International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
Page 741
example, listed bonds, an entity may be able to use, as a starting point, historical default
rates implied by such ratings. It should be stressed that the historical default rates
implied by credit ratings assigned by agencies are historical rates for corporate debt and
so they would not, without adjustment, satisfy the requirements of the standard. IFRS 9
requires the calculation of ECLs, based on current conditions and forecasts of future
conditions, to be based on reasonable and supportable information. A significant
challenge in applying the IFRS 9 impairment requirements to quoted bonds is that the
historical experience of losses by rating grade can differ significantly from the view of
the market, as reflected in, for instance, CDS spreads and bond spreads.
Bank deposits and current accounts that are classified as financial assets measured at
amortised cost, are also subject to the general approach, even if treated as cash and cash
equivalents. However, for most such instruments, given their maturity, the 12-month
and lifetime ECLs are the same and will usually be small.
For any corporate that is a lessor, there is a significant increase in allowances on finance
leases, particularly if they chose to apply the simplified approach and record lifetime
allowances (see 10.2 below).
If the entity prepares separate financial statements under IFRS, then the ECL model will
also apply to intercompany loans (see 13 below). Non-financial entities will also need to
determine whether guarantees and other credit-enhancements can be reflected directly
in the measurement of ECLs (see 5.8.1 below).
The required impairment disclosures have been expanded significantly in comparison
to the disclosures previously required under IFRS 7, including inputs, assumptions and
estimation methods used, operating simplifications applied and credit risk disclosures
for trade receivables, contract assets or lease receivables measured under the
simplified approach. The objective of the new disclosures is to enable users to
understand the effect of credit risk on the amount, timing and uncertainty of future
cash flows (see 15 below).
3748 Chapter 47
5
MEASUREMENT OF EXPECTED CREDIT LOSSES
The standard defines credit loss 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 (i.e. all cash shortfalls), discounted at the original EIR (or credit-
adjusted EIR for purchased or originated credit-impaired financial assets). When
estimating the cash flows, an entity is required to consider: [IFRS 9 Appendix A]
• all contractual terms of the financial instrument (including prepayment, extension,
call and similar options) over the expected life (see 5.5 below) of the financial
instrument. The maximum period to consider when measuring ECLs is the
maximum contractual period (including extension options at the discretion of the
borrower) over which the entity is exposed to credit risk (with an exception for
revolving facilities); and
• cash flows from the sale of collateral held (see 5.8.2 below) or other credit
enhancements that are integral to the contractual terms.
Also, the standard goes on to define ECLs as ‘the weighted average of credit losses with
the respective risks of a default occurring as the weights’. [IFRS 9 Appendix A].
The standard does not prescribe specific approaches to estimate ECLs, but stresses that
the approach used must reflect the following: [IFRS 9.5.5.17]
• an unbiased and probability-weighted amount that is determined by evaluating a
range of possible outcomes (see 5.6 below);
• the time value of money (see 5.7 below); and
• reasonable and supportable information that is available without undue cost or
effort at the reporting date about past events, current conditions and forecasts of
future economic conditions (see 5.9 below).
5.1 Definition
of
default
Default is not defined for the purposes of determining the risk of a default occurring. Because
it is defined differently by different institutions (for instance, 30, 90 or 180 days past due), the
IASB was concerned that defining default could result in a definition that is inconsistent with
that applied internally for credit risk management. In particular, since default is the anchor
point used to measure probabilities of default and losses given default in Basel modelling,
requiring a different definition would require building a different set of models for accounting
purposes. Therefore, the standard requires an entity to apply a definition of default that is
consistent with how it is defined for normal credit risk management practices, consistently
from one period to another. It follows that an entity might have to use different default
definitions for different types of financial instruments. However, the standard stresses that
an entity needs to consider qualitative indicators of default when appropriate in addition to
days past due, such as breaches of covenant. [IFRS 9.B5.5.37].
Financial instruments: Impairment 3749
The IASB did not originally expect ECL calculations to vary as a result of differences in
the definition of default, because of the counterbalancing interaction between the way
an entity defines default and the credit losses that arise as a result of that definition of
default. [IFRS 9.BC5.248]. (For instance, if an entity uses a shorter delinquency period of
30 days past due instead of 60 days past due, the associated loss given default (LGD) will
be correspondingly smaller as it is to be expected that more debtors that are 30 days
past due will in due course recover). However, the notion of default is fundamental to
the application of the model, particularly because it affects the subset of the population
that is subject to the 12-month ECL measure. [IFRS 9.BC5.249].
