Setting the scene the Expected Credit Losses model, start here to get a good understanding of ECL loss allowances or continue, you decide……
The Expected Credit Losses model (ECL) should be applied to:
- investments in debt instruments measured at amortized cost;
- investments in debt instruments measured at fair value through other comprehensive income (FVOCI);
- all loan commitments not measured at fair value through profit or loss;
- financial guarantee contracts to which IFRS 9 is applied and that are not accounted for at fair value through profit or loss; and
- lease receivables that are within the scope of IFRS 16 Leases, and trade receivables or contract assets within the scope of IFRS 15 that give rise to an unconditional right to consideration. Setting the scene the Expected Credit Losses model
The IFRS 9 impairment model requires impairment allowances for all exposures from the time a loan is originated, based on the deterioration of credit risk since initial recognition. If the credit risk has not increased significantly (Stage 1), IFRS 9 requires allowances based on 12-month expected losses. If the credit risk has increased significantly (Stage 2) and if the loan is ‘credit-impaired’ (Stage 3), the standard requires allowances based on lifetime expected losses. Setting the scene the Expected Credit Losses model
The assessment of whether a loan has experienced a significant increase in credit risk varies by product and risk segment. It requires use of quantitative criteria and experienced credit risk judgement. Setting the scene the Expected Credit Losses model
The illustration below shows the overall ECL model; each decision box will be considered on this page:
Explanations to the decision tree: Setting the scene the Expected Credit Losses model
Simplified approach for trade receivables, contract assets and lease receivables
The model includes some operational simplifications for trade receivables, contract assets and lease receivables, because they are often held by entities that do not have sophisticated credit risk management systems. These simplifications eliminate the need to calculate 12-month ECL and to assess when a significant increase in credit risk has occurred.
For trade receivables or contract assets that do not contain a significant financing component, the loss allowance should be measured at initial recognition and throughout the life of the receivable at an amount equal to lifetime ECL. As a practical expedient, a provision matrix may be used to estimate ECL for these financial instruments. Setting the scene the Expected Credit Losses model
For trade receivables or contract assets which contain a significant financing component in accordance with IFRS 15 and lease receivables, an entity has an accounting policy choice: either it can apply the simplified approach (that is, to measure the loss allowance at an amount equal to lifetime ECL at initial recognition and throughout its life), or it can apply the general model.
The policy choice should be applied consistently, but an entity can apply the policy election for trade receivables, contract assets and lease receivables independently of each other.
Purchased or originated credit-impaired assets
The general impairment model does not apply to purchased or originated credit impaired assets. A financial asset is considered credit-impaired on purchase or origination if there is evidence of impairment (as defined in IFRS 9 Appendix A) at the point of initial recognition (for instance, if it is acquired at a deep discount).
For such assets, impairment is determined based on full lifetime ECL on initial recognition. However, lifetime ECL are included in the estimated cash flows when calculating the effective interest rate on initial recognition. The effective interest rate for interest recognition throughout the life of the asset is a credit-adjusted effective interest rate. As a result, no loss allowance is recognized on initial recognition.
Any subsequent changes in lifetime ECL, both positive and negative, will be recognized immediately in profit or loss.
Option – practical expedient for low credit risk financial assets
As an exception to the general model, if the credit risk of a financial instrument is low at the reporting date, management can measure impairment using 12-month ECL, and so it does not have to assess whether a significant increase in credit risk has occurred. In order for this operational simplification to apply, the financial instrument has to meet the following requirements:
- it has a low risk of default;
- the borrower is considered, in the short term, to have a strong capacity to meet its obligations; and
- the lender expects, in the longer term, that adverse changes in economic and business conditions might, but will not necessarily; reduce the ability of the borrower to fulfil its obligations.
The credit risk of the instrument needs to be evaluated without consideration of collateral. This means that financial instruments are not considered to have low credit risk simply because that risk is mitigated by collateral. Financial instruments are also not considered to have low credit risk simply because they have a lower risk of default than the entity’s other financial instruments or relative to the credit risk of the jurisdiction within which the entity operates.
Financial instruments are not required to be externally rated. An entity can use internal credit ratings that are consistent with a global credit rating definition of ‘investment grade’.
The low credit risk simplification is not meant to be a bright-line trigger for the recognition of lifetime ECL. Instead, when credit risk is no longer low, management should assess whether there has been a significant increase in credit risk to determine whether lifetime ECL should be recognized. This means that just because an instrument’s credit risk has increased such that it no longer qualifies as low credit risk, it is not automatically included in Stage 2, Management needs to assess if a significant increase in credit risk has occurred before calculating lifetime ECL for the instrument.
Assessing a significant increase in credit risk
When assessing whether the credit risk on a financial instrument has increased significantly since initial recognition, management looks at the change in the risk of a default occurring over the expected life of the financial instrument rather than the change in the ECL. An entity should compare the risk of a default as at the reporting date with the risk of a default occurring on the financial instrument as at the date of initial recognition. If management chooses to make the assessment by using the probability of default (PD), generally a lifetime PD (over the remaining life of the instrument) should be used. However, as a practical expedient, a 12-month PD can be used if it is not expected to give a different result to using lifetime PDs.
