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Impairment of financial assets - Coggle Diagram
Impairment of financial assets
the expected credit loss (ECL) approach
credit losses on financial assets
measured and recognised using the 'expected credit loss (ECL)
difference between the present value (PV) of all contractual cashflows and the PV of expected future cash flows
referred to as the ‘cash shortfall’
The present values are discounted at the original effective interest rate
ECLs are then calculated using the weighted average of credit losses with the respective risks of a default occurring as the weights
results in the early recognition of credit losses
because it includes, not only losses that have already been incurred, but also expected future credit losses
it is a forward looking model
prudent as both financial assets and profits will be reduced
criticism
by requiring the estimation of future credit losses, which will necessarily involve judgment, it will allow some companies to engage in profit smoothing
Consequently, IFRS 9 has included definitions to provide clarity as to what (and what is not) permitted
impacts on the calculation of interest revenue recognised from the financial asset
further classified into
lifetime ECLs
result from all possible default events over the expected life of a financial instrument
not for Financial assets with a low credit risk
entity does not recognise lifetime ECL for financial assets that are equivalent to 'investment grade'
which means that the asset has a low risk of default
rebuttable presumption
lifetime expected losses should be provided for if contractual cash flows are more than 30 days overdue (‘backstop indicator’)
If the credit quality subsequently improves and the lifetime ECL criterion is no longer met, the credit loss reverts back to a 12-month ECL basis
12-month ECL
result from default events that are possible within 12 months after the reporting date
Some entities would recognise a loss allowance whilst others may choose to present ECLs as a liability
financial asset can move from 12 month ECL to lifetime ECL and back again if
there is evidence that there is no longer a significant increase in credit risk
and there should not be an assumption that a financial asset with a lifetime ECL will default
The assessment of significant increases in credit risk
can be performed on a collective basis
if the financial instruments share the same risk characteristics
rather than on an individual basis
However if any assets are deemed credit impaired they will generally be assessed on an individual basis.
approach required by IFRS 9
no longer necessary for a loss event to have occurred
but instead an entity is required to account for ECLs on initial recognition of the financial asset
the ECL could be nil
then separately account for changes in the ECL at each reporting date
impairment of financial assets is recognised in stages
Stage 1
as soon as a financial instrument is originated or purchased
a 12-month ECL is recognised in profit or loss and a loss allowance is established (may be nil)
For financial assets, interest revenue is calculated on the gross carrying amount (ie without deduction for ECLs)
Stage 2
at each reporting date
the ECL is remeasured
if the credit risk has not increased significantly, continue to recognise a 12 month ECL
The calculation of interest revenue is the same as for Stage 1.
if the credit risk increases significantly and is not considered low, full lifetime ECLs are recognised in profit or loss
The calculation of interest revenue is the same as for Stage 1.
if the credit risk of a financial asset increases to the point that it is considered credit-impaired
interest revenue is calculated based on the amortised cost that is the gross carrying amount less the loss allowance
Financial assets in this stage will generally be assessed individually
Lifetime ECLs are recognised on these financial assets.
Financial assets subject to impairment
If deemed necessary, a loss allowance for ECLs should be recognised for the following financial assets
those measured at amortised cost and at fair value through other comprehensive income (OCI)
lease receivables
contract assets
irrevocable loan commitments
financial guarantee contracts that are not accounted for at fair value through profit or loss under IFRS 9.
this includes
debt instruments
loans
debt securities
trade receivables
Summary of the two-stage approach
Stage 1 - on initial recognition
An entity would recognise a loss allowance based on the 12-months' ECL
This may be assessed as nil.
Stage 2 - each reporting date
Where there is no evidence that the credit quality of a financial asset has deteriorated significantly since initial recognition
then the loss allowance continues to be based on the 12 months ECL (which could continue to be nil).
Where there is evidence that the credit quality of a financial asset has deteriorated significantly since initial recognition
then the impairment loss is based on the lifetime ECL
If the asset is considered credit impaired
then there is a further impact as the interest revenue is calculated on the carrying amount net of the loss allowance.
Simplified approach for trade receivables
no credit loss allowance is recognised on initial recognition
Any loss allowance will be the present value of the expected cash flow shortfalls over the remaining life of the receivables
This approach uses the conventional matrix method (aged receivables list) of considering historically observed default rates and adjusted for forward-looking estimates.
Conclusion
ECL model will require judgment carrying amount of financial assets
assessment of impairment is dependent on forward-looking information which can be subjective
IFRS 9 has attempted to limit this subjectivity by providing detailed definitions
IFRS 9 addressed the criticism that losses were recognised too late, only after a credit event, and by requiring a considered forward looking approach to impairment assessment it will make the financial reporting of financial assets more relevant and useful to users of financial statements.