International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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were to be recognised over the life of a financial asset, by including them in the
computation of the effective interest rate (EIR) when the asset was first recognised. This
would build an allowance for credit losses over the life of a financial asset and so match
the recognition of credit losses with that of the credit spread implicit in the interest
charged. Subsequent changes in credit loss expectations would be reflected in catch-up
adjustments to profit or loss based on the original EIR. Because the proposals were much
more closely linked to credit risk management concepts, the IASB acknowledged that this
would represent a fundamental change from how entities currently operate (i.e. typically,
entities operate their accounting and credit risk management systems separately).
Consequently, the IASB established a panel of credit risk experts, the Expert Advisory
Panel (EAP), to provide input to the project. [IFRS 9.BC5.87].
Comments received on the 2009 ED and during the IASB’s outreach activities indicated
that constituents were generally supportive of a model that distinguished between the
effect of initial estimates of ECLs and subsequent changes in those estimates. However,
they were also concerned about the operational difficulties in implementing the model
proposed. These included: [IFRS 9.BC5.89]
• estimating the full expected cash flows for all financial instruments;
• applying a credit-adjusted EIR to those cash flow estimates; and
• maintaining information about the initial estimate of ECLs.
Also, the proposals would not have been easy to apply to portfolios of loans managed
on a collective basis, in particular, open portfolios to which new financial instruments
are added over time, and concerns were expressed about the volatility of reported profit
or loss arising from the catch up adjustments.
To address these operational challenges and as suggested by the EAP, the IASB decided
to decouple the measurement and allocation of initial ECLs from the determination of
the EIR (except for purchased or originated credit-impaired financial assets). Therefore,
the financial asset and the loss allowance would be measured separately, using an
original EIR that is not adjusted for initial ECLs. Such an approach would help address
Financial instruments: Impairment 3727
the operational challenges raised and allow entities to leverage their existing accounting
and credit risk management systems and so reduce the extent of the necessary
integration between these systems. [IFRS 9.BC5.92].
By decoupling ECLs from the EIR, an entity must measure the present value of ECLs
using the original EIR. This presents a dilemma, because measuring ECLs using such a
rate double-counts the ECLs that were priced into the financial asset at initial
recognition. This is because the fair value of the loan at original recognition already
reflects the ECLs, so to provide for the ECLs as an additional allowance would be to
double count these losses. Hence, the IASB concluded that it was not appropriate to
recognise lifetime ECLs on initial recognition. In order to address the operational
challenges while trying to reduce the effect of double-counting, as well as to replicate
(very approximately) the outcome of the 2009 ED, the IASB decided to pursue a dual-
measurement model that would require an entity to recognise: [IFRS 9.BC5.93]
• a portion of the lifetime ECLs from initial recognition as a proxy for recognising
the initial ECLs over the life of the financial asset; and
• the lifetime ECLs when credit risk had increased since initial recognition (i.e. when
the recognition of only a portion of the lifetime ECLs would no longer be
appropriate because the entity has suffered a significant economic loss).
It is worth noting that any approach that seeks to approximate the outcomes of the
model in the 2009 ED, without the associated operational challenges, will include a
recognition threshold for lifetime ECLs. This gives rise to what has been referred to as
‘a cliff effect’, i.e. the significant increase in allowance that represents the difference
between the portion that was recognised previously and the lifetime ECLs. [IFRS 9.BC5.95].
Subsequently, the IASB and FASB spent a considerable amount of time and effort
developing a converged impairment model. In January 2011, the IASB issued with the
FASB a Supplementary Document – Financial Instruments: Impairment – reflecting a
joint approach that proposed a two-tier loss allowance: [IFRS 9.BC5.96]
• for the good book, an entity would recognise the higher of a time-proportionate
allowance (i.e. the lifetime ECLs over the weighted average life of the portfolio of
assets) or ECLs for the ‘foreseeable future’; and
• for the bad book, an entity would recognise lifetime ECLs on those financial assets
when the collectability of contractual cash flows had become so uncertain that the
entity’s credit risk management objective had changed from receiving the regular
payments to recovery of all, or a portion of, the asset.
However, this approach received only limited support, because respondents were
concerned about the operational difficulties in performing the dual calculation for the
good book, that it also lacked conceptual merit and, potentially, would provide
confusing information to users of financial statements. Moreover, concerns were also
raised as to how ‘foreseeable future’ should be interpreted and applied.
