IFRS 9 Impairment of Financial Instruments establishes a new model for recognition and measurement of impairments in loans and receivables that are measured at Amortized Cost or FVOCI—the so-called “expected credit losses” model. This is the only impairment model that applies in IFRS 9 because all other assets are classified and measured at FVPL or, in the case of qualifying equity investments, FVOCI with no recycling to profit and loss. IFRS 9 Impairment of Financial Instruments
Expected credit losses
Expected credit losses are calculated by: IFRS 9 Impairment of Financial Instruments
- identifying scenarios in which a loan or receivable defaults; IFRS 9 Impairment of Financial Instruments
- estimating the cash shortfall that would be incurred in each scenario if a default were to happen;
- multiplying that loss by the probability of the default happening; and IFRS 9 Impairment of Financial Instruments
- summing the results of all such possible default events. IFRS 9 Impairment of Financial Instruments
Because every loan and receivable has at least some probability of defaulting in the future, every loan or receivable has an expected credit loss associated with it—from the moment of its origination or acquisition.
Observe: The IASB chose to describe its new impairment model as the “expected credit loss” model because this is the term used in statistics to describe the weighted average of outcomes weighted by the probability of their occurrence. Because the result is an average, expected credit losses are neither necessarily “expected” nor “losses”, at least as those terms are commonly understood. Rather, they are a measure of the asset’s credit risk.
Expected Credit Losses – A simple illustration
Estimated future cash flows at initial recognition assuming borrower pays as anticipated, discounted at the loan’s effective interest rate
Estimated future cash flows if default occurs, discounted
Cash shortfall IFRS 9 Impairment of Financial Instruments
Probability of default IFRS 9 Impairment of Financial Instruments
Expected credit loss IFRS 9 Impairment of Financial Instruments
For ease of illustration this example assumes only one default scenario, refer to discussion below for requirements for multiple scenarios. See the following chapter for the rate to be used to discount future cash flows.
Recognition and measurement of expected credit losses (ECLs) IFRS 9 Impairment of Financial Instruments
Expected losses are recognized and measured according to one of three approaches—a general approach, a simplified approach and the so-called “credit adjusted approach”:
All other loans and receivables not covered by another approach
Qualifying trade receivables, IFRS 15 contract assets and lease receivables
Assets that are credit impaired at initial recognition
|Timing of initial recognition|
Same period as asset is acquired
Same as general approach
|Measurement basis of the loss allowance|
12 month ECLs (or Lifetime ECLs if the term of the asset is shorter) unless a significant increase in credit risk occurs, then Lifetime ECLs unless the increase reverses
The general and simplified approaches represent approximations of a new concept of impairment the IASB would have preferred to apply in all situations, but which it decided to apply only to assets that are credit impaired at initial recognition because of practical and other concerns. In what follows, we use a simple example to illustrate this concept and then review the adjustments the IASB made to it in adapting the general and simplified approaches.
The IFRS 9 concept of impairment IFRS 9 Impairment of Financial Instruments
Assume a lender loans $100,000 for two years, at a rate of 5% compounded annually, with both interest and principal payable only at maturity. The total cash flow to be received thus amounts to $110,250. Under traditional loan accounting principles, interest income would be recognized at the constant effective rate in the loan, i.e., 5%, $5,000 in year one and $5,250 in year two. Under the IASB’s new impairment concept, however, interest income would be recognized at a rate that excludes the premium that the lender demands for the risk that the loan will default. Let’s say that rate is 3%. Under this concept only $6,090 of interest income would be recognized over the term of the loan, $3,000 in year one and $3,090 in year two. The difference of $4,160 is a loan impairment allowance. At initial recognition, the carrying value of the loan under both models is the same but its composition is very different, as shown in the following table.
Under the concept, expected credit losses are used as the basis for calculating the impairment allowance and the risk adjusted interest. After initial recognition, the impairment allowance is adjusted, up or down, through profit or loss at each balance sheet date as the probabilities of collection and recoveries change. If the loan turns out to be fully collectible, expected losses eventually would fall to zero as the probability of non-payment declines and “impairment gains” would be recognized in profit and loss. If the loan grows more risky, the probability that a default will occur and thus expected credit losses will increase. If a default happens, and the lender suffers an actual cash shortfall, expected credit losses will equal that shortfall.
Calculating expected credit losses IFRS 9 Impairment of Financial Instruments
Basic principles IFRS 9 Impairment of Financial Instruments
IFRS 9 provides that in measuring expected credit losses an entity must reflect:
- An unbiased evaluation of a range of possible outcomes and their probabilities of occurrence.
- Discounting for the time value of money.
- 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.I
IFRS 9 emphasizes that estimating expected credit losses may not necessarily need to be a complex process and that an entity need not identify every possible scenario. In some cases, relatively simple modelling may be sufficient without the need for a large number of detailed simulations or scenarios. In others, entities will need to determine how many more scenarios are required.
IFRS 9 also permits the use of models for estimating expected losses that do not require explicit scenario and probability analysis. For example, it states that the average credit losses for a large group with shared risk characteristics may be a reasonable estimate of the probability-weighted amount. IFRS 9 Impairment of Financial Instruments
As a general rule, the maximum period to consider in measuring expected credit losses is the maximum contractual period (including extension options).
Observe: Calculating expected credit losses requires information that is relevant in the management of credit risk and entities therefore should be looking to integrate accounting and credit risk management systems and processes rather than treating the calculation as an independent accounting exercise. IFRS 9 thus provides an opportunity for reassessing whether existing credit management systems could, or should, be improved.
Meaning of default IFRS 9 Impairment of Financial Instruments
A key issue in measuring expected losses is identifying when a “default” may occur. IFRS 9 does not define the term. Instead, an entity must apply a definition that is consistent with the definition it uses for internal credit risk management purposes and considers qualitative indicators (e.g., financial covenants).
There is a rebuttable presumption that a default does not occur later than when a financial asset is 90 days past due.
See also: The IFRS Foundation