within
the context of the revolving facility exception. If the lender derecognises
272
IFRS 9.B5.5.47
273
IFRS 9.B5.5.44
140 April 2018 Impairment of financial instruments under IFRS 9
a facility at the end of its contractual term and recognises a new one when
it decides to renew or extend credit, in line with the Basis of Conclusions, it
would be consistent to assess if there has been a significant increase in credit
risk from when the current facility was first recognised.
274
Similarly, it may
make sense to use the date that the limit was increased if a facility is now far
larger than would have been granted on original recognition. There is also
a view that the credit risk on the date that the facility was last increased
may be a useful proxy for the credit risk on the date of original recognition.
There is a particular challenge on transition to IFRS 9, since entities may
have limited data on the credit risk at the date of original recognition (see
section 4.8 above).
However, as discussed at section 11.2 above, another view is that only
a reduction or cancellation of the facility would lead to the revolving
facility being derecognised. In some circumstances, issuing a new
card may be indicative that the original facility has been derecognised
(e.g., replacement of a student credit card with a new credit card upon
graduation), but in other cases, this may be a purely operational process
and thus, would not indicate that a new facility has been issued.
The ITG did not conclude further on this issue and it was not discussed in
the IASB’s May 2017 webcast. Consequently, at the date of writing, this
issue had not been resolved.
12 Intercompany loans
For those entities that prepare stand-alone IFRS financial statements,
or consolidated financial statements for part of a wider group, one of
the challenges in complying with the IFRS 9 impairment requirements is
the application to intercompany loans.
Many intercompany loans are structured so as to be on an arm’s length basis,
often for tax purposes, or because they involve transactions with special
purpose entities (SPEs) that are consolidated because the group retains control.
For these loans, application of IFRS 9 will be similar to loans to third parties.
It is more likely that these loans are clearly documented and priced at market
rates which will reflect the PD and LGD. One of the challenges for applying
IFRS 9 to intercompany loans is that money is often lent by one group company
to another on terms that are not ‘arm’s length’ or even without documented
terms at all. It is strongly recommended that the implementation of IFRS 9
is used as an opportunity to determine the terms of such arrangements and
document them so as, where possible, to reflect their substance. This is
because it is particularly difficult to apply IFRS 9 to arrangements where
the terms are unknown or the legal form (if documented) differs from their
substance. Examples of the latter include:
1) Loans that may be documented as on demand, and interest free,
but which are intended to be either a capital investment unlikely
to be repaid, or a loan to be repaid after a number of years.
2) Loans that are structured between group companies on
terms whereby there is an implicit guarantee of credit risk
by a parent company, but this is never explicitly documented.
In some cases (subject, of course, to consideration of the implications for
tax and distributable profits), it may be possible to restructure intercompany
arrangements on an arm’s length basis (and document them accordingly)
and so better enable the application of the standard.
274
IFRS 9.BC5.260
The first problem with
intercompany loans
is that they are often
undocumented and
advanced on non-
arm’s length terms.
141 April 2018 Impairment of financial instruments under IFRS 9
All intercompany loans are in the scope of IFRS 9. It is possible that
a group company is financed entirely by debt rather than partly
through equity, so that the substance of the loan (at least in part)
may be closer to an equity investment in that company. This raises
the question as to whether loans to group companies can ever be
regarded as an ‘investment’ in them, which could be accounted for
under IAS 27 Separate Financial Statements at cost, rather than a
loan accounted for under IFRS 9. ‘Investments’ are not defined for
this purpose. Although IAS 27 is usually read to refer to investments in
shares, an argument might be made that it can also cover intercompany
arrangements which are, in substance, capital investments. However,
the IFRS Interpretations Committee (IFRIC) in September 2016 seem
to have ruled against this. IFRIC discussed the interaction of IFRS 9
and IAS 28 Investments in Associates and Joint Ventures, when a loan
is regarded as part of ‘long-term interests that, in substance, form part
of the entity’s net investment’ as set out in paragraph 38 of IAS 28, which
gives as an example, ‘an item for which settlement is neither planned nor
likely to occur in the foreseeable future’. IFRIC concluded that although
a loan is considered as ‘in substance part of the investment’, for the
purposes of allocating losses in IAS 28, it is still in the scope of IFRS 9
as it is not ‘an investment’, as mentioned in scope paragraph 2.1 (a)
of IFRS 9 and, except for the allocation of losses, is not accounted for
using the equity method. Since then, in October 2017, the IASB amended
IAS 28 to clarify that IFRS 9 should be applied to long-term interests in
associates and joint ventures.
How we see it
The IFRIC discussion on long-term interests in associates was in the context
of IAS 28 and not IAS 27. It is perhaps relevant that IFRS 9 in its scope
paragraph refers to ‘interests’ in subsidiaries, rather than ‘investments’,
although IAS 27 itself uses ‘investments’. IAS 27 also allows investments
to be at cost, rather than accounted for using the equity method. However,
it would probably be difficult to sustain an argument that ‘investments’ as
used in IAS 27, encompasses loans which are, in substance, part of the net
investment, when the IFRIC has concluded that the same term in IAS 28
does not.
Having said that, an undocumented interest free loan to a subsidiary,
when there is no expectation of repayment, may, in substance, be more like
a capital contribution. If this is the case, then it will be helpful to document
it as such (with the features of equity) and then it may be measured at
cost and subject to the impairment requirements of IAS 36 Impairment
of Assets – rather than those of IFRS 9. The amendment of a loan (if
previously documented as such) to a capital contribution would be similar
to a forgiveness of the debt and so, as already mentioned above, may
have implications for (or be constrained by) tax and may only in future
be capable of being repaid if there are adequate distributable profits.
Another example of where it may be helpful to restructure (and
so amend the documented terms of) loans is where a subsidiary is
only financed by loan capital and there is little or no equity capital,
a situation that tax experts refer to as ‘thinly capitalised’. Interest
paid on a portion of the loan may be disallowed for tax purposes,
reflecting that a portion of the loan is, in substance, the subsidiary’s
capital. The requirements of IFRS 9 may make it worthwhile for such
loans to be restructured (and the new terms documented), so that
142 April 2018 Impairment of financial instruments under IFRS 9
a portion becomes an investment in the subsidiary, which is outside
the scope of the standard. This has the additional benefit that the
probability of default on the remaining portion of the loan will be
lower if the company has loss absorbing equity.
Most intercompany loans will qualify to be measured at amortised cost since
they are held in a business model to collect the cash flows rather than to sell
the loan and they normally have features which represent solely payments of
principal and interest. Loans which may provide greater challenges include:
•
Some loans pay no interest, even though they are not expected to be
repaid for a number of years. If they are not repayable on demand,
then these will normally be recognised initially at fair value and so at
less than par. The discount will then be accreted to par as part of the
EIR. Consequently, they are deemed to pay interest and so may satisfy
the SPPI criterion.
•
Loans that are ‘non-recourse’, in which repayment of the loan is either
contractually or implicitly dependent on the performance of an asset,
or assets, held by the subsidiary. This is most likely to be an issue for
loans to SPEs or other related parties such as joint ventures, where
there is insufficient equity capital to absorb the likely variability of
cash flows of the underlying asset(s). This problem is equivalent to
the ‘thin capitalisation’ issue, described above. Such non-recourse
loans are required to be measured at fair value through profit or loss.