Many constituents emphasised the importance of achieving convergence and this
encouraged the IASB and FASB to attempt to develop another joint alternative
approach. In May 2011, the boards decided to develop jointly an expected credit loss
model that would reflect the general pattern of increases in the credit risk of financial
instruments, the so-called three-bucket model. [IFRS 9.BC5.111].
3728 Chapter 47
However, due to concerns raised by the FASB’s constituents about the model’s complexity,
the FASB decided to develop an alternative expected credit loss model. [IFRS 9.BC5.112]. In
December 2012, the FASB issued a proposed accounting standard update, Financial
Instruments Credit Losses (Subtopic 825-15), that would require an entity to recognise a
loss allowance from initial recognition at an amount equal to lifetime ECLs (see 1.4 below).
In March 2013, the IASB published a new Exposure Draft – Financial Instruments: Expected
Credit Losses (the 2013 ED), based on proposals that grew out of the joint project with the
FASB. The 2013 ED proposed that entities should recognise a loss allowance or provision at
an amount equal to 12-month credit losses for those financial instruments that had not yet
seen a significant increase in credit risk since initial recognition, and lifetime ECLs once there
had been a significant increase in credit risk. This new model was designed to:
• ensure a more timely recognition of ECLs than the existing incurred loss model;
• distinguish between financial instruments that have significantly deteriorated in
credit quality and those that have not; and
• better approximate the economic ECLs.3
This two-step model was designed to approximate the build-up of the allowance as
proposed in the 2009 ED, but involving less operational complexit
y. Figure 47.1 below
illustrates the stepped profile of the new model, shown by the solid line, compared to
the steady increase shown by the black dotted line proposed in the 2009 ED (based on
the original ECL assumptions and assuming no subsequent revisions of this estimate). It
shows that the two step model first overstates the allowance (compared to the method
set out in the 2009 ED), then understates it as the credit quality deteriorates, and then
overstates it once again, as soon as the deterioration is significant.
Figure 47.1 Accounting for expected credit losses – 2009 ED versus IFRS 9 4
Loss allowance
Incurred
(% of gross carrying amount)
loss
Significant
deterioration
Lifetime expected
credit losses
12-month expected
credit losses
Economic expected credit losses
Deterioration in credit quality
(2009 Exposure Draft)
from initial recognition
IFRS 9 Impairment
Financial instruments: Impairment 3729
Feedback received on the IASB’s 2013 ED and the FASB’s 2012 Proposed Update was
considered at the joint board meetings. In general, non-US constituents preferred the
IASB’s proposals whilst the US constituents preferred the FASB’s proposals. These
differences in views arose in large part because of differences in the starting point of
how preparers apply US GAAP for loss allowances from that for most IFRS preparers,
while the interaction between the role of prudential regulators and calculation of loss
allowances is historically stronger in the US. [IFRS 9.BC5.116].
Many respondents urged the IASB to finalise the proposals in the 2013 ED as soon as
possible, even if convergence could not be achieved, in order to improve the accounting
for the impairment of financial assets in IFRSs. [IFRS 9.BC5.114]. The IASB re-deliberated
particular aspects of the 2013 ED proposals, with the aim of providing further
clarifications and additional guidance to help entities implement the proposed
requirements. The IASB finalised the impairment requirements and issued them in
July 2014, as part of the final version of IFRS 9.
1.2
Overview of the IFRS 9 impairment requirements
The new impairment requirements in IFRS 9 are based on an ECL model and replace
the IAS 39 incurred loss model. The ECL model applies to debt instruments (such as
bank deposits, loans, debt securities and trade receivables) recorded at amortised cost
or at fair value through other comprehensive income, plus lease receivables and
contract assets. Loan commitments and financial guarantee contracts that are not
measured at fair value through profit or loss are also included in the scope of the new
ECL model.
Conceptually, an impairment model is a necessary complement to an accounting
model for financial assets that is based on the concept of realisation, i.e. when cash
flows are received and paid. For financial assets in the scope of the impairment
model, the recognition of revenue follows the effective interest method, and gains
and losses relating to changes in their fair value are generally only recognised in profit
or loss when the financial asset is derecognised, when that gain or loss is realised. In
order to avoid delaying the recognition of impairment losses, those accounting
models are complemented by an impairment model that anticipates impairment
losses by recognising them before they are realised. The new impairment model of
IFRS 9 does this on the basis of ECLs, which means impairment losses are anticipated
earlier than under the incurred loss impairment model of IAS 39. In contrast, the
accounting models for financial assets in IFRS 9 that are not based on the concept of
realisation, i.e. those measured at fair value through profit or loss or at fair value
through other comprehensive income without recycling (under the presentation
choice for fair value changes of some investments in equity instruments, see
Chapter 44 at 8 and Chapter 46 at 2.5) do not involve any separate impairment
accounting. Those measurement categories implicitly include impairment losses in
the fair value changes that are recognised immediately (and without any later
reclassification entries between other comprehensive income and profit or loss when
they are realised).
