to determine whether there has been a significant increase in credit risk (see 6
below). Hence, IFRS 9 will also require any entities that intend to use this approach
to track the likelihood of default.
ECLs must be discounted at the EIR. However, in this example, the present value of the
observed loss is just assumed. This is an additional area of complexity that entities have
to take into account when trying to build upon their existing loss rate approaches.
5.5
Expected life versus contractual period
Lifetime ECLs are defined as the ECLs that result from all possible default events over
the expected life of a financial instrument. [IFRS 9 Appendix A]. This is consistent with the
requirement that an entity should assess whether the credit risk on a financial
instrument has increased significantly since initial recognition by using the change in
the risk of a default occurring over the expected life of the financial instrument.
[IFRS 9.5.5.9].
An entity must therefore estimate cash flows and the instrument’s life by considering all
contractual terms of the financial instrument (for example, prepayment, extension, call
and similar options). There is a presumption that the expected life of a financial
instrument can be estimated reliably. In those rare cases when it is not possible to
reliably estimate the expected life of a financial instrument, the entity shall use the
remaining contractual term of the financial instrument. [IFRS 9 Appendix A, B5.5.51].
However, the maximum period to consider when measuring ECLs should be the
maximum contractual period (including extension options) over which the entity is
exposed to credit risk and not a longer period, even if that longer period is consistent
with business practice. [IFRS 9.5.5.19]. Although an exception to this principle has been
added for revolving facilities (see 12 below), the IASB remains of the view that the
contractual period over which an entity is committed to provide credit (or a shorter
period considering prepayments) is the correct conceptual outcome. The IASB noted
that most loan commitments will expire at a specified date, and if an entity decides
to renew or extend its commitment to extend credit, it will be a new instrument for
which the entity has the opportunity to revise the terms and conditions.
[IFRS 9.BC5.260].
This means that extension options should only be reflected in the measurement of
ECLs as long as this does not extend the horizon beyond the maximum contractual
period over which the entity is exposed to credit risk. Extension options at the
discretion of the lender should therefore be excluded from the measurement of
ECLs. Similarly, a lender’s ability to require prepayment limits the horizon over
which it is exposed to credit risk. The first prepayment date at the discretion of the
lender should therefore represent the maximum period to be reflected in the
expected loss calculation.
When assessing the impact of extension options at the discretion of the borrower, an
entity should estimate both the probability of exercise of the extension option as well
as the portion of the loan that will be extended (if the extension option can be
Financial instruments: Impairment 3759
exercised for a portion of the loan only). This is consistent with how lifetime
expected losses must be assessed for loan commitments where an entity’s estimate
of ECLs must be consistent with its expectations of drawdowns on that loan
commitment. Although the standard is not explicit on this point, the effect of
extension options is best modelled not by estimating an average life of the facility but
by estimating the EAD each year over the maximum lifetime. This is because use of
an average life would not reflect losses expected to occur beyond the average life.
[IFRS 9.B.5.5.31].
Expected prepayments at the discretion of borrowers should also be reflected in the
measurement of ECLs. As with extension options, an entity must estimate both the
probability of exercise of the prepayment option as well as the portion of the loan that
will be prepaid (if the prepayment option can be exercised for a portion of the loan
only). As with extension options, the standard does not specify whether prepayment
patterns should be reflected through an amortising EAD over the maximum contractual
period of the financial instruments or, rather, by shortening the horizon over which to
measure ECLs to the average life of the financial instruments. Similar to the treatment
of extension options, described above, in our view it is more appropriate to adjust the
EAD for the facility each year over the maximum lifetime. We consider this a more
transparent way of incorporating product features and potential impacts of different
macroeconomic scenarios that can, for example, affect pre-payment patterns and
customers’ ability to refinance.
Further complexity in assessing expected prepayments and extensions arises if one
considers that the behaviour of borrowers is affected by their creditworthiness. This
means that prepayment and extension patterns should probably be estimated separately
for stage 1 and stage 2 assets. This may represent a significant challenge, as making such
estimates would require distinct historical observations for each of the stage 1 and 2
populations, which are unlikely to be available given that these populations were never
identified in the past. Prepayment assumptions for stage 2 assets would need to factor
in the probabilities that some may subsequently default and some may cure. A further
complication is that expected prepayment and extension behaviour may vary with
changes in the macroeconomic outlook.