All financial assets within the scope of IFRS 9 must be measured on initial
recognition at fair value. This means that an interest free loan, or a loan at
below a market rate of interest, will need to be recognised initially at less than
its nominal value unless it is repayable on demand. This criterion would require
both that the lender may legally call the loan and that it is expected that the
subsidiary would be able to repay the loan if called. The fair value of the loan
on initial recognition will normally reflect the economics of the arrangement.
The loan will then accrete in value over its expected life, and so will compensate
the lender for the time value of money and credit risk, and so qualify to be
recorded at amortised cost.
If the fair value of the loan when first recorded is less than the par value, the
accounting for the difference will depend on whether the loan is to a subsidiary,
a fellow subsidiary, or a parent. If the loan is to a subsidiary, the difference will
normally be recorded as a capital contribution, which will be outside the scope
of IFRS 9. If the loan is to a fellow subsidiary, or to a parent, it will normally be
recorded as a distribution of capital to the parent.
It should be stressed that any ECLs measured on a loan to a group company will
require a charge to profit or loss; the expense cannot be capitalised as part of
the investment in a subsidiary.
Compared to most loans to third parties, a lender within a group is likely to have
access to much more qualitative and quantitative information about the credit
risk of the borrower. Consequently, the staging assessment is likely to be much
better informed than for a third party loan and will be, primarily, a qualitative
exercise. In many cases, it will be reasonably clear whether there has been
a significant increase in credit risk since the loan was first made, although there
will still be a judgement to be made as to what is ‘significant’. Circumstances
that indicate a significant increase in credit risk may include a significant change
in the business, financial or economic conditions, or regulatory, economic or
technological environment in which the borrower operates, declining revenues
Not all intercompany
loans may qualify to be
measured at amortised
cost.
143 April 2018 Impairment of financial instruments under IFRS 9
and margins, or capital deficiencies, in each case that are likely to have
a significant impact on the entity’s ability to meet its debt obligations.
275
Also, the credit risk on a loan depends, in part, on the level of loss absorbing
equity of the borrowing entity. If the parent of a group company commits to
support a distressed subsidiary (in advance of becoming distressed) by injecting
new equity, this may mean that there is no significant increase in the credit risk
of the loan.
How we see it
It is probably fair to say that much less attention has been paid to how to
calculate ECLs on intercompany loans than on other aspects of IFRS 9.
However, we make the following observations:
a) As long as group companies are adequately capitalised, most
intercompany loans will be in stage 1 and, so, will require an allowance
equal to the 12 month ECLs.
b) Those balances that are genuinely repayable on demand will attract
a negligible ECL, since ECLs are only measured over the period in which
the entity is exposed to credit risk. However, if the loan is incapable of
being repaid on demand, such that the borrower would default if the
loan were called, the probability of default would probably need to be
set to 100%. However, even though the PD
may be 100%, the LGD may be much lower if the lender can expect,
in due course, to recover most or all of the amount of the loan once
the underlying assets are realised.
c) For those stage 1 intercompany loans that are term loans with a
maturity greater than 12 months, it will be necessary to determine
the 12-month PD and the LGD. This will often be difficult given that
there will be no statistical basis to do so. It will be easier to assess
a PD – and for it to be reasonably low – if the borrower is adequately
capitalised relative to the risks it faces, so that it could raise funding
from a third party.
d) For those intercompany loans between fellow subsidiaries that are
guaranteed by a parent which is listed (and the guarantee is considered
to be part of the loan’s contractual terms (see 4.8.1 above)), the
expected loss will normally be equal to the parent’s PD multiplied by
its LGD, since the parent will usually ensure, if it can do so, that its
subsidiary will not default (and the subsidiary is also likely to default
if the parent does). It will often be much easier to calculate an ECL
based on a parent PD and LGD, since there may be bond spreads, CDS
spreads and credit ratings to draw upon. It may, therefore, be advisable
to document guarantee arrangements when this is already the implicit
basis on which the loan was given. However, it may be that the parent
has no other activities other than acting as a holding company, in which
case, its PD will be closely aligned with that of its subsidiaries. There will
also be cases where the subsidiary can be expected to survive even if
the parent defaults.
e) To the extent that the lender is the parent, it cannot, for its own
accounting purposes, rely on guarantees given to itself. Meanwhile,
any entity that does provide a guarantee will need to measure its
exposure to the guarantee, hence the existence of a guarantee
275
IFRS 9.B5.5.17 (f), (g), (i)
144 April 2018 Impairment of financial instruments under IFRS 9
does not remove the challenge of calculating the PD and LGD of
the subsidiary. In general, the fact that a group intends to ensure
that a subsidiary will never default does not eliminate the risk posed
by that subsidiary’s activities or remove the need for an ECL allowance.
f) In some cases it may be possible to derive a PD for a loan to a group
company based on the cost of loans provided to that, or similar
companies, by external lenders.
13 Presentation of expected credit losses in
the statement of financial position
IFRS 9 uses the term ‘loss allowance’ throughout the standard as an umbrella
term for ECLs that are recognised in the statement of financial position.
However, that umbrella term leaves open the question of how those ECLs
should be presented in that statement. Their presentation differs by the type of
the credit risk exposures that are in scope of the impairment requirements.
276
This section explains how presentation applies in the different situations.
Any adjustment to the loss allowance balance due to an increase or decrease of
the amount of ECLs recognised in accordance with IFRS 9, is reflected in profit
or loss in a separate line as an impairment gain or loss.
277
13.1 Allowance for financial assets measured at amortised
cost, contract assets and lease receivables
ECLs on financial assets measured at amortised cost, lease receivables and
contract assets are presented as an allowance, i.e., as an integral part of
the measurement of those assets in the statement of financial position.
Unlike the requirement to show impairment losses as a separate line item in
the statement of profit or loss, there is no similar consequential amendment to
IAS 1 to present the loss allowance as a separate line item in the statement of
financial position.
278
It is clear from the standard that the definition of amortised cost of a financial
asset refers to after it has been adjusted for any loss allowance and hence,
the loss allowance would reduce the gross carrying amount in the statement
of financial position (which is why an allowance is sometimes referred to as a
contra asset account).
279
Accordingly, financial assets measured at amortised
cost, contract assets and lease receivables should be presented net of the loss
allowance at their amortised cost in the statement of financial position.
This was confirmed at the ITG meeting in December 2015, when the ITG
discussed whether an entity is required to present the loss allowance for
financial assets measured at amortised cost (or trade receivables, contract
assets or lease receivables) separately in the statement of financial position.
The ITG members first noted that, irrespective of how the loss allowance is
presented or how it is included in the measurement of the financial instrument,
IFRS 7 contains disclosure requirements pertaining to the loss allowance for all
financial instruments within the scope of the IFRS 9 impairment requirements.
The ITG members also noted that, in contrast to the case of financial assets
measured at fair value through other comprehensive income, neither IFRS 9 nor
IFRS 7 contains any specific requirements regarding the presentation of the loss
allowance for financial assets measured at amortised cost (or trade receivables,
276
IFRS 9 Appendix A
277
IAS 1.82(ba), IFRS 9.5.5.8, Appendix A
278
IAS 1.82(ba)
279
IFRS 9 Appendix A
A write-off is considered
a derecognition event.
145 April 2018 Impairment of financial instruments under IFRS 9
contract assets or lease receivables) on the face of the statement of financial
position. In accordance with the general requirements of IAS 1, the financial
statements should fairly present the financial position of an entity. However,
the ITG members noted that paragraph 54 of IAS 1 does not list the loss
allowance as an amount that is required to be separately presented on
the face of the statement of financial position.
