How has the approach to recognition of ECLs changed since IAS 39? Here’s our guide.
The International Accounting Standards Board (IASB) developed IFRS 9 to replace IAS 39 and address its shortcomings. One major weakness identified in IAS 39 was the late recognition of credit losses. Under IAS 39, credit losses were only recognised when there was objective evidence that a financial asset was impaired. An example would have been a missed payment on a loan agreement.
The new model
The IASB developed IFRS 9 to introduce a new forward-looking expected credit loss (ECL) model. The impairment approach to IFRS 9 means it is no longer necessary for a credit event to have occurred before credit losses are recognised. Generally, recognition of credit losses is accelerated and may be recognised immediately after initial measurement of a new financial asset. This new model applies to debt instruments measured at amortised cost – or at fair value through other comprehensive income.
Most companies with large loan portfolios find it difficult to calculate ECLs because the requirements under IFRS 9 involve a high level of judgment and complexity. IFRS 9 does not prescribe a specific way of calculating ECLs. So the ECL calculation varies between entities, depending on the nature of their debt instruments, business operations and risk management.
Entities applying IFRS 9 must recognise ECLs on either a 12-month or lifetime basis, depending on whether there has been a significant increase in credit risk at initial recognition. The 12-month ECLs are a portion of the lifetime ECLs that will result if a default occurs within 12 months after the reporting date.
Factors to consider
Under IFRS 9, there is a rebuttable presumption that a significant increase in credit risk exists when contractual payments are more than 30 days past their due date. Some companies apply a shorter period because of the short-term nature of their loan portfolio. This may be the case for short-term consumer lending companies where the loan has a bi-weekly or weekly repayment frequency.
Other factors may also indicate that a significant credit deterioration has occurred (for example a downgrade in the credit rating of the borrower, significant changes in the value of the collateral item supporting the loan, restructuring or modification of the loan agreement). Entities must provide qualitative and quantitative disclosures in the notes to the financial statements to explain the inputs and assumptions they’ve used to determine significant increases in credit risk.
Risk of default
When deciding whether the credit risk on a financial instrument has increased significantly, an entity should also consider the change in the risk of a default occurring since initial recognition. Entities need to provide a definition of ‘default’ that is consistent with the definition they use for internal credit risk management purposes for the relevant financial instrument, and consider qualitative factors when appropriate.
There is a rebuttable presumption in IFRS 9 that default does not occur later than when a financial asset is 90 days past its due date – unless an entity has reasonable and supportable information to demonstrate that a longer default criterion is more appropriate.
Probability is key
The measurement of ECLs should reflect a probability-weighted outcome, the time value of money and forward-looking information. IFRS 9 requires entities to evaluate a range of possible future economic outcomes, such as ‘optimistic’, ‘realistic’ and ‘stressed’.
Entities need to evaluate the probability of each of these outcomes and their impact on the amount and timing of cash flows from financial assets and then apply a weighting to each scenario.
The weightings applied to each of the outcomes should be reviewed and changed in line with actual and predicted changes in the general economy. For example, entities during the early Covid period in 2020 increased the probability applied to a stressed economic scenario, while reducing the probability weighting applied to an optimistic economic scenario.
Entities also need to determine the correlation of key economic indicators (GDP, unemployment rates and inflation) with the probability of default, based on historical analysis of data within the entity.
Each entity is different
The application of forward-looking information is one of the most complex areas in the calculation of ECL. It requires an entity to create a model and prove that the macro-economic factors used have a strong relationship with the entity’s default rates. This process involves a high level of judgment and complexity. Because of this, it will be difficult to compare the ECLs of different entities.
But IFRS 9 does ask entities to provide disclosures in the notes to the financial statements about the inputs, assumptions and techniques used in measuring the ECL. This provides greater transparency to the users of financial statements.
The entities should consider the reasonable and supportable information available, without ‘undue cost or effort’ at the reporting date, about past events, current conditions and forecast of future economic events that is relevant in measuring the ECLs. The term ‘undue cost or effort’ is not clearly defined in IFRS 9. What is available without undue cost or effort is subject to management’s judgment in assessing the costs and associated benefits.
Stay up to date
Although IFRS 9 does not prescribe a specific way of calculating the ECL, it does provide guidance on how to measure ECLs. Entities should document their methodology with regard to the application of IFRS 9, as it involves many judgments and a high degree of complexity in its calculation.
As a form of control, management should review and approve the methodology at least annually, to make sure the inputs and assumptions are still applicable and to take into account any changes in the entity’s products.