IFRS 9 is the new international financial reporting standard for financial instruments, replacing IAS 39, and is applicable from 1 January 2018 (with early application permitted). The principal updates of IFRS 9 relate to:
- Classification and measurement: classification of financial instruments is now driven by cash flow characteristics and the business model in which an instrument is held;
- Impairment: a new expected loss impairment model which requires more timely recognition of expected credit losses is introduced;
- Hedge accounting: a new reformed model for hedge accounting is introduced with enhanced disclosures about risk management activity.
IFRS 9: Impairment Scope
A significant new feature of IFRS 9 is the requirement to record loss allowances based on an expected credit loss model, being substantially more forward looking in nature, compared to the incurred loss accounting model of IAS 39. A uniform model is applied for:
- Financial assets measures at amortized cost;
- Financial assets that are mandatorily measured at fair value through other comprehensive income (FVTOCI);
- Loan commitments when there is a present obligation to extend credit (except when these are measured through Fair Value Through Profit and Loss (FVTPL));
- Financial guarantee contracts under IFRS 9 (except those measured at FVTPL);
- Lease receivables under IAS 17;
- Contract assets as specified under IFRS 15.
Expected credit losses (ECL)
For financial assets, within the scope of the impairment requirements of IFRS 9, expected credit losses are required to be measured through a loss allowance at each financial reporting date at an amount equal to:
- The 12-month expected credit losses (expected credit losses that result from default events that are possible within 12 months after the reporting date); or
- Lifetime expected credit losses (expected credit losses that result from all possible default events over the life of the financial instrument).
Twelve month expected credit losses are applicable unless the credit risk of the relevant financial instrument has increased significantly since initial recognition. If a significant increase in credit risk is reversed in a subsequent reporting period, expected credit losses revert to being measured at a 12-month basis.
For financial assets measured through FVTOCI, loss allowances are recognized directly in OCI and shall not reduce the carrying value of the financial asset in the statement of financial position. For other financial assets, the amount of expected credit losses and reversals required to adjust the loss allowance at the reporting date are recognized in PL.
Lifetime expected credit losses (as opposed to 12-month expected credit losses) are applied for:
- contract assets and trade receivables that do not contain a significant financing component under IFRS 15;
- contract assets and trade receivables that do contain a significant financing component under IFRS 15 and for which the entity chooses as its accounting policy to apply lifetime expected credit losses;
- lease receivables resulting from transactions within the scope of IFRS 16 for which the entity chooses as its accounting policy to apply lifetime expected credit losses;
- purchased or originated credit-impaired financial assets (lifetime expected credit losses are measured from the time of recognition, and only changes in lifetime expected credit losses from the time of recognition are subsequently recognized in profit or loss).
Recognition of interest revenue for financial assets measured at amortized cost
Interest revenue is calculated using the effective interest method:
- For financial assets that are not credit-impaired, the effective interest method is applied on the gross carrying amount of the financial asset;
- For purchased or originated credit impaired assets, the entity shall apply the credit-adjusted effective interest rate to the amortized cost (gross carrying amount adjusted for loss allowance) of the financial asset;
- For assets that were not purchased or originated credit impaired, but which have subsequently become credit impaired, the entity shall apply the effective interest rate to the amortized cost (gross carrying amount adjusted for loss allowance) of the financial asset in subsequent reporting periods.
Assessment of Changes in credit risk
Assessment of changes in credit risk is required at each reporting date.
The assessment of changes in credit risk is based on whether there has been an increase in the probability of default since initial recognition. When making the assessment of significant increases in credit risk, an entity shall use the change in the risk of default occurring over the expected life of the financial instrument, instead of the change in the amount of expected credit losses.
Credit institutions should have a clear policy including well-developed criteria on what constitutes a significant increase in credit risk for different types of lending exposures. Such criteria and the reasons why these approaches and definitions are considered appropriate should be disclosed in accordance with IFRS 7.
Section B5.5.17 of IFRS 9 presents a non-exhaustive list of information that may be relevant when assessing changes in credit risk. If reasonable and supportable forward-looking information is available without undue cost or effort, an entity cannot rely solely on past due information when determining whether credit risk has increased significantly since initial recognition. Lifetime expected credit losses are generally expected to be recognized before a financial instrument becomes past due.
There is a rebuttable presumption implying that credit risk has changed significantly since the date of initial recognition if contractual payments are more than 30 days past due.
If the credit risk of the relevant financial instrument is deemed low at the reporting date, an entity may assume that there has not been a significant increase in credit risk since initial recognition. The credit risk is deemed low at the date of reporting if there is a low risk of default, the borrower has a strong capacity to meets its contractual cash flow obligations in the near term and adverse changes in economic and business conditions in the longer term may, but will not necessarily, reduce the ability of the borrower to fulfill its contractual cash flow obligations. To determine whether a financial instrument has low credit risk, an entity may use its internal credit risk ratings or other methodologies that are deemed consistent.
In order to meet the objective of recognizing lifetime expected credit losses for significant increases in credit risk since initial recognition, it may be necessary to perform the assessment of significant increases in credit risk on a collective basis.
Methodology for estimating expected credit losses
A credit loss is defined as the difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flows that the entity expects to receive, discounted at the original effective interest rate (or credit-adjusted effective interest rate for purchased or originated credit-impaired financial assets) to the date of reporting. If a financial instrument has a variable interest rate, the current effective interest rate should be used to discount expected credit losses. Because expected credit losses consider the amount and timing of payments, a credit loss arises even if the entity expects to be paid in full but later than when contractually due.
