Impairment of Financial Assets under IFRS 9

IFRS 9 Financial Instruments, issued in its final form in July 2014, replaced IAS 39 Financial Instruments: Recognition and Measurement, while IAS 32 Financial Instruments: Presentation remains applicable. The primary objective of IFRS 9 is to provide principles that ensure the financial reporting of financial assets and liabilities delivers relevant and useful information to users, particularly for assessing an entity's future cash flows in terms of amount, timing, and uncertainty (para 1.1).

Key Impairment Considerations:

Impairment of a financial asset affects its carrying amount and future cash flows.
The standard establishes principles for evaluating impairment to ensure transparency and consistency in financial statements.

This framework improves users' ability to assess risks and impacts related to financial assets.

Key Points on the Expected Credit Loss (ECL) Approach in IFRS 9

ECL Definition: Credit losses are calculated as the difference between the present value (PV) of all contractual cash flows and the PV of expected future cash flows, discounted at the original effective interest rate. This difference is termed the "cash shortfall."
Forward-Looking Model: The ECL approach includes expected future credit losses, not just those incurred, promoting early recognition of losses.
Judgment and Estimation: ECL estimations require judgment, potentially allowing for-profit smoothing, though IFRS 9 provides clear definitions to mitigate misuse.
Classification of ECLs:
- Lifetime ECLs: Consider all possible default events over the financial instrument's expected life.
- 12-month ECLs: Focus on default events that could occur within 12 months after the reporting date.
Initial Recognition: ECLs are accounted for upon the financial asset's initial recognition, even if the ECL is nil, and are updated at each reporting date.
Stages of Impairment: Financial assets are assessed in three stages:
- Stage 1: Recognise a 12-month ECL and calculate interest revenue on the gross carrying amount.
- Stage 2: Remeasure ECL:
  - Continue with a 12-month ECL if credit risk remains stable.
  - Recognize lifetime ECLs if credit risk increases significantly.
- Stage 3: If the asset is credit-impaired, calculate interest revenue based on amortized cost, with lifetime ECLs recognized.
Significant Credit Risk Increase: A shift from 12-month to lifetime ECL occurs when credit risk significantly increases and is no longer considered low.
Interest Revenue Impact:
- In Stages 1 and 2, interest revenue is calculated on the gross carrying amount.
- In Stage 3, it is calculated on the amortized cost (gross carrying amount minus loss allowance).
Prudence in Recognition: The ECL model is prudent, as it reduces financial assets and profits early, aligning with the principle of conservative accounting.
Individual Assessment in Stage 3: Financial assets deemed credit-impaired are typically assessed individually for impairment and interest revenue calculation

Summary and Calculation of Lifetime Expected Credit Loss (ECL)

Scenario Overview:

Stage 1: Initially, no loss allowance was recognized as the 12-month ECL was assessed to be nil with no significant credit risk changes.
Stage 2: At year-end, economic conditions worsened, increasing credit risk significantly. Lifetime ECLs must now be calculated, though the assets are not credit-impaired.

Key Information:

Portfolio value: $50,000
Coupon rate (contractual cash flow): 10% per annum
Effective rate (original discount rate): 10%
Expected rate of return (revised due to increased risk): 6% per annum
Remaining loan period: 2 years

Calculation:

Contractual Cash Flows (based on the original 10% rate):
- Year 1: $50,000 × 10% = $5,000
- Year 2: $50,000 × 10% = $5,000 + $50,000 (principal) = $55,000
Expected Cash Flows (based on the revised 6% rate):
- Year 1: $50,000 × 6% = $3,000
- Year 2: $50,000 × 6% = $3,000 + $50,000 (principal) = $53,000
Present Value of Contractual Cash Flows (discounted at 10% effective rate):
- Year 1: $5,000 ÷ (1 + 10%) = $4,545.45
- Year 2: $55,000 ÷ (1 + 10%)² = $45,454.55
- Total PV: $4,545.45 + $45,454.55 = $50,000
Present Value of Expected Cash Flows (discounted at 10% effective rate):
- Year 1: $3,000 ÷ (1 + 10%) = $2,727.27
- Year 2: $53,000 ÷ (1 + 10%)² = $43,801.65
- Total PV: $2,727.27 + $43,801.65 = $46,528.92
Lifetime ECL (Cash Shortfall):
- $50,000 (contractual PV) − $46,528.92 (expected PV) = $3,471.08

Loss Allowance Required:

The loss allowance to be recognized at the year-end is $3,471.08.

Financial Assets Subject to Impairment under IFRS 9

Scope of ECL Recognition:

ECL loss allowances are required for the following financial assets:
- Measured at amortised cost or fair value through OCI.
- Lease receivables, contract assets, irrevocable loan commitments, and financial guarantee contracts.
- Debt instruments such as loans, debt securities, and trade receivables.

ECL Recognition and Presentation:

ECLs can be recognised as a loss allowance or presented as a liability.
Assets with low credit risk (e.g., investment grade) are typically assessed for 12-month ECLs, not lifetime ECLs.
The 30-day overdue backstop indicator is used to rebut claims of low credit risk.

Two-Stage Approach:

Stage 1 (Initial Recognition):
- Recognize a 12-month ECL. It may be nil if no credit risk is evident.
Stage 2 (Reporting Date Assessment):
- If credit risk hasn’t significantly increased, continue recognising 12-month ECL.
- If credit risk has increased significantly, recognise lifetime ECL.
- For credit-impaired assets, calculate interest revenue based on the carrying amount net of loss allowance.

Simplified Approach for Trade Receivables:

No credit loss is recognized on initial recognition.
Loss allowance is based on the present value of expected cash shortfalls using a matrix method (historical default rates adjusted for forward-looking estimates).

Conclusion: The ECL model emphasizes forward-looking assessments, addressing the late recognition of losses under previous standards. Although the process requires judgment and subjective estimates, IFRS 9 limits subjectivity with clear definitions, enhancing the relevance and utility of financial reporting for users.

To read the main article

Assurance Report: