Although the focus for IFRS 9 Financial Instruments is on financial institutions such as banks and insurance companies, ‘normal’ operating entities are also affected by IFRS 9. Maybe their investment and loan portfolios are less complex but in operating a business and as part of the internal credit risk management practice policy making it is still important to implement the impairment model under IFRS 9 Financial Instruments. This is step 5 which started with an introduction in Impairment of investments and loans.
Low credit risk receivables are not going to be individually assessed for impairment, only the higher than low credit risk receivables will be included individually in the measurement of Expected Credit Losses.
In making a multi-criteria model for default risk assessment of counterparties more credit risks rates could be used, providing a possibly more accurate measurement of the Expected Credit Losses, however such a model can easily become too complicated to understand and as a result become susceptible to manipulation. The model could be improved for example by using an usual categorical scale of the type of credit risk: poor, fair, good, very good and excellent (poor credit risk being the worst rating).
However keep in mind this is an estimation process, inherently judgmental and subjective.
Low Credit Risk, in the context of IFRS 9, is an indicator assigned to financial instruments deemed to:
- have low Default Risk, that is low likelihood of any credit event
- the borrower has strong capacity to meet contractual cash flow obligations both in the near term.
Under adverse changes in economic and business conditions in the longer term a low credit risk borrower may (but need not) have reduced ability to meet contractual cash flow obligations.
An instrument categorized as low credit risk does not require recognition of Lifetime Expected Credit Losses
Even if an instrument ceases to be categorized as low credit risk, recognition of lifetime expected credit losses requires that there has been a Significant Increase in Credit Risk
- Determination of the low credit risk may be based on internal credit risk ratings or other methodologies that are consistent with a globally understood definition of low credit risk and that consider the risks and the type of financial instruments that are being assessed. Step 5 Allocate receivables to high and low credit risk
- External ratings of ‘investment grade’ may be considered as having low credit risk
- Financial instruments are not required to be externally rated to be considered to have low credit risk.
- Financial instruments should be considered to have low credit risk from a market participant perspective taking into account all of the terms and conditions of the financial instrument.
As an indicative calibration, a financial instrument with an external rating of Investment Grade is an example of an instrument that may be considered to have a low credit risk
A loan is not considered to have a low credit risk simply because: Step 5 Allocate receivables to high and low credit risk
- the value of collateral results in a low risk of loss. This is because collateral affects the magnitude of the loss when default occurs (Loss Given Default, rather than the risk of default
- it has a lower risk of default relative to other financial instruments
See an excerpt from the financial statements of Vodafone for 2018. Step 5 Allocate receivables to high and low credit risk
After ‘Allocating receivables to high and low credit risk’ go to Step 7 Measure Expected credit losses
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