The standard is clear that, for loan commitments and financial guarantee contracts, the
time horizon to measure ECLs is the maximum contractual period over which an entity
has a present contractual obligation to extend credit. [IFRS 9.B5.5.38]. However, for
revolving credit facilities (e.g. credit cards and overdrafts), as an exception to the normal
rule, this period is extended beyond the maximum contractual period and includes the
period over which the entity is exposed to credit risk and ECLs would not be mitigated
by credit risk management actions (see 12 below). This exception is limited to facilities
that include both a loan and an undrawn commitment component, that do not have a
fixed term or repayment structure and usually have a short contractual cancellation
period (for example, one day). [IFRS 9.5.5.20, B5.5.39, B5.5.40].
At its April 2015 meeting, the ITG discussed how to determine the maximum period for
measuring ECLs, by reference to the following example.13
3760 Chapter 47
Example 47.5: Determining the maximum contractual period when measuring
expected credit losses
Bank A manages a portfolio of variable rate mortgages on a collective basis. The mortgage loans are issued
to retail customers in Country X with the following terms:
• the stated maturity is 6 months with an automatic extension feature whereby, unless the borrower or
lender take action to terminate the loan at the stated maturity date, the loan automatically extends for the
following 6 months;
• the interest rate is fixed f
or each 6-month period at the beginning of the period. The interest rate is reset
to the current market interest rate on the extension date; and
• the lender’s right to refuse an extension is unrestricted.
It is assumed that the mortgage loans meet the criteria for amortised cost measurement under paragraph 4.1.2
of IFRS 9.
In practice, borrowers are generally expected not to elect to terminate their loans on the stated maturity date,
because moving the mortgage to another bank, or applying for a new product, generally involves an
administrative burden and has little or no economic benefit for the borrower.
Furthermore, Bank A does not complete regular credit file reviews for individual loans and as a result does not
usually cancel the loans unless it receives information about an adverse credit event in respect of a particular
borrower. On the basis of historical evidence, such loans extend many times and can last for up to 30 years.
The ITG noted that:
• IFRS 9 is clear that the maximum period to consider when measuring ECLs in this
example would be restricted to 6 months, because this is the maximum contractual
period over which the lender is exposed to credit risk, i.e. the period until the
lender can next object to an extension. [IFRS 9.5.5.19].
• The standard requires that extension options must be considered when determining
the maximum contractual period, but does not specify whether these are lender or
borrower extension options. However, if the extension option is within the control
of the lender, the lender cannot be forced to continue extending credit and therefore
such an option cannot be considered as lengthening the maximum period of
exposure to credit risk. Conversely, if a borrower holds an extension option that
could force the lender to continue extending credit, this would have the effect of
lengthening that maximum contractual period of credit exposure.
• The maximum contractual period over which the entity is exposed to credit risk
should be determined in accordance with the substantive contractual terms of the
financial instrument. To further illustrate this point, a situation in which a lender is
legally prevented from exercising a contractual right should be seen as distinct
from a situation in which a lender chooses not to exercise a contractual right for
practical or operational reasons.
• In the example presented, the facility is not of a revolving nature and the borrower
does not have any such flexibility regarding drawdowns. Consequently, it would
not be appropriate to analogise the 6-month mortgage loan to a revolving credit
facility that has been fully drawn at the reporting date. Hence, the example falls
outside the narrow scope exception for revolving credit facilities (e.g. credit cards
and overdraft facilities) in which the maximum period to consider when measuring
ECLs is over the period that the entity is exposed to credit risk and ECLs would
Financial instruments: Impairment 3761
not be mitigated by credit risk management actions, even if that period extends
beyond the maximum contractual period (see 12 below). [IFRS 9.5.5.20].
• Consequently, it was acknowledged that there may be a disconnect between the
accounting and credit risk management view in some situations (e.g. an entity may
choose to continue extending credit to a long-standing customer despite being in
a position to reduce or remove the exposure). See further discussion on the
application of the revolving credit facilities exception to multi-purpose facilities
(see 12 below).