The standard restricts diversity resulting from this effect by establishing a rebuttable
presumption that default does not occur later than when a financial asset is 90 days past
due. This presumption may be rebutted only if an entity has reasonable and supportable
information to support an alternative default criterion. [IFRS 9.B5.5.37, BC5.252].
A 90 day default definition would also be consistent with that used by banks for the
advanced Basel II regulatory capital calculations (with a few exceptions). We observe that
most banks intend to align their regulatory and accounting definitions of default. This
generally means aligning the number of days past due trigger to 90 days under IFRS 9, with
some exceptions for certain portfolios such as mortgages for which the regulatory definition
may allow longer delinquency periods. Most banks also intend to align the accounting
definition of credit-impaired for transfer to stage 3 with the definition of default.
5.2
Lifetime expected credit losses
IFRS 9 defines lifetime ECLs as the ECLs that result from all possible default events
over the expected life of a financial instrument (i.e. an entity needs to estimate the risk
of a default occurring on the financial instrument during its expected life).
[IFRS 9 Appendix A, B5.5.43]. The expected life considered for the mea
surement of lifetime
ECLs cannot be longer than the maximum contractual period (including extension
options at the discretion of the borrower) over which the entity is exposed to credit risk.
However, there is an exception for revolving facilities (see 12 below).
ECLs should be estimated based on the present value of all cash shortfalls over the
remaining expected life of the financial asset, i.e. the difference between: [IFRS 9.B5.5.29]
• the contractual cash flows that are due to an entity under the contract; and
• the cash flows that the holder expects to receive.
As ECLs take into account both the amount and the timing of payments, a credit loss
arises even if the holder expects to receive all the contractual payments due, but at a
later date. [IFRS 9.B5.5.28].
3750 Chapter 47
When estimating lifetime ECLs for undrawn loan commitments (see 11 below), the
provider of the commitment needs to:
• estimate the expected portion of the loan commitment that will be drawn down
over the expected life of the loan commitment. Except for revolving facilities
(see 12 below), the expected life will be capped at the maximum contractual period,
including extension options at the discretion of the borrower, over which the
entity is exposed to credit risk (see 5.3 below for 12-month ECLs); [IFRS 9.B5.5.31] and
• calculate the present value of cash shortfalls between the contractual cash flows
that are due to the entity if the holder of the loan commitment draws down that
expected portion of the loan and the cash flows that the entity expects to receive
if that expected portion of the loan is drawn down. [IFRS 9.B5.5.30].
For a financial guarantee contract (see 11 below), the guarantor is required to make
payments only in the event of a default by the debtor in accordance with the terms of
the instrument that is guaranteed. Accordingly, the estimate of lifetime ECLs would be
based on the present value of the expected payments to reimburse the holder for a
credit loss that it incurs, less any amounts that the guarantor expects to receive from the
holder, the debtor or any other party. If an asset is fully guaranteed, the ECL estimate
for the financial guarantee contract would be consistent with the estimated cash
shortfall estimate for the asset subject to the guarantee. [IFRS 9.B5.5.32].
5.3
12-month expected credit losses
The 12-month ECLs is defined as a portion of the lifetime ECLs that represent the ECLs
that result from default events on a financial instrument that are possible within
the 12 months after the reporting date. [IFRS 9 Appendix A]. The standard explains further
that the 12-month ECLs are a portion of the lifetime ECLs that will result if a default
occurs in the 12 months after the reporting date (or a shorter period if the expected life
of a financial instrument is less than 12 months), weighted by the probability of that
default occurring. [IFRS 9.B5.5.43].
Because the calculation is based on the probability of default (PD), the standard
emphasises that the 12-month ECL is not the lifetime ECL that an entity will incur on
financial instruments that it predicts will default in the next 12 months (i.e. for which the
PD over the next 12 months is greater than 50%). For instance, the PD might be only 5%,
in which case this should be used to calculate 12-month ECLs, even though it is not
probable that the asset will default. Also, the 12-month ECLs are not the cash shortfalls
that are predicted over only the next 12 months. For an asset defaulting in the next
12 months, the lifetime ECLs that need to be included in the calculation will normally
be significantly greater than just the cash flows that were contractually due in the next
12 months.
If the financial instrument has a maturity of less than 12 months then the 12-month ECLs
are the credit losses expected over the period to maturity.
Financial instruments: Impairment 3751
For undrawn loan commitments (see 11 below), an entity’s estimate of 12-month ECLs
should be based on its expectations of the portion of the loan commitment that will be
drawn down within 12 months of the reporting date. [IFRS 9.B5.5.31].