13.1.1 Write-off
IFRS 9 provides guidance on when the allowance should be used, i.e., when
it should be applied against the gross carrying amount of a financial asset. This
occurs when there is a write-off on a financial asset, which happens when the
entity has no reasonable expectations of recovering the contractual cash flows
on a financial asset in its entirety or a portion thereof. A write-off is considered
a derecognition event.
280
No similar guidance is provided in IAS 39 and its
derecognition guidance does not refer to write-offs.
For example, a lender plans to enforce the collateral on a loan and expects
to recover no more than 30 per cent of the value of the loan from selling
the collateral. If the lender has no reasonable prospects of recovering any
further cash flows from the loan, it should write off the remaining 70 per
cent.
281
The example given in the standard demonstrates that write-offs
can be for only a partial amount instead of the entire gross carrying amount.
If the amount of loss on write-off is greater than the accumulated loss
allowance, the difference will be an additional impairment loss. In situations
where a further impairment loss occurs, the question has arisen as to how
it should be presented: either simply as a loss in profit or loss with a credit
directly to the gross carrying amount; or as an addition to the allowance that
is then applied against the gross carrying amount. The difference between
those alternatives is whether the additional impairment loss flows through
the allowance, showing up in a reconciliation of the allowance as an addition
and a use (i.e., a write-off), or whether such additional impairment amounts
bypass the allowance. The IASB’s original 2009 ED (see section 1.1 above)
explicitly mandated that all write-offs could only be debited against the
allowance, meaning that any direct write-offs against profit or loss without
flowing through the allowance were prohibited.
282
IFRS 9 does not include
any similar explicit guidance on this issue (see section 7.1 above in relation
to presentation of modification losses).
Similarly, the standard does not provide guidance on accounting for
subsequent recoveries of a financial asset. Arguably, there would be a higher
threshold when recognising an asset that has been previously written-off
and this is likely to be when cash is received rather than when the criteria
for write-off are no longer met. It might also be argued that such recoveries
should not often be significant, as write-off should only occur when there is
no reasonable expectations of recovering the contractual cash flows. As the
nature of recoveries are similar to reversals of impairment, it makes sense
to present such recoveries in the impairment line in profit or loss as it would
provide useful and relevant information to the users of the financial
statements.
283
280
IFRS 9.5.4.4, B3.2.16(r)
281
IFRS 9.B5.4.9.
282
Exposure Draft – Financial Instruments: Amortised Cost and Impairment, November 2009,
para. B23.
283
IAS 1.82(ba)
146 April 2018 Impairment of financial instruments under IFRS 9
In addition, IFRS 7 requires an entity to disclose its policies in relation to write-
offs and also, the amounts written off during the period that are still subject
to enforcement activity (see section 14).
284
It should be noted that there is a
tension between this requirement and the criteria in IFRS 9 for write-offs, since
it may be difficult to argue that there is no reasonable expectation of recovering
the contractual cash flows if the loan is still subject to enforcement activity.
13.1.2 Presentation of the gross carrying amount and expected credit loss
allowance for credit-impaired assets
For financial assets that are not purchased or originated credit-impaired,
but subsequently have become credit-impaired (i.e., moved to stage 3), the
application of the EIR to the financial asset’s amortised cost, i.e., the gross
carrying amount net of the ECL allowance, applies only to the calculation and
presentation of interest revenue in subsequent reporting periods.
285
The Basis
for Conclusions confirms that this does not affect the measurement of the loss
allowance.
286
As long as the asset was not credit-impaired on initial
recognition, the EIR is based on the contractual cash flows, excluding ECLs and
this does
not change when the asset becomes credit-impaired.
287
Consequently, the
calculation of the gross carrying amount and the ECL allowance are not
affected by the recognition of interest revenue moving from a gross to a net
basis.
During its meeting in December 2015, the ITG discussed the measurement
of the gross carrying amount and loss allowance for credit-impaired
financial assets that are measured at amortised cost (excluding those
that are purchased or originated credit-impaired). Interest revenue for
credit-impaired financial assets is required to be reported in profit or loss
based on the original EIR multiplied by the amortised cost (i.e., the gross
carrying amount less the loss allowance). A question was raised on how
the disclosed figures for the gross carrying amount and loss allowance
should each be calculated. The example below is based on the ITG
discussion, but has been amended to reflect unpaid accrued interest
in the gross carrying amount.
288
Example 25: Disclosing the gross carrying amount and loss
allowance for credit-impaired financial assets that are not
purchased or originated credit-impaired
The Bank originated a loan on 1 January 2018, with an amortised cost of $100
and an EIR of 10% per annum. On 31 December 2018, the loan is considered to
be credit-impaired and so is moved to stage 3, and an impairment allowance is
recognised of $70. Accordingly, the gross carrying amount of the loan is now
$110 and the amortised cost is now $40. During 2019, no cash is received, and
on 31 December 2019, there is no change in the expected cash flows. Accordingly,
the amortised cost becomes $44 (being $40 + ($40 × 10%)). Three different ways
could be used to reflect the changes in the net amortised cost in the gross carrying
amount and the loss allowance. In Approach A, interest continues to be accrued in
the measurement of the gross carrying amount at 10%, in Approach B, the interest
accrued to the gross carrying amount is only the $4 recorded in profit or loss, while
in Approach C, no interest is added to the gross carrying amount:
284
IFRS 7.35F(e), 35L
285
IFRS 9.5.4.1(b)
286
IFRS 9.BC5.75
287
IFRS 9.B5.4.4, Appendix A
288
Transition Resource Group for Impairment of Financial Instruments, Agenda ref 9,
Measurement of the loss allowance for credit-impaired financial assets, 11 December 2015.
For stage 3 loans, the
disclosed gross amount
and the allowance each
need to be grossed up
for the accrual of
interest.
147 April 2018 Impairment of financial instruments under IFRS 9
Example 25: Disclosing the gross carrying amount and loss
allowance for credit-impaired financial assets that are not
purchased or originated credit-impaired (cont’d)
Approach
A
B
C
$
$
$
Gross carrying amount
121*
114
110
Loss allowance
(77)
(70)
(66)
Amortised cost
44
44
44
* The gross carrying amount is calculated by adding the EIR of 10% per annum on the
31 December 2018 gross carrying amount of $110, i.e., 10% × $110 = $11.
It was acknowledged by the ITG members that IAS 39 provides no specific
guidance on this matter and that there is diversity in current practice.
The ITG members appeared to agree that only Approach A is IFRS 9-compliant.
Thereby, for assets in stage 3, it is necessary to ‘gross up’ accrued interest
income, to increase both the disclosed gross carrying amount and loss
allowance in the notes to the financial statements. This is because IFRS 9,
unlike IAS 39, defines the gross carrying amount. Approach A requires
the entity to calculate:
(a) The gross carrying amount by discounting the estimated contractual
cash flows (without considering ECLs) using the original EIR
(b) The loss allowance by discounting the expected cash shortfalls
using the original EIR
This conclusion has caused some discussion. Some have pointed out that,
assuming no further loss is expected, this results in an increase in the amount
of the impairment allowance over time that is not presented as an impairment
loss, even though all movements in the allowance are required by IAS 1 to
be reported in a separate line in the income statement.
289
Presumably the
IASB considers the requirements of IFRS 9 to be more relevant, since it is
specific on how the gross carrying amount is defined and how interest should
be recognised. However, it would be useful for IAS 1 to be amended so as to
be consistent.
