Thursday, December 8, 2022

Impairment of Financial Assets , Expected credit loss- IFRS 9

IFRS 9 requires recognition of impairment losses on a forward-looking basis, which means that impairment loss is recognised before the occurrence of any credit event. These impairment losses are referred to as expected credit losses. (‘ECL’)

Approach of recognition has changed from incurred loss to expected loss.

Three approaches to impairment

IFRS 9 sets out three approaches to impairment:

  • General approach,
  • Simplified approach for certain trade receivables, contract assets and lease receivables,
  • Specific approach for purchased or originated credit-impaired financial assets.

1.General approach

The general IFRS 9 approach to impairment follows a three-stage model (sometimes referred to as three-bucket model):

IFRS 9 requires recognition of impairment losses on a forward-looking basis, which means that impairment loss is recognised before the occurrence of any credit event. These impairment losses are referred to as expected credit losses. (‘ECL’)

Approach of recognition has changed from incurred loss to expected loss.

Three approaches to impairment

IFRS 9 sets out three approaches to impairment:

  • General approach,
  • Simplified approach for certain trade receivables, contract assets and lease receivables,
  • Specific approach for purchased or originated credit-impaired financial assets.

1.General approach

The general IFRS 9 approach to impairment follows a three-stage model (sometimes referred to as three-bucket model):

Under the general approach, an entity recognises expected credit losses for all financial assets. ECL can be 12-month ECL or lifetime ECL depending on whether there was a significant increase in credit risk.

Changes in the loss allowance are recognised in P/L as impairment gains/losses.

2.Simplified approach

To assist entities that have less sophisticated credit risk management systems, IFRS 9 introduced a simplified approach under which entities do not have to track changes in credit risk of financial assets (IFRS 9.BC5.104). Instead, lifetime ECL are recognised from the date of initial recognition of a financial asset (IFRS 9.5.5.15).

The simplified approach is required for trade receivables or contract assets that result from transactions that are within the scope of IFRS 15 and do not contain a significant financing component (or are accounted for under the one-year practical expedient as per IFRS 15.63). For trade receivables or contract assets that do contain a significant financing component, it is the entity’s choice to apply simplified approach. Similarly, the entity can choose to apply simplified approach to lease receivables accounted for under IFRS 16 (IFRS 9.5.5.15). See also the practical approach to simplified loss rate approach (provision matrix).

3.Specific approach for purchased or originated credit-impaired financial assets

IFRS 9 sets out a specific approach for purchased or originated credit-impaired financial assets (often abbreviated to ‘POCI’ assets). For these assets, entity recognises only the cumulative changes in lifetime ECL since initial recognition of such an asset (IFRS 9.5.5.13-14). Purchased or originated credit-impaired financial asset is an asset that is credit-impaired on initial recognition (IFRS 9.Appendix A).

It is important to note that an asset is not credit impaired merely because it has high credit risk at initial recognition (IFRS 9.B5.4.7)

Calculation of Expected credit loss:

 Expected credit loss is calculated as – Definition of credit losses

Credit loss is 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 (EIR) or credit-adjusted EIR (IFRS 9.Appendix A)

Cash flows used in ECL measurement

When estimating cash flows for ECL measurement, the entity takes into account (IFRS 9.Appendix A):

  • expected life of a financial instrument,
  • all contractual terms of the financial instrument (e.g. prepayment, extension, call and similar options),
  • collaterals held,
  • other credit enhancements integral to the contractual terms.

Lifetime expected credit losses (ECL)

Lifetime ECL are ECL that result from all possible default events over the expected life of a financial instrument (IFRS 9.Appendix A). Lifetime ECL are therefore the present value of the difference between (IFRS 9.B5.5.29):

  1. the contractual cash flows that are due to an entity under the contract; and
  2. the cash flows that the entity expects to receive.
  3. 12-month ECL are a portion of lifetime ECL and represent the lifetime ECL resulting from a default occurring in the 12 months after the reporting date weighted by the probability of that default occurring. Obviously, a shorter period should be used for financial assets if their expected life is less than 12 months (IFRS 9.B5.5.43).
  4. IFRS 9 clarifies that 12-month ECL are neither the lifetime ECL that an entity will incur on financial instruments that it predicts will default in the next 12 months nor the cash shortfalls that are predicted over the next 12 months (IFRS 9.B5.5.43). This results from the fact that that 12-month ECL are weighted by the probability of default (‘PD’). For example, 12-month ECL will be recognised even if PD is minuscule.
CA Divya Thakkarhttps://www.financeshadow.com
Chartered accountant | IIM Bangalore 7+years of experience in Consultancy, Investment Banking, Ecommerce & IT Industry. Expert in IFRS, USGAAP, INDAS & US Regulatory requirement. Currently working with Deloitte Touche & Company in Risk ,Finance & Control advisory. Worked in Companies like Barclays Bank, HCL Technologies Ltd & BazaarCart.

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