As already mentioned at 1.2 above, the IASB believes that the 12-month ECLs serve as
a proxy for the recognition of initial ECLs over time, as proposed in the 2009 Exposure
Draft, and they mitigate the systematic overstatement of interest revenue that was
recognised under IAS 39. [IFRS 9.BC5.135]. This practical approximation was necessary as
a result of the decision to decouple the measurement and allocation of initial ECLs from
the determination of the EIR following the re-deliberations of the 2009 Exposure Draft.
[IFRS 9.BC5.199].
The stage 1, 12-month allowance overstates the necessary allowance for each financial
instrument after initial recognition. However, this is offset by the fact that the allowance
is not further increased (except for changes in the 12-month ECLs) until the instrument’s
credit risk has significantly increased and it is transferred to stage 2. For a portfolio of
instruments, with various origination dates, the overall provision may (very
approximately) be a similar size as might be achieved using a more conceptually robust
approach. Although there is no conceptual justification for an allowance based on 12-
month ECLs, it was designed to be a pragmatic solution to achieve an appropriate
balance between faithfully representing the underlying economics of a transaction and
the cost of implementation.
How accurate a proxy the 12-month and lifetime ECL model is for a more conceptually
pure approach will depend on the nature of the portfolio. Also, the effect of recording
a 12-month ECL in the first reporting period that a financial instrument is recognised
will not have a significant effect on reported income if the portfolio is stable in size from
one period to the next. The 12-month ECL allowance may, however, significantly
reduce the reported income for entities which are expanding the size of their portfolio.
Although the choice of 12 months is arbitrary, it is the same time horizon as used for the
more advanced bank regulatory capital calculation under the Basel framework.10 The
definition of 12-month ECLs is similar to the Basel Committee’s definition of ECL,
although the modelling requirements differ significantly.11 The 12-month requirement
under IFRS 9 will always differ from that computed for regulatory capital purposes, as
the IFRS 9 measure is a point-in-time estimate, reflecting currently forecast economic
conditions (see 5.9.3 below), while the Basel regulatory figure is based on through-the-
cycle assumptions of default and conservative estimates of losses given default.
However, banks that use an advanced approach to calculate their capital requirements
should be able to use their existing systems and methodologies as a starting point and
make the necessary adjustments to flex the calculation to comply with IFRS 9.
3752 Chapter 47
As mentioned above, the 12-month ECLs is defined as a portion of the lifetime ECLs
that represent the ECLs that result from default events on a financial instrument that are
possible within the 12-months after the reporting date. [IFRS 9 Appendix A]. When
<
br /> measuring 12-month ECLs, one question is whether the cash shortfalls used should take
into account only default events within the next 12 months or subsequent default events
as well. The issue arises for instruments that are expected to default and cure (i.e. to
restore to performing) and then default again after curing.
IFRS 9 does not explicitly mention the treatment of cures and subsequent defaults when
calculating ECLs. However the ITG briefly talked about this in their discussion about
the life of revolving credit card portfolios in April 2015: ‘As regards assets in Stage 2, it
was acknowledged that the probability of assets defaulting and curing would have to be
taken into account and that it would be necessary to build this into any models dealing
with expected credit loss calculations. However, it was noted that materiality would
need to be considered.’12
We conclude from the ITG discussion that cure events should only be reflected in the
calculation of the LGD to the extent that they are expected to be effective.
Consequently, if it is predicted that the asset will re-default in subsequent years, this
need not be included in the calculation of 12-month expected losses if the defaults are
expected to be unrelated to the first default. In practice, however, IFRS 9 acknowledges
that a variety of techniques can be used to meet the objective of ECL and that the
definition of default may vary, by product, across a bank and between banks.
[IFRS 9.B5.5.37, BC5.252, BC5.265].
When measuring ECLs the treatment of re-defaults affects both the PD and the LGD.
Therefore, the same treatment should be applied consistently to determine both the PD
and the LGD.
5.4
Probability of default (PD) and loss rate approaches
As mentioned above, the standard does not prescribe specific approaches to estimate
ECLs. Some of the common approaches include the PD and loss rate approaches
(see 5.4.1 and 5.4.2 below, respectively).
5.4.1
Probability of default (PD) approach
Following from Example 47.1 at 1.2 above, calculations of the 12-month and lifetime
ECLs are illustrated below.
Financial instruments: Impairment 3753
Example 47.3: 12-month and lifetime expected credit loss measurement based