Depending on the legal form of the loan, we assume that, once interest is no
longer contractually due, for instance, when the bank moves to take possession
of collateral, there would be no need to continue to make these gross-up
entries.
In addition, the gross carrying amount, as required to be disclosed, is not the
same as the amount normally required by banking regulators to be disclosed
as ‘non-performing loans’ and used as a key reporting metric by banks. This is
because such measures do not normally continue to accrue interest once they
default, if no further interest is expected to be received. Banks may, therefore,
wish to add further disclosure, as illustrated by Example 26 below:
289
IAS 1.82
148 April 2018 Impairment of financial instruments under IFRS 9
Example 26: Disclosing the gross carrying amount and loss
allowance for credit-impaired financial assets that are not
purchased or originated credit-impaired and the value of
non-performing loans
The fact pattern is the same as in Example 25 above.
The bank has a policy of disclosing its non-performing loans measured without
accruing interest. The following approach is designed to disclose both methods
of reporting the loans as of 31 December 2019.
Non-performing loans
$100
Accrued interest
$21
Gross carrying amount
$121
Loss allowance
($77)
Amortised cost
$44
The IASB is of the view that, conceptually, an entity should assess whether
financial assets have become credit-impaired on an ongoing basis, thus, altering
the presentation of interest revenue as the underlying economics change.
However, the IASB noted that such an approach would be unduly onerous
for preparers to apply. Thus, it decided that an entity should be required to
make the assessment of whether a financial asset is credit-impaired at the
reporting date and then change the interest calculation from the beginning
of the following reporting period.
290
Arguably, if an entity is able to change the
interest calculation earlier than the reporting date, then this would be a timelier
adjustment and reflection of the interest revenue. However, this is not what the
standard requires.
If there are subsequent improvements in the credit risk of the financial
asset such that it is moved back to stage 2, there should not be any catch-up
adjustments to the interest revenue recognised in a subsequent reporting
period unless there are changes in expected cash flows. This is illustrated in
the example below:
Example 27: Presentation of the interest revenue, gross carrying
amount, loss allowance and amortised cost for when assets move
from stage 2 to stage 3 and vice versa
Based on the fact pattern in Example 25 above, for the reporting period to
31 December 2018, the interest revenue would be calculated by applying the 10%
EIR to the gross carrying amount of the loan of $100, i.e., $10. For the subsequent
reporting period to 31 December 2019, the interest revenue would be calculated
by applying the 10% EIR to the amortised cost of the loan of $40, i.e., $4, instead
of the gross carrying amount.
During 2020, the credit risk of the loan improves and the contractual interest
for 2018, 2019 and 2020 of $33 (including interest on interest) is received at
the beginning of 2021. At the end of 2020, the loan is transferred to stage 2 and
the ECL is reduced to $40. For the next reporting period to 31 December 2021,
the interest revenue would be calculated by applying the 10% EIR to the gross
carrying amount of the financial asset once the backlog of interest has been received
of $100, i.e., $10. It is assumed that the ECL is left unchanged during 2021 except
for the unwind of the discount.
Consistent with the treatment of interest income when an asset first becomes credit
impaired, we have restored the recognition of interest income to the EIR multiplied
290
IFRS 9.BC5.78
149 April 2018 Impairment of financial instruments under IFRS 9
Example 27: Presentation of the interest revenue, gross carrying
amount, loss allowance and amortised cost for when assets move
from stage 2 to stage 3 and vice versa (cont’d)
by the gross amortised cost only from the start of the next reporting period.
31 December
2018
31 December
2019
31 December
2020
31 December
2021
$
$
$
$
Gross carrying
amount
As at 1 Jan
100
110
121
133
Interest
accrued (EIR)
on the gross
carrying
amount
10
11
12
10
Interest
received
–
–
–
(33)
As at 31 Dec
110
121
133
110
ECL allowance
As at 1 Jan
–
70
77
40
Impairment
70
–
(45)
4
Adjustment to
interest
accrued
–
7
8
–
As at 31 Dec
70
77
40
44
Amortised cost
As at 1 Jan
$100
$40
$44
$93
As at 31 Dec
$40
$44
$93
$66
13.2 Provisions for loan commitments and financial guarantee
contracts
In contrast to the presentation of impairment of assets, ECLs on loan
commitments and financial guarantee contracts are presented as a provision
in the statement of financial position, i.e., as a liability.
291
For financial institutions that offer credit facilities, commitments may often
be partially drawn down, i.e., an entity may have a facility that includes both
a loan (a financial asset) and an undrawn commitment (a loan commitment).
If the entity cannot separately identify the ECLs attributable to the drawn
amount and the undrawn commitment, IFRS 7 requires an entity to present
the provision for ECLs on the loan commitment together with the allowance
for the financial asset. IFRS 7 states, further, that if the combined ECLs exceed
the gross carrying amount of the financial asset, then the ECLs should be
recognised as a provision.
292
291
IFRS 9 Appendix A
292
IFRS 7.B8E
150 April 2018 Impairment of financial instruments under IFRS 9
13.3 Accumulated impairment amount for debt instruments
measured at fair value through other comprehensive
income
Rather than presenting ECLs on financial assets measured at fair value through
other comprehensive income as an allowance, this amount is presented as
the ‘accumulated impairment amount’ in other comprehensive income. This is
because financial assets measured at fair value through other comprehensive
income are measured at fair value in the statement of financial position and
the accumulated impairment amount cannot reduce the carrying amount of
these assets (see section 8 above for further details).
293
14 Disclosures
14.1 Introduction
For entities applying IFRS 9, the IFRS 7 disclosure requirements for impairment
are expanded significantly compared to the requirements for entities applying
IAS 39. The IFRS 7 requirements are supplemented by some detailed
implementation guidance.
14.2 Scope and objectives
The objective of the disclosures is to enable users to understand the effect
of credit risk on the amount, timing and uncertainty of future cash flows.
To achieve this objective, the disclosures should provide:
294
•
Information about the entity’s credit risk management practices and
how they relate to the recognition and measurement of ECLs, including
the methods, assumptions and information used to measure those losses
(see section 14.4 below)
•
Quantitative and qualitative information that allows users of financial
statements to evaluate the amounts in the financial statements arising from
ECLs, including changes in the amount of those losses and the reasons for
those changes (see section 14.5 below)
•
Information about the entity’s credit risk exposure, i.e., the credit risk
inherent in its financial assets and commitments to extend credit, including
significant credit risk concentrations (see section 14.6 below)
An entity will need to determine how much detail to disclose, how much
emphasis to place on different aspects of the disclosure requirements, the
appropriate level of aggregation or disaggregation, and whether additional
explanations are necessary to evaluate the quantitative information
disclosed.
295
If the disclosures provided are insufficient to meet the
objectives above, additional information that is necessary to meet those
objectives must be disclosed.
296
To avoid duplication, IFRS 7 allows this information to be incorporated by
cross-reference from the financial statements to some other statement that
is available to users of the financial statements on the same terms and at
the same time, such as a management commentary or risk report. Without
the information incorporated by cross-reference, the financial statements
are incomplete.
297
293
IFRS 9.4.1.2A, 5.5.2, Appendix A
294
IFRS 7.35B
295
IFRS 7.35D
296
IFRS 7.35E
297
IFRS 7.35C
The new IFRS 7 credit
risk disclosure
requirements have been
expanded significantly
and are supplemented
by some detailed
implementation
guidance.
151 April 2018 Impairment of financial instruments under IFRS 9
A number of the disclosures in respect of credit risk are required to be given
by class. In determining these classes, financial instruments in the same class
should reflect shared economic characteristics with respect to credit risk.
A lender, for example, might determine that residential mortgages, unsecured
consumer loans and commercial loans each have different economic
characteristics.
298
14.3 EDTF recommendations on ECL disclosures for banks
The Enhanced Disclosure Task Force (EDTF) was established by the Financial
Stability Board (FSB) in 2012, to seek to improve the quality, comparability
and transparency of risk disclosures, by bringing together banks, investors,
analysts and auditors. In 2015, the FSB asked the EDTF to consider disclosures
that might be useful to help the market understand the changes as a result
of the ECL approach and to promote consistency and comparability. In
November 2015, the EDTF published its report, Impact of Expected Credit
Loss Approaches on Bank Risk Disclosures, in which it recommended disclosures
for banks to provide with the implementation of the ECL requirements of IFRS 9
and US GAAP.
While some of the EDTF recommended disclosures overlap with those required
by IFRS 7, as amended by IFRS 9, many of the disclosures are new and not
included in any other framework or authoritative guidance. Banks have
to assess the availability and quality of data that are necessary to provide
these disclosures and, more generally, the full range of the EDTF disclosures.
It should be noted that, while the EDTF is not a standard setter and its
recommendations are not mandatory, regulators in a number of countries have
strongly encouraged their implementation, and analysts, investors and other
stakeholders are showing an increased interest in them. The recommendations
are designed for large international banks, but they should be equally relevant
for other banks that actively access the major public equity or debt markets.
Many of the recommendations relate to the period from 2015 to 2017 as
the implementation date of IFRS 9 drew near. In this publication, we make
reference only to the EDTF’s recommendations for ongoing reporting under
IFRS 9 subsequent to implementation and not to the transition discosures.
The recommended disclosures of the consequent impact on regulatory capital
are also outside the scope of this publication.
How we see it
Although the EDTF recommendations are targeted at large international
banks, they provide a useful list of considerations for all entities for which
the impact of the IFRS 9 impairment requirements is particularly material.
14.4 Credit risk management practices
IFRS 7 requires that an entity should explain its credit risk management
practices and how they relate to the recognition and measurement of expected
credit losses. To meet this objective, the entity should disclose information
that enables users to understand and evaluate:
299
•
How it has determined whether the credit risk of financial instruments has
increased significantly since initial recognition, including if and how:
• Financial instruments are considered to have low credit risk (see section
5.4.1), including the classes of financial instruments to which it applies
298
IFRS 7.IG21
299
IFRS 7.35F
152 April 2018 Impairment of financial instruments under IFRS 9
• The presumption that there have been significant increases in credit
risk since initial recognition when financial assets are more than
30 days past due has been rebutted (see section 5.4.2)
•
Its definitions of default, including the reasons for selecting those
definitions (see section 4.1). This may include:
300
• The qualitative and quantitative factors considered in defining default
• Whether different definitions have been applied to different types of
financial instruments
• Assumptions about the cure rate, i.e., the number of financial assets
that return to a performing status, after a default has occurred on
the financial asset
•
How the instruments were grouped if ECLs were measured on a collective
basis (see section 5.5.2)
•
How it has determined that financial assets are credit-impaired (see
section 3.1)
•
Its write-off policy, including the indicators that there is no reasonable
expectation of recovery and information about the policy for financial
assets that are written-off but are still subject to enforcement activity
(see section 13.1.1)
•
How the requirements for the modification of contractual cash flows of
financial instruments have been applied (see section 7), including how
the entity:
• Determines whether the credit risk on a financial asset that has been
modified, while the loss allowance was measured at an amount equal
to lifetime ECLs, has improved to the extent that the loss allowance
reverts to being measured at an amount equal to 12-month ECLs
• Monitors the extent to which the loss allowance on financial assets
meeting the criteria in the previous bullet is subsequently re-measured
at an amount equal to lifetime ECLs
How we see it
An asset (or portion thereof) should be written off only if there is no
reasonable expectation of recovery.
301
Consequently, it is not entirely
clear in which circumstances an entity would need to disclose a policy
for financial assets that are written off but are still subject to enforcement
activity
The standard suggests that quantitative information that will assist users in
understanding the subsequent increase in credit risk of modified financial
assets, may include information about modified financial assets meeting
the criteria above for which the loss allowance has reverted to being measured
at an amount equal to lifetime ECLs, i.e., a re-deterioration rate.
302
Including
qualitative information can also be a useful way of meeting this disclosure
requirement.
The EDTF recommends banks to disclose how the risk management
organisation, processes and key functions have been organised to calculate
300
IFRS 7.B8A
301
IFRS 9.5.4.4
302
IFRS 7.B8B
153 April 2018 Impairment of financial instruments under IFRS 9
ECLs, highlighting how credit practices and policies form the basis for ECL
calculations.
303
The EDTF highlights that, although regulatory and accounting frameworks
use calculations with similar concepts, the precise definitions of these
concepts will differ. Consequently, it recommends that banks clearly define
all the terms used in the calculation of expected credit losses, with a focus on
explaining differences between the definitions used for regulatory purposes
and those for IFRS 9. For example, banks should make clear the extent to
which the accounting definition of default is consistent with the definition
used for internal management purposes and how it compares to the regulatory
definition. A further example is the time horizon over which ECLs are measured
for types of contracts where a specific interpretation is required, such as
revolving facilities. The EDTF also recommends that banks should provide
their definition for those terms that are not formally defined, such as ’through
the cycle’, ‘point in time’ and ‘behavioural life’.
304
Other disclosures encouraged by the EDFT for banks to consider include:
305
•
In addition to defining ‘default’, describing whether the 90-day rebuttable
presumption is used and in what circumstances
•
In describing how a significant increase in credit risk is determined, how
individual assessments and portfolio assessments are applied, plus the
application of any temporary collective adjustments. This description
should address:
• Indicators used, such as credit risk ratings, past due status, PDs, or
watch lists
• Interpretation of what is understood by a ‘significant increase in credit
risk’, at an appropriate level of portfolio segmentation and granularity
• The types of forward-looking information used and how it is used
• For portfolio assessments, identification of specific exposures or sub-
portfolios affected by a deterioration in macroeconomic conditions
(the bottom up approach), or how a top down approach has been
applied (see section 5.5.3)
•
For exposures where it may be difficult to determine credit risk at initial
recognition, such as current accounts, revolving facilities and renewable
exposures, the approach the bank has used.
•
The circumstances in which modifications of a loan would lead to its
derecognition and the recognition of a new loan.
•
How forbearance is treated, including when forborne exposures are
transferred to stage 2 or are considered credit-impaired, and the
procedures for transferring ’cured’ exposures back to stage 1. Also,
when there are specific regulatory pronouncements on modifications,
how these are reflected in the IFRS 9 approach.
IFRS 7 requires that an entity should explain the inputs, assumptions and
estimation techniques used to apply the impairment requirements of IFRS 9.
For this purpose it should disclose:
306
•
The basis of inputs and assumptions and the estimation techniques used to:
303
EDTF Recommendation 5
304
EDTF Recommendation 2
305
EDTF Recommendation 2
306
IFRS 7.35G
154 April 2018 Impairment of financial instruments under IFRS 9
• Measure 12-month and lifetime ECLs (see sections 4.2. and 4.3)
• Determine whether the credit risk of financial instruments has
increased significantly since initial recognition (see section 5)
• Determine whether a financial asset is credit-impaired (see section 3.1)
This may include information obtained from internal historical information
or rating reports and assumptions about the expected life of financial
instruments and the timing of the sale of collateral.