Expected credit losses shall reflect an unbiased probability-weighted amount determined by evaluating a range of possible outcomes, and are defined as the weighted average of credit losses with the respective risks of a default occurring as the weights. The purpose of estimating expected credit losses is neither to estimate a worst-case scenario nor to estimate the best-case scenario. Instead, an estimate of expected credit losses shall always reflect the possibility that a credit loss occurs and the possibility that no credit loss occurs even if the most likely outcome is no credit loss.
For the purposes of measuring expected credit losses, the estimate of expected cash shortfalls shall reflect the cash flows expected from collateral and other credit enhancements that are part of the contractual terms and are not recognized separately by the entity.
In practice, the estimation of ECLs may not need to be a complex analysis. In some cases, relatively simple modelling may be sufficient, without the need for a large number of detailed simulations of scenarios. In other situations, the identification of scenarios that specify the amount and timing of the cash flows for particular outcomes and the estimated probability of those outcomes will probably be needed.
When defining default for the purposes of determining the risk of a default occurring, an entity shall apply a default definition that is consistent with the definition used for internal credit risk management purposes for the relevant financial instrument and consider qualitative indicators when appropriate.
In estimating expected credit losses, an entity shall consider past, current as well as reasonable and supportable forecasts of future economic conditions. However, an entity is not required to incorporate forecasts of future conditions over the entire expected life of a financial instrument. Thus, an entity need not undertake an exhaustive search for information but shall merely consider all reasonable and supportable information that is available without undue cost or effort and that is relevant to the estimate of expected credit losses, including the effect of expected prepayments. For this purpose an entity may use various sources of data (internal and external). Possible data sources include internal historical credit loss experience, internal ratings, credit loss experience of other entities and external ratings, reports and statistics.
IFRS 9: Special considerations for credit institutions
On 12th of May 2017 the EBA published its Guidelines on credit institutions’ credit risk management practices and accounting for expected credit losses.
Moreover, on 13th of July 2017 the EBA published a Consultation paper as well as a Report on results from the second EBA impact assessment of IFRS 9.
Important matters affecting credit institutions include:
Disclosure requirements under CRR
Due to the forward looking nature of ECLs under IFRS 9, increased provisions for ECLs are expected, affecting financial ratios reported under the Capital Requirements Regulation (CRR). The EBA report on “results from the second EBA impact assessment of IFRS 9” finds the average estimated impact of IFRS 9 on the Common Equity Tier 1 (CET1) ratio and on the total capital ratio, to be a 45 bps decrease and a 35 bps decrease respectively.
The Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 575/2013 from the 31st of May 2017, suggests an amendment of the CRR to accomodate the introduction of IFRS 9. The target is to phase-in the impact of the impairment requirements resulting from IFRS 9 on capital and leverage ratios. Thus, where a credit institution’s opening balance sheet as of the day when first applying IFRS 9 in 2018 reflects a decrease in CET1 capital as a result of increased ECL provisions compared to the closing balance sheet on the previous day, the institution should be allowed to include in its CET1 capital a portion of the increased ECL provisions during a transitional period. This transitional period should have a duration of 5 years and should start on the first day of 2018 on which the institution first applies IFRS 9.
Credit institutions are thus left with two options:
- Phase-in the impact of the implementation of ECLs under IFRS 9 on capital and leverage ratios;
- Recognise the full impact of ECLs under IFRS 9 on capital and leverage ratios from 1 January 2018 or before the end of the transitional period.
Credit institutions that apply the transitional arrangements are required to disclose the effect of such transitional arrangements on own funds, risk-based-capital and leverage ratios under CRR. A quantitative template for the required comparison of a credit institution’s own funds, capital and leverage ratios with and without the application of the transitional arrangements is provided for in Annex I of the EBA consultation paper from 13th of July 2017.
Development of internal processes
For the purpose of estimating lifetime and 12-month expected credit losses, credit institutions need appropriate models for:
- Lifetime probability of default (PD) and exposure at default (EAD);
- Twelve-month PD and EAD;
- Loss given default (LGD) – models for LGD would generally be the same for lifetime and 12-months expected credit losses.
In general, all models should incorporate forward-looking information, including macroeconomic information.
Although, IFRS 9 does not specify the method applicable to calculate PDs used when assessing credit risk and expected credit losses, it is stated that information should be forward looking, incorporate current economic circumstances, and that historical information shall be adjusted to reflect current conditions. Thus, point-in-time PDs are deemed more appropriate than through-the-cycle PDs for purposes of assessing credit risk and expected credit losses.
Proper processes for the application of a sound and consistent methodology and governance process, when making use of approximations to meet the objectives of IFRS 9 and to avoid bias in ECL measurement, will furthermore be necessary. While the EBA report on “results from the second EBA impact assessment of IFRS 9” highlighted that it is of great importance that a robust validation process is implemented and that regular monitoring of the key elements of the ECL models is performed, it also showed that many credit institutions have yet to decide on the validation processes for ECL measurement.
The implementation of IFRS 9 leads to new challenges for credit institutions as internal processes need to be developed and/or reshaped. Proper processes for the estimation of lifetime and 12-month ECLs (incorporating, where possible, forward-looking information) need to be established, including proper government, monitoring and validation processes relating to ECL meausurement. Also, proper processes for the due and timely assessment of changes in credit risk are required. Credit institutions furthermore need to assess the impact of IFRS 9 on other reporting and disclosure requirments, such as those under CRR. Hence, taking a holistic when implementing IFRS 9 is of the essence.
Latest update: 18.07.2017