For demand deposits that have no fixed maturity and can be withdrawn by the holder
on very short notice (e.g. one day) (assuming there is no contractual or legal constraint
that could prevent the holder from withdrawing its cash at any time), the period used
by the holder of such demand deposits to estimate ECLs would be limited to the
contractual notice period, i.e. one day. This is the maximum contractual period over
which the holder is exposed to credit risk. In accordance with paragraph 5.5.19 of
IFRS 9, extension periods at the option of the holder are excluded in estimating the
maximum contractual period because the holder can unilaterally choose not to extend
credit and thus can limit the period over which it is exposed to credit risk. Furthermore,
demand deposits do not fall under the revolving credit facility exception (see 12 below)
as they do not comprise an undrawn element. [IFRS 9.5.5.20].
5.6
Probability-weighted outcome and multiple scenarios
ECLs must reflect an unbiased and probability-weighted estimate of credit losses
over the expected life of the financial instrument (i.e. the weighted average of credit
losses with the respective risks of a default occurring as the weights).
[IFRS 9.5.5.17(a), Appendix A, B5.5.28].
The standard makes it clear that when measuring ECLs, in order to derive an unbiased
and probability-weighted amount, an entity needs to evaluate a range of possible
outcomes. [IFRS 9.5.5.17(a)]. This involves identifying possible scenarios that specify:
a)
the amount and timing of the cash flows for particular outcomes; and
b) the
estimated
probability of these outcomes.
Although an entity does not need to identify every possible scenario, it will need to take
into account the possibility that a credit loss occurs, no matter how low that probability
is. [IFRS 9.5.5.18]. This is not the same as a single estimate of the worst-case or best-case
scenario, or the most likely outcome (i.e. when there is a low risk or probability of a
default (PD) with high loss outcomes, the most likely outcome could be no credit loss
even though an allowance would be required based on probability-weighted cash
flows). [IFRS 9.B5.5.41]. It is worthwhile noting that it is implicit that the sum of the
weighted probabilities will be equal to one. A simple example of application of a
probability-weighted calculation is shown in Example 47.6.
Without taking into account multiple economic scenarios (see below) calculating a
probability-weighted amount may not require a complex analysis or a detailed
simulation of a large number of scenarios and the standard suggests that relatively simple
modelling may be sufficient. For instance, the average credit losses of a large group of
financial instruments with shared risk characteristics may be a reasonable estimate of
3762 Chapter 47
the probability-weighted amount. 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. In those situations,
the ECLs shall reflect at least two outcomes in accordance with paragraph 5.5.18 of
IFRS 9. [IFRS 9.B5.5.42].
At the December 2015 ITG meeting the question was asked as to whether the use of
multiple scenarios referred to in the standard relates only to what might happen to
particular assets given a single forward-looking economic scenario (i.e. default or no
default), or whether application of the standard requires an entity to use multiple
forward-looking economic scenarios, and if so how.
The ITG members noted that the measu
rement of ECLs is required to reflect an
unbiased and probability-weighted amount that is determined by evaluating a range of
possible outcomes. Consequently, when there is a non-linear relationship between the
different forward-looking scenarios and their associated credit losses, using a single
forward-looking economic scenario would not meet this objective. In such cases, more
than one forward-looking economic scenario would need to be used in the
measurement of ECLs.14 For each scenario the associated ECLs would need to be
multiplied by the weighting allocated to that scenario.
The ITG also discussed the use of multiple economic scenarios to assess whether
exposures should be measured using lifetime economic losses (see 6.7 below). It was
noted by the ITG that if the same variable is relevant for determining significant increase
in credit risk and for measuring ECLs, the same forward-looking scenarios should be
used for both.
The ITG discussed a particular example in which there are considered to be three
possible economic scenarios.15 This is illustrated in the example below.
Example 47.6: Incorporating single versus multiple forward-looking scenarios
when measuring expected credit losses
Scenario Future
unemployment
Likelihood of occurrence
ECLs
(a)
4%
20%
£30
(b)
5%
50%
£70
(c)
6%
30%
£170
Use of a single central economic scenario based on the most likely outcome of 5 per cent unemployment, i.e.
scenario (b), would give rise to an ECL of £70. However, using a probability-weighted range of scenarios,
the ECL would be £92 ((£30 × 0.2) + (£70 × 0.5) + (£170 × 0.3)). Consequently, the ITG observed that in
this example, using a single central forward-looking economic scenario would not result in an unbiased and
probability-weighted amount in accordance with the standard.
The ITG were concerned about the distribution of possible losses often being ‘non-
linear’, in that the increase in losses associated with those economic scenarios that are
worse than the central forecast will be greater than the reduction in losses associated
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 743