307
•
How forward-looking information has been incorporated into the
determination of ECLs, including the use of macroeconomic information.
Where relevant, this will include information about the use of multiple
economic scenarios in determining the expected credit losses (see
section 4.6)
•
Changes in estimation techniques or significant assumptions made during
the reporting period and the reasons for those changes
The EDTF also recommends that banks should consider disclosing the following
features of their ECL modelling techniques:
308
•
For PDs, EADs, LGDs and credit conversion factors, the types of input used,
the most relevant assumptions and judgements made, and the uncertainties
involved
•
The types of forward looking information used to calculate ECLs and how
the impact of this information on ECLs is determined. This discussion
should include the extent to which judgement is required and how it is
applied
•
How ECL modelling builds on Basel regulatory capital models and
the differences in approach, such as the use of Basel floors, downturn
adjustments, time horizons and discount factors
Where the parameters are not based on those used for Basel modelling,
how they were developed and the use of expert judgement, which may be
of particular relevance for low-default and low-volume portfolios
•
The use and nature of material additional adjustments to capture factors
not specifically embedded in the models used to calculate ECLs
The EDTF further recommends that banks should describe their policies for
identifying impaired or non-performing loans, including how the bank defines
impaired or non-performing, restructured and returned-to-performing (cured)
loans as well as explanations of loan forbearance policies.
309
The EDTF recommends that consideration should be given to providing
dislcosure of the key drivers of change in credit losses, but only where they
are meaningful and relevant to understanding the material changes:
310
•
All top and emerging risks should be discussed, including their impact (or
not) on ECLs, either quantitatively or qualitatively as appropriate.
•
Sensitivity analyses can provide useful quantitative information when they
are meaningful and relevant to understanding how credit risks can change
materially. This is most likely to be the case if an individual risk parameter
has a significant impact on the overall credit risk of the portfolio, because a
change in any individual parameter will often be associated with correlated
307
IFRS 7.B8C
308
EDTF Recommendation 2
309
EDTF Recommendation 27
310
EDTF Recommendation 3
Sensitivity analysis is
useful if an individial
risk parameter has
a significant impact on
the portfolio’s credit risk.
155 April 2018 Impairment of financial instruments under IFRS 9
changes in other factors. Sensitivity information is also likely to be more
useful for users if it is used for internal credit risk management. Examples
of possible sensitivities that might be disclosed include:
• Variables that cause an impact on a loan portfolio on an ongoing basis.
An example would be the sensitivity to house prices for a residential
mortgage portfolio
• Changes that emerge at a particular point in time for specific portfolios.
An example would be an economic shock to a specific industry
•
An alternative to disclosure of the effect of varying an individual parameter
would be to disclose the ECLs based on an alternative reasonably possible
scenario, which would incorporate changes in several underlying
parameters.
•
Quantitative disclosures may be less appropriate for some risks that are
relevant, but which are not easily reflected in ECL models. Examples of
risks that are not easily reflected in ECL models would include economic
or political developments, for which qualitative disclosures may be more
appropriate. An example that has emerged since the EDTF published its
report is the impact of ‘Brexit’.
14.5 Quantitative and qualitative information about amounts
arising from expected credit losses
14.5.1 Changes in the loss allowance and the gross exposures
An entity should explain the changes in the loss allowance and reasons for
those changes by presenting a reconciliation of the opening balance to the
closing balance. This should be given in a table for each relevant class of
financial instruments, showing separately the changes during the period
for:
311
•
The loss allowance measured at an amount equal to 12-month ECLs
•
The loss allowance measured at an amount equal to lifetime ECLs for:
• Financial instruments for which credit risk has increased significantly
since initial recognition, but that are not credit-impaired financial assets
• Financial assets that are credit-impaired at the reporting date (but
were not credit-impaired when purchased or originated)
• Trade receivables, contract assets or lease receivables for which
the loss allowance is measured using a simplified approach based
on lifetime ECLs
•
Financial assets that were credit-impaired when purchased or originated.
The total amount of undiscounted ECLs on initial recognition of any such
assets during the reporting period should also be disclosed
In addition, it may be necessary to provide a narrative explanation of the
changes in the loss allowance during the period. This narrative explanation
may include an analysis of the reasons for changes in the loss allowance
during the period, including:
312
•
The portfolio composition
•
The volume of financial instruments purchased or originated
•
The severity of the ECLs
311
IFRS 7.35H
312
IFRS 7.B8D
156 April 2018 Impairment of financial instruments under IFRS 9
These requirements, along with a number of others set out in IFRS 7 and/or
recommended by the EDTF, are illustrated in Example 28.
The EDFT emphasises the importance of distinguishing between changes
in ECLs that are due to movements in loan balances (including new lending,
recoveries and write offs), from those due to model changes and those due
to changes to credit risk parameters.
The EDTF also notes that the sequencing of movements is important when
preparing an allowance reconciliation. First, if transfers between stages are
considered to take place at the beginning of the period, the amount of the
transfer could be based on the closing balance from the previous period, which
would not include any difference in measurement as a result of the change
in stage or change in assumptions. Alternatively, if transfers are considered
to take place at the end of the period, the amount transferred could be based
on the period end balances, which may or may not include the difference
in measurement as a result of the change in stage. Similarly, if changes
in measurement due to movements in risk parameters are the first in the
sequence, this will give a different amount for the transfer as a result of
the change in stage than if the change in stage is calculated first.
313
We also note that there are two possible ways of presenting the effect of
changes in stage in the reconciliation. One possibility is to show transfers
from stage 1 to 2 based on the 12 month ECLs, which will mean that the total
for each transfer line will sum to zero. The change in ECLs due to the uplift
from 12-month to lifetime ECLs, and the effect of any changes in parameters,
must then be shown separately. Another approach, as shown in Example 28,
would be to show the transfers as a reduction of the stage 1 column based
on the 12-month allowances and the increase in stage 2 column based on the
lifetime allowances, so that the sum of the row will equal the overall effect on
ECLs due to the transfers between stages.
An explanation should also be provided of how significant changes in the gross
carrying amount of financial instruments during the period contributed to
changes in the loss allowance. This information should be provided separately
for each class of financial instruments for which loss allowances are analysed
(see above). Examples of changes in the gross carrying amount of financial
instruments that contribute to changes in the loss allowance may include:
314
•
Changes because of financial instruments originated or acquired during
the reporting period
•
The modification of contractual cash flows on financial assets that do not
result in a derecognition of those financial assets
•
Changes because of financial instruments that were derecognised, including
those that were written-off during the reporting period
•
Changes arising from the measurement of the loss allowance moving from
12-month expected credit losses to lifetime losses (or vice versa)
Although, as worded, the IFRS 7 requirement to explain movements in the gross
value of loans does not require a quantitative reconciliation, the implementation
guidance to the standard gives one in its illustrative example.
315
The EDTF
gives a similar example
316
and we have adopted this approach in Example 28.
313
EDTF Recommendation 28
314
IFRS 7.35I
315
IFRS 7 IG20B
316
EDTF Recommendation 28
157 April 2018 Impairment of financial instruments under IFRS 9
The EDTF also advocates a reconciliation of non-performing or impaired loans
in the period and the associated allowance for loan losses. Disclosures should
include an explanation of the effects of loan acquisitions on ratio trends, and
qualitative and quantitative information about restructured loans.
