Chris Ragkavas, BA, MA, FCCA, CGMA
StudySmart management consultant, senior finance & accounting tutor, IFRS technical expert
IFRS 9 Financial Instruments is due to be applied by all entities reporting under IFRSs as per 1/1/2018, early adoption is permitted.
The marked departures from the current standard IAS 39 Financial Instruments: Recognition and Measurement are the treatment of impairment losses, and the classification and designation of financial assets.
We will deal in this short piece with the former, as it poses a significant challenge to financial institutions across the board.
The current standard, which has been applied since 2001 states, that:
Impairment losses should be recognized when they are incurred, rather than as expected;
An impairment loss is regarded as incurred if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after initial recognition (‘a loss event’).
Financial institutions have been recognizing discounted shortfalls, between the contractual and expected cash flows, only once a loss event had occurred [IAS 39:58].
On the contrary, IFRS 9 introduces an impairment model for financial assets that is based on expected credit losses (ECLs). This model aims at timely reflection of anticipated deterioration in credit quality of financial assets, since initial recognition.
When estimating ECLs, the entity must consider [IFRS 9:5.5.17]:
An unbiased and probability weighted amount that is determined by evaluating a range of possible outcomes;
The time value of money;
Reasonable and supportable information that is available without undue cost or effort at the reporting date about past events, current conditions and forecasts about future economic conditions. This point calls for significant level of judgment with regards to the impact that future macroeconomic factors will have on the ability of the borrowers to settle their obligations in a timely fashion, and in full.
The requirements of IFRS 9 signal a clear departure from calculation of losses based on an incurred credit event, towards an estimation of the impact that a wide range of events are assessed to have on the credit quality of financial assets including forward-looking information.
IFRS 9 will exert significant pressure to reporting entities to design, maintain and control a system of internal controls that enables them to provide reasonable and supportable evidence for the (non-) credit deterioration of their receivables.
IFRS 9 states that discounted ECLs must be calculated on origination of a financial instrument, say, a mortgage loan (when in fact no credit events may have occurred) by using forward-looking information. This will have a material impact on the loss allowances to be recognized by entities. The assessment is repeated at each reporting period-end.
Currently, absent to a credit event as defined by IAS 39 as per the reporting date, entities do not generally recognize any loss allowance.
As per the adoption of IFRS 9, they should consider a wide range of factors in a market with originated loans as or example:
Expected trend in unemployment rate,
Country financial and monetary risk;
Credit deterioration of counterparty by rating agencies;
Expected adverse economic conditions in the environment in which the borrower operates,
and assess their impact on collectability of contracted cash flows.
ECLs are categorized as follows:
12 month ECLs
This measurement is required if the credit risk has not increased significantly since asset origination. The entity considers the effect of events expected to occur in the following 12 months only, to credit deterioration of the asset until maturity. They are a portion of the lifetime ECLs as described below.
This is required if the credit risk has risen significantly since asset origination and the credit quality of the financial asset is not considered to be anymore low risk. The entity considers the effect of events expected to occur throughout the lifetime of the asset, to credit deterioration of the asset until maturity.
IFRS 9 will most probably result into a marked increase of loss allowances and a commensurate reduction in the net assets of reporting entities. This may trigger new recapitalizations in 2017 (for early adopters of IFRS 9) and in 2018.
We will be closely monitoring the effect of IFRS 9 implementation in financial institutions and keeping you informed of the related issues.