IFRS 9 could lead to earlier (and frequently greater) impairment recognition
One of the major changes introduced by IFRS 9 Financial Instruments is the impairment of financial assets.
Incurred loss model
Currently, the ‘incurred loss’ impairment model for financial assets under IAS 39 Financial Instruments: Recognition and Measurement recognises impairment losses on financial assets only when there is objective evidence of impairment as a result of a past event that occurred subsequent to the initial recognition of the financial asset.
Expected loss model
In contrast, IFRS 9 uses a forward looking ‘expected loss’ model to determine the impairment of financial assets. The IFRS 9 ‘expected loss’ model is a three stage model that recognises impairment based on whether there has been a significant deterioration in the credit risk of a financial asset. The stage that the asset is in determines the amount of impairment to be recognised (as well as the amount of interest revenue).
Under IFRS 9, at each reporting date, a three stage approach to impairment is applied as follows:
| Stage | Impairment | Interest revenue |
| One: Credit risk has not increased significantly since initial recognition | Recognise 12 month expected credit losses (ECL) (i.e. portion of ‘lifetime expected credit losses’ resulting from default events that are possible within 12 months of reporting date) | Calculated based on the gross amount of the asset (i.e. before credit losses have been taken into account) |
| Two: Credit risk has increased significantly since initial recognition | Recognise lifetime expected credit losses (ECL) (i.e. expected credit losses resulting from all possible default events over the life of the instrument) | Calculated based on the gross amount of the asset (i.e. before credit losses have been taken into account) |
| Three: There is objective evidence of impairment as at the reporting date (using the criteria currently included in IAS 39) | Recognise lifetime expected credit losses (ECL) (i.e. expected credit losses resulting from all possible default events over the life of the instrument) | Based on the net amount of the asset (i.e. after credit losses have been taken into account) |
Lifetime expected losses are the present value of expected credit losses that arise if a borrower defaults on its obligation at any point throughout the term (i.e. the weighted average of losses multiplied by the probability of default during the term of the financial asset are included in the analysis).
The recognition pattern for impairment and interest revenue is therefore:
| Stage: | 1 | 2 | 3 |
| Impairment recognition: | 12 month expected credit loss | Lifetime expected credit loss (ECL) | |
| Interest recognition: | On the gross (i.e. unimpaired) amount | On the net (i.e. impaired) amount | |
Example
Company A lends $100 to Company X for five years at 10% interest; the loan is unsecured.
At the end of:
- Year one, the probability of default over the life of the loan is unchanged and there is a 0.5% probability of the loan defaulting in the next 12 months with a 100% loss
- Year two, Company X is expected to have cash flow problems due to a deterioration in economic conditions and is expected to breach its loan covenants; the probability that the loan will default over the remaining life of the loan is 35%
- Year three, Company X breaches its banking covenants; Company A estimates that the probability that the loan will default over the remaining life of the loan is 60%.
The following table shows Company A’s calculation of impairment and interest revenue on the loan, and the impairment journal entries at the end of each of the first three years of the loan period:
| Period | Stage | Impairment | Impairment journal entry | Interest |
| End of year 1: | Stage one | $0.50 ($100 x 0.5%) | Dr Profit or loss $0.50 Cr Impairment allowance $0.50 | $10 ($100 x 10%) |
| End of year 2: | Stage two | $35 ($100 x 35%) | Dr Profit or loss $34.50 Cr Impairment allowance $34.50 | $10 ($100 x 10%) |
| End of year 3: | Stage three | $60 ($100 x 60%) | Dr Profit or loss $25 Cr Impairment allowance $25 | $4 ([$100 - $60] x 10%) |
Simplified approach
IFRS 9 establishes a simplified approach to impairment in certain circumstances, as the diagram below illustrates:
| TRADE RECEIVABLES AND CONTRACT ASSETS THAT DO NOT CONTAIN A SIGNIFICANT FINANCING COMPONENT |  | MUST USE SIMPLIFIED APPROACH (ALWAYS RECOGNISE LIFETIME ECL) |
| TRADE RECEIVABLES AND CONTRACT ASSETS THAT DO CONTAIN A SIGNIFICANT FINANCING COMPONENT | | ACCOUNTING POLICY CHOICE TO USE THE SIMPLIFIED APPROACH |
| LEASE RECEIVABLES | | |
| SIMPLIFIED APPROACH NOT AVAILABLE FOR INTERCOMPANY LOANS AND RECEIVABLES, REGARDLESS OF THEIR MATURITY | ||
The simplified approach allows an entity to always recognise lifetime ECL, rather than having to work through the three stage model. It is only mandatory for trade receivables and contract assets under IFRS 15 Revenue from Contracts with Customers where there is no significant financing component. This is usually the case where maturity is one year or less.
For long-term trade receivables, contract assets and lease receivables, entities can choose to apply the simplified approach as an accounting policy choice.
To determine the impairment allowance under the simplified approach, trade receivables are grouped based on their due date or other attributes (e.g. geographical location, customer credit rating, industry etc.). Impairment losses are then calculated based on a weighted average of expected credit losses, with the weightings being based on the respective probabilities of default – these probabilities must reflect both historical and forecast credit conditions.
IFRS 9 is not prescriptive in how balances should be grouped when assessing impairment and the standard includes extensive guidance in this area.
The table below sets out a provision matrix which is one way of applying the simplified impairment approach to a trade receivables portfolio of $30 million:
| Due status | Expected default rate | Gross carrying amount | Credit loss allowance |
| Current | 0.3% | $15 million | $45,000 |
| 1-30 days past due | 1.6% | $7.5 million | $120,000 |
| 31-60 days past due | 3.6% | $4 million | $144,000 |
| 61-90 days past due | 6.6% | $2.5 million | $165,000 |
| > 90 days past due | 10.6% | $1 million | $106,000 |
| Total | $30 million | $580,000 |
In this instance, impairment of $580,000 would be recognised on the portfolio of receivables. The main differences compared to the provision that would have been recognised under IAS 39 are:
- It includes a provision for trade debtors that are current (i.e. not yet past due), and
- Default rates are based on both historic and forecast data.
Concluding thoughts
Changing from the IAS 39 ‘incurred loss’ model to the IFRS 9 ‘expected loss’ model will likely result in earlier impairment recognition, and the recognition of greater levels of impairment over the life of financial assets.
In preparation for the implementation of IFRS 9, accounting teams will need to ensure that their financial reporting systems and processes are equipped to calculate impairment based on the new requirements.