There are cases where using a 12-month PD is not a reasonable approximation to using lifetime PD. These include, for example, bullet repayment loans where the payment obligations of the debtor are not significant during the first 12 months of the loan facility; or loans where changes in credit-related factors only have an impact on the credit risk of the financial instrument beyond 12 months.
In order to perform the assessment all information available should be taken into account. When the financial instrument is collateralized, entities should assess significant increases in credit risk without taking into account the collateral. Nevertheless, when calculating ECL, the expected recovery from collateral should be taken into account.
When determining whether the credit risk on an instrument has increased significantly, management should consider reasonable and supportable best information available without undue cost or effort. This information should include actual and expected changes in external market indicators, internal factors and borrower-specific information.
Examples of ways in which the assessment of significant increases in credit risk could be implemented more simply include:
- Establishing the initial maximum credit risk for a particular portfolio by product type and/or region (the ‘origination credit risk’) and comparing that to the credit risk at the reporting date. This would only be possible for portfolios of financial instruments with similar credit risk on initial recognition;
- Assessing increases in credit risk through a counterparty assessment, as long as such assessment achieves the objectives of the proposed model; and
- An actual or expected significant change in the financial instrument’s external credit rating.
The examples above are not exhaustive, so other ways of assessing a significant increase in credit risk might be used. Refer to Example 3 in the Appendix for an example on assessing increases in credit risk based on PD.
Generally a financial instrument would have a significant increase in credit risk before there is objective evidence of impairment or before a default occurs. The standard requires both forward-looking and historical information to be used in order to determine whether a significant increase in credit risk has occurred.
Lifetime ECL are expected to be recognized before a financial asset becomes delinquent. If forward-looking information is reasonably available, an entity cannot rely solely on delinquency information when determining whether credit risk has increased significantly since initial recognition; it also needs to consider the forward-looking information. However, if information that is more forward-looking than past due status is not available, there is a rebuttable presumption that credit risk has increased significantly since initial recognition no later than when contractual payments are more than 30 days past due.
This presumption can be rebutted if there is reasonable and supportable evidence that, regardless of the past-due status, there has been no significant increase in the credit risk: For example, where non-payment is an administrative oversight, instead of resulting from financial difficulty of the borrower. Another example is where management has access to historical evidence that demonstrates that there is no correlation between significant increases in the risk of a default occurring and financial assets on which payments are more than 30 days past due, but that evidence does identify such a correlation when payments are more than 60 days past due.
Generally, a significant increase in credit risk happens gradually over time and before the financial asset becomes credit-impaired or is in default. As a result, the lifetime ECL should not be delayed and is recognized before a financial asset is regarded as credit-impaired or in default.
Portfolio or individual credit risk assessment Setting the scene the Expected Credit Losses model
The model can be applied at an individual or portfolio level. However, some factors or indicators may not be identifiable at an instrument level. In such cases, the factors or indicators should be assessed at a portfolio level. Management cannot avoid calculating lifetime ECL by considering the assessment at an individual asset level only, if information available at portfolio level indicates that there has been an increase in credit risk for the instruments included in the portfolio.
Depending on the nature of the financial instrument and the credit risk information available for particular groups of financial instruments, management might not be able to identify significant changes in credit risk for individual financial instruments before the financial instrument becomes past due. This might be the case for financial instruments, such as retail loans, for which there is little or no updated credit risk information that is routinely obtained and monitored on an individual instrument basis until a customer breaches the contractual terms.
If changes in the credit risk for individual financial instruments are not captured before they become past due, a loss allowance based only on credit information at an individual financial instrument level would not faithfully represent the changes in credit risk since initial recognition.
In some circumstances management does not have reasonable and supportable information that is available without undue cost or effort to measure lifetime ECL on an individual instrument basis. In that case, lifetime ECL should be recognized on a collective basis that considers comprehensive credit risk information. This comprehensive credit risk information must incorporate not only past-due information but also all relevant credit information, including forward-looking macro-economic information, in order to approximate the result of recognizing lifetime ECL when there has been a significant increase in credit risk since initial recognition on an individual instrument level.
Management can group financial instruments on the basis of shared credit risk characteristics with the objective of facilitating an analysis that is designed to enable significant increases in credit risk to be identified on a timely basis. The entity should not obscure this information by grouping financial instruments with different risk characteristics. Examples of shared credit risk characteristics might include, but are not limited to:
- the instrument type;
- the credit risk ratings;
- the collateral type;
- the date of origination;
- the remaining term to maturity;
- the industry;
- the geographical location of the borrower; and
- the value of collateral relative to the commitment if it has an impact on the probability of a default occurring (for example, non-recourse loans in some jurisdictions or loan-to-value ratios).
See also: The IFRS Foundation