This is part of the impairment of financial instruments in IFRS 9 Impairment of Financial Instruments
The credit adjusted approach applies only rarely when an entity acquires or originates a loan or receivable that is “credit impaired” at the date of its initial recognition (e.g., when a loan is acquired at a deep discount due to credit concerns via a business combination). An asset is credit impaired when one or more events that have a detrimental effect on the estimated future cash flows of the asset have occurred.
Examples in IFRS 9 of evidence that an asset is credit-impaired
- Significant financial difficulty of the issuer or borrower The credit adjusted approach
- A breach of contract, such as a default or past due event (i.e., a borrower has failed to make a payment when contractually due)
- The lender, for economic or contractual reasons relating to the borrower’s financial difficulty, has granted a concession that the lender would not otherwise consider
- It is becoming probable that the borrower will enter bankruptcy or other financial reorganization
- The disappearance of an active market for that financial asset because of financial difficulties
- The purchase or origination of a financial asset at a deep discount that reflects incurred credit losses
When a financial asset is credit-impaired, IFRS 9 5.4.1(b) requires an entity to calculate (a lower) interest revenue by applying the effective interest rate to the amortised cost of the financial asset, i.e. the (original) gross amount less expected credit losses. This results in a difference between (a) the interest that would be calculated by applying the effective interest rate to the gross carrying amount of the credit-impaired financial asset, and (b) the interest revenue recognised for that asset.
If a financial asset ‘cures’, so that it is transferred back to stage 2 or stage 1, interest revenue would once again be recognised based on the gross carrying amount. As a result, an entity recognises the adjustment required to bring the loss allowance to the amount required to be recognised in accordance with IFRS 9 as a reversal of expected credit losses ECLs in profit or loss [IFRS 9 5.5.8].