The following example shows, for a fictitious bank, what some of the IFRS 7
disclosures for one class of lending might look like.
Example 28: Certain disclosures of impairment allowances by
a bank for one class of lending
Small business lending
The table below shows the credit quality and the maximum exposure to credit risk
based on the Bank’s internal credit rating system and year-end stage classification.
Except for POCI loans, the amounts presented are gross of impairment allowances.
The table analyses separately those loans which are assessed and measured
individually and those which are assessed and measured on a collective basis:
In $ million
2018
2017
Internal rating
grade
Stage 1
Individual
Stage 1
Collective
Stage 2
Individual
Stage 2
Collective
Stage
3
POCI
Total
Total
Performing
High grade
1,168
832
–
–
–
–
2,000
2,358
Standard
grade
728
340
299
358
–
–
1,725
1,886
Sub-standard
grade
–
–
213
321
–
23
557
180
Low grade
–
–
75
194
-
-
269
120
Non-
performing
Individually
impaired
–
–
–
–
205
31
236
208
Total
1,896
1,172
587
873
205
54
4,787
4,752
The following is a reconciliation of the gross carrying amounts at the beginning and
end of the year:
In $ million
Stage 1
Individual
Stage 1
Collective
Stage 2
Individual
Stage 2
Collective
Stage
3
POCI
Total
Gross carrying
amount as at
1 January 2018
1,871
1,129
626
938
188
–
4,752
New assets
originated or
purchased
167
163
–
–
–
56
386
Assets
derecognised or
repaid
(excluding write
offs)
(137)
(125)
(59)
(81)
(35)
(4)
(341)
Transfers to
Stage 1
16
8
(16)
(8)
–
–
158 April 2018 Impairment of financial instruments under IFRS 9
Example 28: Certain disclosures of impairment allowances by
a bank for one class of lending (cont’d)
Transfers to
Stage 2
(48)
(19)
62
19
(14)
–
–
Transfers to
Stage 3
(5)
(4)
(36)
(12)
57
–
–
Changes to
contractual cash
flows due to
modifications
not resulting in
derecognition
–
–
–
–
(9)
–
(9)
Change in
interest charged
but not received
21
12
4
13
27
279
Amounts written
off
–
–
–
(12)
–
(12)
Foreign
exchange
revaluation
11
8
6
4
3
–
32
At 31
December 2018
1,896
1,172
587
873
205
54
4,787
The following is a reconciliation of the ECL allowances as at the beginning and end of
the year. The effect on ECLs of transfers between stages has been calculated based
on the allowances recorded at the date of transfer:
In $ million
Stage 1
Individual
Stage 1
Collective
Stage 2
Individual
Stage 2
Collective
Stage 3
POCI
Total
ECL allowances
as at 1 January
2018
48
41
36
47
79
–
251
New assets
originated or
purchased
5
15
–
–
–
–
20
Assets
derecognised or
repaid
(excluding write
offs)
(4)
(12)
(5)
(3)
(4)
–
(28)
Transfers to
Stage 1
1
–
(2)
(1)
-
–
(2)
Transfers to
Stage 2
(4)
(1)
21
5
–
–
21
Transfers to
Stage 3
(1)
(1)
(10)
(4)
20
–
4
Unwind of
discount
9
10
5
6
13
–
43
Changes to
contractual cash
flows due to
modifications
not resulting in
derecognition
–
–
–
–
(6)
–
(6)
159 April 2018 Impairment of financial instruments under IFRS 9
Example 28: Certain disclosures of impairment allowances by
a bank for one class of lending (cont’d)
Changes to
models and
inputs used for
ECL calculations
7
10
6
5
18
3
49
Amounts written
off
–
–
–
–
(12)
–
(12)
Foreign
exchange
revaluation
2
2
1
1
1
–
7
At 31
December 2018
63
64
52
56
109
3
347
Of the $587m of loans classified as stage 2 on an individual basis, $ 37m
(1 January: $33m) of loans and $17m (1 January: $16m) of ECLs are more than
30 days past due.
The credit risk for the bank’s small business customers is mostly affected by factors
specific to individual borrowers, but, given the available information, the ECLs
for the majority of the loans are measured on a collective basis. The key inputs
in the ECL model, apart from the bank’s own credit risk appraisal process, are
assumptions about changes in Gross Domestic Product (GDP) and future interest
rates. As at 1 January 2018, the base scenario assumed that GDP will increase by
2.6% in 2018 and 2.0% in 2019, with the rate of increase declining over the next
four years to 1.5%. GDP grew during 2018 by only 2.0% and is now forecast to grow
by only 1.3% in 2019, increasing to 1.5% over the next four years. The base rate
of interest assumed in the base scenario as at 1 January 2018 was 1.2% for 2018
and 1.4% for 2109, increasing to 2.2% over the next four years. The average rate
for 2018 was 1.4% and the forecast for 2019 is now 1.5%, increasing to 2.3% over
the next four years.
The allowance was calculated using, in addition to the base scenario, an upside
scenario and two downside scenarios, all weighted to reflect their likelihood of
occurrence. The allowance as at 31 December 2018, based upon the bank’s base
case scenario, is $312.5m. The effect of applying multiple economic scenarios is
to increase the allowance by £34.5m (11%). (As at 1 January the equivalents were:
$230m, $40m and 14.8%).
Based upon past experience, reducing the growth in GDP over the next three years
by 1% (keeping interest rates constant) would increase the ECLs by approximately
$14m (1 January: $18m).
The largest contribution to the increase in ECLs of the portfolio during the year was
the update to inputs to models to reflect the deterioration in economic conditions.
However, the result of changes in the base scenario has been partly offset by a
small reduction in the effect of using multiple economic scenarios.
In preparing Example 28 we have made a number of choices:
1.
IFRS 7R.35I does not explicitly require a reconciliation of movements in the
gross carrying amounts in a tabular format and the standard’s requirement
could be addressed using a narrative explanation. However, the example
in the Illustrative Guidance (IFRS 7R.IG20B) provides a reconciliation in
a tabular format and the EDTF does too.
160 April 2018 Impairment of financial instruments under IFRS 9
2.
Small business lending was chosen for the example as it is possible that
some are assessed on a specific basis and some collectively. IFRS 7 does
not specifically require these to be shown separately, but two examples
in the standard (IFRS7R.IG20A and B) do so.
3.
The disclosure of the proportion of stage 2 loans that are 30 days past due
is not required by IFRS 7, but is regarded by users as useful information.
4.
We have chosen to provide only the net effect of using multiple scenarios,
rather than providing details of the scenarios and their weightings, in order
to avoid excessive detail.
5.
Consistent with the EDTF recommendations (and aware that the various
parameters are not independent), we have only disclosed sensitivity to
one parameter.
The following example in the standard’s Implementation Guidance illustrates
how ECL information might be presented for trade receivables.
317
Example 29:
Information about credit risk exposures using
a provision matrix
The reporting entity manufactures cars and provides financing to both dealers and
end customers. It discloses its dealer financing and customer financing as separate
classes of financial instruments and applies the simplified approach to its trade
receivables so that the loss allowance is always measured at an amount equal to
lifetime expected credit losses. The following table illustrates the use of a provision
matrix as a risk profile disclosure under the simplified approach:
20XX
Trade receivables days past due
CU’000
Current
More than
30 days
More than
60 days
More than
90 days
Total
Dealer financing
Expected credit loss
rate
0.10%
2%
5%
13%
Estimated total
gross carrying
amount at default
20,777
1,416
673
235
23,101
Expected credit
losses
21
28
34
31
114
Customer financing
Expected credit loss
rate
0.20%
3%
8%
15%
Estimated total
gross carrying
amount at default
19,222
2,010
301
154
21,687
Expected credit
losses
38
60
24
23
145
IFRS 7 also requires the disclosure of the contractual amount outstanding on
financial assets that were written off during the reporting period and which are
still subject to enforcement activity.