The guiding principle of the ECL model is to reflect the general pattern of deterioration,
or improvement, in the credit quality of financial instruments. The ECL approach has
3730 Chapter 47
been commonly referred to as the three-bucket approach, although IFRS 9 does not use
this term. Figure 47.2 below summarises the general approach in recognising either 12-
month or lifetime ECLs.
Figure 47.2 General approach
Stage 1
Stage 2
Stage 3
Loss allowance
12-month expected
updated at each
Lifetime expected credit losses
credit losses
reporting date
(credit losses that result
from default events that
are possible within the next
12-months)
Lifetime
Credit risk has increased significantly
expected credit
since initial recognition
losses criterion
(whether on an individual or collective basis)
+
Credit-impaired
Interest revenue
Effective
Effective
Effective
calculated based
interest rate on
on
interest rate on
interest rate on
gross carrying
gross carrying
amortised cost
amount
amount
(gross carrying amount
less loss allowance)
Change in credit risk since initial recognition
Improvement
Deterioration
The amount of ECLs recognised as a loss allowance or provision depends on the extent
of credit deterioration since initial recognition. Under the general approach (see 3.1
below), there are two measurement bases:
• 12-month ECLs (stage 1), which apply to all items as long as there is no significant
deterioration in credit risk; and
• lifetime ECLs (stages 2 and 3), which apply when a significant increase in credit
risk has occurred on an individual or collective basis.
When assessing significant increases in credit risk, there are a number of operational
simplifications available, such as the low credit risk simplification (see 6.4.1 below).
Stages 2 and 3 differ in how interest revenue is recognised. Under stage 2 (as under
stage 1), there is a full decoupling between interest recognition and impairment, and
interest revenue is calculated on the gross carrying amount. Under stage 3, when a credit
event has occurred, interest revenue is calculated on the amortised cost (i.e. the gross
carrying amount adjusted for the impairment allowance).
The following example illustrates how the ECL allowance changes when a loan moves
from stage 1 to stage 3.
Financial instruments: Impairment 3731
Example 47.1: Expected credit loss allowance in stages 1, 2 and 3 under the
general approach
On 31 December 2018, Bank A originates a 10 year loan with a gross carrying amount of $1,000,000, with
interest being due at the end of each year and the principal due on maturity. There are no transaction costs
and the loan contracts include no options (for example, prepayment or call options), premiums or discounts,
points paid, or other fees.
At origination, the loan is in stage 1 and a corresponding 12-month ECL allowance is recognised in the year
ending 31 December 2018.
On 31 December 2021, the loan has shown signs of significant deterioration in credit quality and Bank A
moves the loan to stage 2. A corresponding lifetime ECL allowance is recognised. In the following year, the
loan defaults and is moved to stage 3.
The ECL allowance in each stage is shown below and the detailed calculation is
illustrated in Example 47.3 at 5.4.1 below.
Stage 2: lifetime
Stage 1: 12-month
Stage 3: lifetime
expected credit losses
expected credit losses
expected credit losses
On 31 December 2021,
the loan has shown signs
On 31 December 2018, the
On 31 December 2022,
of a significant increase in
loan is originated. An
the loan defaults. An
credit risk. An allowance
allowance of $422
allowance of $262,850
of $50,285 is recognised
is recognised.
is recognised.
(the 12-month ECL is $3,495).
There are two alternatives to the general approach:
• the simplified approach, that is either required or available as a policy choice for
trade receivables, contract assets and lease receivables (see 3.2 below); and
• the credit-adjusted effective interest rate approach, for purchased or originated
credit-impaired financial assets (see 3.3 below).
ECLs are an estimate of credit losses over the next 12 months or the life of a financial
instrument and, when measuring ECLs (see 5 below), an entity needs to take into account:
• the probability-weighted outcome (see 5.6 below), as ECLs should not be simply
either a best or a worst-case scenario, but should, instead, reflect the possibility