enhancements such as collateral and financial guarantees, cash flows from the sale of a
defaulted loan and collection costs paid to an external debt collection agency.
5.8.1
Credit enhancements: collateral and financial guarantees
Although credit enhancements such as collateral and guarantees play only a limited role
in assessing whether there has been a significant increase in credit risk (see 6.1 below),
they do affect the measurement of ECLs. For example, for a mortgage loan, even if an
entity determines that there has been a significant increase in credit risk on the loan
since initial recognition, if the expected proceeds from the collateral (i.e. the mortgaged
property) exceeds the amount lent, then the entity may have nil ECLs, and hence an
allowance of zero.
In measuring the ECLs and hence the expected cash shortfalls for a collateralised
financial instrument, an entity should include the cash flows from the realisation of the
collateral and other credit enhancements that are: [IFRS 9.B5.5.55]
• part of the contractual terms; and
• not recognised separately by the entity.
Similar to IAS 39, the standard specifies that the estimate of cash flows from collateral
should include the effect of a foreclosure, regardless of whether foreclosure is probable,
and the resulting cash flows from foreclosure on the collateral less the costs of obtaining
and selling the collateral, taking into account the amount and timing of these cash flows.
[IFRS 9.B5.5.55]. The wording does not mean that the entity is required to assume that
recovery will be through foreclosure only, but rather that the entity should calculate the
cash flows arising from the various ways that the asset may be recovered, only some of
which may involve foreclosure, and to probability-weight these different scenarios (see
Example 47.3 at 5.4 above).
Although the standard does not refer to fair value when determining the valuation of
the collateral, in practice, an entity is likely to estimate the cash flows from the
realisation of the collateral, based on the fair value of the collateral. In the case of illiquid
collateral, such as real estate, adjustments will probably need to be made for expected
changes in the fair value, depending on the economic conditions at the estimated date
of selling the collateral. Also, as described at 5.6 above, the entity should consider
multiple scenarios in ascribing value to collateral.
Financial instruments: Impairment 3769
Also, as in IAS 39, any collateral obtained as a result of foreclosure is not recognised as
an asset that is separate from the collateralised financial instrument unless it meets the
relevant recognition criteria for an asset in IFRS 9 or other standards. [IFRS 9.B5.5.55].
If a loan is guaranteed by a third party as part of its contractual terms, it should carry an
allowance for ECLs based on the combined credit risk of the guarantor and the
guaranteed party, by reflecting the effect of the guarantee in the measurement of losses
expected on default.
5.8.1.A
Guarantees that are integral to the contract
A challenge is interpreting what constitutes ‘part of the contractual terms’. This was
addressed by the ITG at its meeting in December 2015, specifically whether the credit
enhancement must be an explicit term of the related asset’s contract in order for it to be
taken into account in the measurement of ECLs, or whether other credit enhancements
that are not recognised separately can also be taken into account. The ITG noted that:
• The definition of credit losses states that, when estimating cash flows, an entity
shall include cash flows from the sale of collateral held or other credit
enhancements that are integral to the contractual terms. Consequently, credit
enhancements included in the measurement of ECLs should not be limited to those
that are explicitly part of the contractual terms.
• An entity must apply its judgement in assessing what is meant by ‘integral to the
contractual terms’ and in making that assessment, an entity should consider all relevant
facts and circumstances. Also, an entity must not include cash flows from credit
enhancements in the measurement of ECLs if the credit enhancement is accounted
for separately. This was particularly important in order to avoid double counting.
• IFRS 7 requires disclosures to enable users of financial statements to understand
the effect of collateral and other credit enhancements on the amounts arising from
ECLs (see 15 below and Chapter 50 at 5.3).
Although not reflected in the official minutes of the ITG meeting, the IASB members
highlighted during the course of the discussion that there was no intention to alter the
treatment when drafting IFRS 9. In practice, previously under IAS 39 most banks
incorporated guarantees as part of their measurement of losses given default.
The ITG also emphasised that paragraph B5.5.55 of IFRS 9 was drafted only with the
intention to caution against double counting those credit enhancements that are already
recognised separately, and was not intended to limit the inclusion of credit
enhancements that were previously included in IAS 39 allowances for loan losses.
However, the ITG discussion does not fully answer the question of how to interpret
when a financial guarantee is ‘integral to the contractual terms’ when it is not mentioned
in the contractual terms of the loan.
