IFRS 9 for Non-Financial Institutions
IFRS 9 Financial Instruments is replacing IAS 39 Financial Instruments: Recognition and Measurement with effect from annual periods beginning on or after 1 January 2018. IFRS 9 brings about major changes to the classification and measurement of an entity’s financial assets, reviewed in the first part of this article published in the autumn edition of the Accountant, and the calculation of impairment thereon, and is expected to have a major impact across all organisations, particularly financial institutions.
Although the new impairment model is expected to hit banks and other financial services companies the hardest, Non-Financial Institutions (NFIs) will also be impacted by larger and more volatile bad debt provisions on trade, lease receivables and contract assets, and the impact of expected credit losses on financial investments. The following high-level impact assessment is thus made mainly with reference to financial instruments commonly held by NFIs.
The new impairment model revolves around ‘expected credit losses’ (ECLs) and replaces IAS 39’s backwards looking ‘incurred loss’ model. ECLs are a probability-weighted estimate of credit losses i.e. they are calculated as the present value of cash shortfalls (the difference between the cash flows due under the contract and those expected to be received) over the expected life of the financial asset. These requirements apply to debt assets measured at amortised cost or FVOCI, contract assets under IFRS 15 Revenue from Contracts with Customers, lease receivables, and certain financial guarantees and loan commitments. The impairment model does not apply to financial assets measured at FVTPL and equity instruments however, as these are outside the scope of the impairment requirements.
The ECL model has a dual measurement approach:
- Lifetime ECLs, which are defined as ECLs resulting from all possible default events over the life of a financial asset, and
- 12-month ECLs, which are defined as the portion of lifetime ECLs that represent the ECLs resulting from those default events on the financial asset that are possible within the 12 months after the reporting date.
Hence, a financial instrument which is measured under lifetime ECLs will command a larger loss allowance than an identical financial instrument which is measured under 12-month ECLs.
Significant increase in credit risk
At each reporting date, an entity assesses whether the credit risk on a financial asset has increased significantly since initial recognition. IFRS 9 does not define this term, instead, an NFI has to define it in the context of its type of financial instruments. The consequence of credit risk increasing significantly since initial recognition is that a loss allowance, equal to lifetime ECLs, must be recognised.
To illustrate this assessment in practice, consider two financial assets which have the same risk grading at reporting date. Despite having the same risk-grading, the analysis is made relative to initial recognition and thus only the financial asset which had the largest drop in credit rating, consistent with the NFI’s definition of a significant increase, will recognise lifetime ECLs.
|Financial Asset||Credit at Initial Recognition||Credit Rating at Reporting Date||Significant Increase in Credit Risk since Initial Recognition?||ECL|
There is however an exception in this assessment if credit risk is low at the reporting date. This is the case when:
- the financial asset has a low risk of default;
- the borrower has a strong capacity to meet 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 ability of the borrower to fulfil its contractual cash flow obligations.
The key impact of this exception is for externally rated investment grade bonds. It is important to note that, just because an instrument is no longer of investment grade, it does not necessarily mean that there has been a significant increase in credit risk. Similarly, a financial asset of investment grade does not automatically meet the low credit risk exception because the credit rating may be out of date.
The standard also includes a rebuttable presumption that credit risk on a financial asset has increased significantly when payments are more than 30 days overdue, and this is the latest point at which lifetime ECLs should start to be recognised. As the delinquency of a debtor is a lagging indicator and thus normally information would have been available to identify a significant increase well before the 30 days indicator, an NFI should seek to obtain this more forward-looking information, if available, without undue cost or effort. There are instances when this presumption may be rebutted, such as if non-payment by the borrower was only due to a technical or administrative oversight rather than resulting from the borrower’s financial difficulties.
Impact of impairment requirements on NFIs
The magnitude of the ECL model will depend on the extent and nature of an entity’s financial assets. Under IAS 39, impairment losses would only be recognised once objective evidence exists that a loss event happened after initial recognition, such as missed contractual payments by a debtor. Under IFRS 9, impairment losses will be pre-emptively recognised before actual losses occur and thus the scope of impairment has now increased significantly.
Applying the new ECL model to the same broad asset categories identified earlier will allow NFIs to better understand how to approach the new impairment requirements.
Loans, trade and lease receivables and contract assets
Bad debt provisions are likely to be larger and more volatile. Impairment of trade receivables and contract assets without a significant financing component will always carry a loss allowance equal to lifetime ECLs, whilst for those with a significant financing component, and lease receivables, an accounting policy choice is available to either recognise lifetime ECLs or apply the general impairment model. This is known as the ‘simplified approach’ for trade receivables, contract assets and lease receivables.
Impairment losses must be recognised for investments in debt securities not classified at FVTPL. These reflect probability-weighted estimates of ECLs based on historical experience and forward-looking information: 12-month ECLs for assets that have not suffered a significant increase in credit risk; lifetime ECLs for those that have.
NFIs should thus review the contractual terms and redesign impairment methodology to comply with IFRS 9. They should review credit risk management processes and data available, and assess whether credit risk management systems can record changes in credit risk since initial recognition. They will also have to design and test new impairment methodologies.
The standard brings with it extensive qualitative and quantitative disclosures generally by class of financial instruments, including:
- a description of credit risk management practices, including how an entity determined whether credit risk has increased significantly;
- an explanation of inputs, assumptions and techniques used when applying the impairment requirements; and
- a reconciliation of loss allowances and explanation of significant changes in the gross carrying amount.
NFIs should assess current systems to identify data gaps that must be filled to meet the new disclosure requirements. The general financial instrument disclosure requirements covered by IFRS 7 Financial Instruments: Disclosures are of course applicable – NFIs should provide enough disclosures to enable users to understand (i) the significance of financial instruments, (ii) the credit, liquidity and market risk exposures resulting from said instruments, and (iii) how they manage these risks.
IFRS 9 allows various transition options. NFIs shall apply IFRS 9 retrospectively, in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, with significant exemptions on transition with respect to classification, measurement and impairment requirements. A robust impact assessment phase to transition to IFRS 9 is imperative to ensure a successful implementation project.
Transitioning to the new standard will consume energy and resources over the next few months. Post-implementation reviews following adoption of this standard will be high on the agenda in years to come as entities have to demonstrate adherence to their business models and test the validity of assumptions applied in the ECL model.