318
317
IFRS 7.IG20C, 20D
318
IFRS 7.35L
161 April 2018 Impairment of financial instruments under IFRS 9
14.5.2 Modifications
Information should be disclosed to provide an understanding of the nature and
effect of modifications of contractual cash flows on financial assets that have
not resulted in derecognition as well as the effect of such modifications on
the measurement of expected credit losses. The following information should
therefore be given:
319
•
The amortised cost before the modification and the net modification gain
or loss recognised for financial assets for which the contractual cash flows
have been modified during the reporting period while they had a loss
allowance based on lifetime ECLs
•
The gross carrying amount at the end of the reporting period of financial
assets that have been modified since initial recognition at a time when
the loss allowance was based on lifetime ECLs and, for which, the loss
allowance has changed during the reporting period to an amount equal
to 12-month ECLs
The discussion at the ITG on 22 April 2015 highlighted that these requirements
apply to all modifications, whether they are credit-related or are due to other
commercial reasons. However, if an entity has the ability to separately identify
different types of modifications and considers that the separate disclosure of
these items is relevant to achieving the overall objective of the disclosures in
this section, the entity could provide this additional detail as part of the
disclosure.
Where the loss allowance for trade receivables or lease receivables is measured
using a simplified approach based on lifetime ECLs, the information about
modifications need be given only if those financial assets are modified while
more than 30 days past due.
320
14.5 3. Collateral and other credit enhancements
To provide an understanding of the effect of collateral and other credit
enhancements on the amounts arising from expected credit losses, the
following must be disclosed by class of financial instrument:
321
•
The amount that best represents the maximum exposure to credit risk at
the end of the reporting period without taking account of any collateral held
or other credit enhancements (e.g., netting agreements that do not qualify
for offset in accordance with IAS 32)
•
A narrative description of collateral held as security and other credit
enhancements, including:
• A description of the nature and quality of the collateral held
• An explanation of any significant changes in the quality of that
collateral or credit enhancements as a result of deterioration or
changes in the entity’s collateral policies during the reporting period
• Information about financial instruments for which a loss allowance
has not been recognised because of the collateral
This might include information about:
322
• The main types of collateral held as security and other credit
enhancements, examples of the latter being guarantees, credit
319
IFRS 7.35J
320
IFRS 7.35A(a)
321
IFRS 7.35K
322
IFRS 7.B8G
162 April 2018 Impairment of financial instruments under IFRS 9
derivatives and netting agreements that do not qualify for offset
in accordance with IAS 32
• The volume of collateral held and other credit enhancements and
their significance in terms of the loss allowance
• The policies and processes for valuing and managing collateral
and other credit enhancements
• The main types of counterparties to collateral and other credit
enhancements and their creditworthiness
• Information about risk concentrations within the collateral and other
credit enhancements
•
Quantitative information about the collateral held as security and other
credit enhancements, e.g., quantification of the extent to which collateral
and other credit enhancements mitigate credit risk on financial assets that
are credit-impaired at the reporting date
Disclosure of information about the fair value of collateral and other credit
enhancements is not required by the standard, nor is a quantification of the
exact value of the collateral included in the calculation of ECLs (i.e., the LGD).
323
Further, these requirements do not apply to lease receivables.
324
14.6 Credit risk exposure
Users should be able to assess an entity’s credit risk exposure and understand
its significant credit risk concentrations. Therefore, an entity should disclose,
by ‘credit risk rating grades’ (see below), the gross carrying amount of financial
assets and the exposure to credit risk on loan commitments and financial
guarantee contracts. This information should be provided separately for
financial instruments (see Example 28):
325
•
For which the loss allowance is measured at an amount equal to 12-month
ECLs
•
For which the loss allowance is measured at an amount equal to lifetime
ECLs and that are:
• Financial instruments for which credit risk has increased significantly
since initial recognition but are not credit-impaired financial assets
• Financial assets that are credit-impaired at the reporting date (but
were not credit-impaired when purchased or originated)
• Trade receivables, contract assets or lease receivables for which the
loss allowances are measured using a simplified approach based on
lifetime ECLs. Information for these assets may be based on a provision
matrix
326
•
That are financial assets that were credit-impaired when purchased or
originated
The guidance to IFRS 7 explains that the number of credit risk rating grades
used to disclose the information above should be consistent with the number
that the entity reports to key management personnel for credit risk
management purposes. If past due information is the only borrower-specific
information available and so, using the operational simplification discussed at
323
IFRS 7.B8F
324
IFRS 7.35A(b)
325
IFRS 7.35M
326
IFRS 7.35N
163 April 2018 Impairment of financial instruments under IFRS 9
5.4.2, it is used to assess whether credit risk has increased significantly since
initial recognition, an analysis by past due status should be provided for that
class of financial assets
.
327
The standard adds that, when ECLs are measured on a collective basis, it may
not be possible to allocate the gross carrying amount of individual financial
assets or the exposure to credit risk on loan commitments and financial
guarantee contracts to the credit risk rating grades for which lifetime ECLs
are recognised. In that case, the disclosure requirement above should be
applied to those financial instruments that can be directly allocated to a credit
risk rating grade and separate disclosure should be given of the gross carrying
amount of financial instruments for which lifetime ECLs have been measured on
a collective basis.
328
IFRS 7 also requires similar disclosure for concentrations of credit risk.
329
A concentration of credit risk exists when a number of counterparties are
located in a geographical region or are engaged in similar activities and
have similar economic characteristics that would cause their ability to meet
contractual obligations to be similarly affected by changes in economic or
other conditions. Information should be provided to enable users to understand
whether there are groups or portfolios of financial instruments with particular
features that could affect a large portion of that group of financial instruments,
such as concentration to particular risks. This could include, for example, loan-
to-value groupings, geographical, industry or issuer-type concentrations.
330
EDTF also advises banks to provide a vintage analysis, where it aids
understanding of the credit risk exposures, particularly when there is a lending
portfolio with heightened credit risk, and the period in which it was originated
has a bearing on the extent of that credit risk and the resulting ECLs.
331
14.7 Collateral and other credit enhancements obtained during
the period
When an entity obtains financial or non-financial assets during the period by
taking possession of collateral it holds as security, or calling on other credit
enhancements such as guarantees, and these assets meet the recognition
criteria in other standards, it should disclose for such assets held at the
reporting date:
332
•
The nature and carrying amount of the assets
•
When the assets are not readily convertible into cash, the entity’s policies
for disposing of such assets or for using them in its operations
This disclosure is intended to provide information about the frequency of
such activities and the entity’s ability to obtain and realise the value of the
collateral.
333
How we see it
The disclosures required by IFRS 7 in respect of ECLs are substantial. It is
critical for entities to align their credit risk practices and financial reporting
systems and processes, not only to estimate the loss allowances for ECLs,
but also to produce sufficiently detailed information to meet the disclosure
requirements.
327
IFRS 7.B8I
328
IFRS 7.B8J]
329
IFRS 7.35M
330
IFRS 7.B8H
331
Recommendation 26
332
IFRS 7.38
333
IFRS 7.BC56.
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