Under IFRS 9, the scope of the three-stage impairment approach is extended to apply to such off-balance sheet items. An entity would consider the expected portion of the loan commitment that will be drawn down within the next 12 months when estimating 12-month expected credit losses (Stage 1), and the expected portion of the loan commitment that will be drawn down over the remaining life of the loan commitment when estimating lifetime expected credit losses (Stage 2).
The following table summarises the requirement for loan commitments and financial guarantees:
No significant increase in credit risk
|Expected portion to be drawn down within the next 12 months Loan commitments and financial guarantee contracts||12-month expected credit losses|
Significant increase in credit risk
|Expected portion to be drawn down over the remaining life of the facility||Lifetime expected credit losses|
Expected credit losses are an estimate of the present value of all cash shortfalls over the remaining life of the financial instrument arising either from defaults within the next 12 months (Stage 1) or over the life of the instrument (Stage 2). A cash shortfall for undrawn loan commitments is the difference between: Loan commitments and financial guarantee contracts
- The present value of the principal and interest cash flows due to the entity if the holder of the loan commitment draws down the loan; and
- The present value of the cash flows that the entity expects to receive if the loan is drawn down.
The remaining life of a loan commitment and of financial guarantee contracts is the maximum contractual period during which an entity has exposure to credit risk. Consequently, if a lender has the ability to withdraw a loan commitment, the maximum period to consider when estimating credit losses is the period up to the date on which the entity is able to cancel the facility and not a longer period, even if that would be consistent with its business practice. Loan commitments and financial guarantee contracts
Bank A extends credit to Company C. Bank A can cancel the commitment by giving one day’s notice. Company C’s financial position is poor and is deteriorating, and there is a significant risk that it will enter bankruptcy. Bank A would only estimate one day of expected losses because Bank A does not have a contractual obligation to provide credit beyond that one day. This approach is followed, even if Bank A might not (for commercial/business reasons) cancel the arrangement.
For credit exposure management purposes, loan commitments and financial guarantee contracts are managed no differently than loans, and for financial reporting purposes those off-balance sheet financial items should be subject to the same impairment model as other ‘on balance sheet’ financial items. This aligns financial reporting more closely with credit risk management practices. This means that the level of provisions for amounts that have been approved but not drawn down is recognised at a higher level under the IFRS 9 model.
Under the IFRS 9 model, Bank A recognises a provision of CU250,000 for the undrawn portion of its overdraft facilities.
In terms of presentation, because the allowance would not relate to any balance sheet line item, the expected loss estimate would be recognised and presented as a separate liability line item.
The discount rate used to discount expected credit losses is the effective interest rate for the financial asset that results from the loan commitment. If the effective interest rate cannot be determined, then an entity discounts using a rate that reflect the current market assessment of the time value of money and the risks that are specific to the cash flows. Loan commitments and financial guarantee contracts
As an exception to the maximum contractual period, it is noted that some financial instruments (such as revolving overdraft facilities and balances arising from credit cards) include both a loan and an undrawn commitment component, and that the lender’s ability to demand repayment and cancel the undrawn commitment does not limit the entity’s exposure to credit losses to the contractual notice period. For those instrument only, the period over which expected credit losses is measured can be extended beyond the maximum contractual period, if expected credit losses would not be mitigated by credit risk management actions.