It seems reasonably clear that a credit default swap on a loan entered into by the lender
to mitigate its credit risk on the loan, would not normally be classed as integral to a loan’s
contractual terms. The second criteria mentioned in paragraph B5.5.55 is that the credit
enhancement should not be recognised separately and separate accounting for a
derivative is clearly required by IFRS 9. Also, payment under a credit default swap does
not normally require the holder of the instrument to have suffered the credit loss
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referenced by the swap. As a result, cash flows from a credit default swap that is
accounted for as a derivative would not be included in the measurement of ECLs of the
associated loan.
For a financial guarantee (as defined in IFRS 9), one view is that it is integral to the
contractual terms of a loan only if it is, at least implicitly, part of the contractual terms
of the loan. Examples of an implicit contractual linkage might include:
• Inseparability: The financial guarantee is inseparable from the loan contract, i.e.
the loan cannot be transferred without the guarantee.
• Local laws and regulations: Credit enhancements required by local laws and
regulations that govern the loan contract but that are not specifically in the contract
itself. For example, in some jurisdictions legislation requires that lenders must take
out financial guarantee contracts that contain little or no down payment in respect
of certain loans.
• Business purpose: The guarantee and the loan have been contracted in
contemplation of one another, i.e. the loan would not have been contracted
without the guarantee.
• Market convention: The exposure and the financial guarantee are traded as a
package in the market.
Anot
her view might be that any contract that meets the definition of a financial
guarantee under IFRS 9 can be considered ‘integral to the contractual terms’ of the
guaranteed loan, as long as the guarantee is entered to at the same time as, or within a
short time after, the loan is advanced. As the definition of a financial guarantee contract
requires the loan to be specified in the contractual terms of the financial guarantee and
it is necessary for the lender to incur a credit loss on the loan to be reimbursed, there is
a clear contractual linkage that ensures that any credit loss incurred on the loan will be
compensated by the financial guarantee and no compensation will arise on the financial
guarantee unless a credit loss is actually incurred by the lender on the guaranteed loan.
Most guarantees require payment of a premium. To the extent that the guarantee is
considered integral to the loan, it would be consistent with this notion to treat the cost of
the guarantee as a transaction cost of making the loan. This means that the lender would
add this cost to the initial carrying amount of the loan and so reduce the future EIR. It
should not make a difference to the accounting for the loan whether the guarantee
premium is paid upfront or in instalments over the life of the loan. If the premium is
payable in instalments, it follows (at least, in theory, although the effect may not be
material) that the full cost of the guarantee should be included in setting the loan’s EIR.
5.8.1.B
Guarantees that are not integral to the contract
Although it is not clear as to when a financial guarantee contract would be regarded as
‘integral’, this may not affect the profit or loss recognition by the lender if an asset can
be recognised in respect of the guarantee. Such outcome may be achieved following
either of the two approaches described below.
A financial guarantee contract is likely to satisfy the definition of an insurance contract
in IFRS 4 – Insurance Contracts – but will be excluded from the scope of IFRS 4
because it is a direct insurance contract held by a policyholder (as opposed to a
Financial instruments: Impairment 3771
policyholder of a reinsurance contract). [IFRS 4.4(f)]. It is therefore outside the scope of
IFRS 9 as well as IFRS 4. [IFRS 9.2.1(e)]. IFRS 4 points to paragraphs 10 to 12 of IAS 8 –
Accounting Policies, Changes in Accounting Estimates and Errors – which address
situations where no IFRS specifically applies to a transaction, i.e. the holder of a
financial guarantee contract will normally need to develop its accounting policy in
accordance with the hierarchy in IAS 8. [IFRS 4 IG2 Example 1.11].
Applying the IAS 8 hierarchy, one possibility would be to look to IAS 37 and treat the
guarantee as a right to a reimbursement in respect of the impairment loss. IAS 37 permits
a reimbursement of a liability to be recognised as an asset, not exceeding the amount of
the provision, when it is virtually certain that the reimbursement will be received if the
obligation for which a provision has been established is settled. [IAS 37.53]. In this
instance, the benefit of the guarantee would be recognised as an asset to the extent it is
virtually certain a recovery could be made if the lender were to suffer the impairment
loss on the loan. One of the key advantages of a financial guarantee contract, compared
to a normal insurance contract, is that they are typically drawn up using standard terms
and conditions and there is often little doubt that an obligation would arise for the
guarantor if the reference asset were to default. However, care should be taken to
establish, based on the contractual terms of the arrangement, that a right to a recovery
would, indeed, be virtually certain.
To record a reimbursement asset under IAS 37, it is less clear whether the credit risk of
the guarantor needs to be assessed in determining whether recovery would be virtually
certain, or whether the guarantor’s credit risk would only be reflected in measuring the
reimbursement asset. One view is that the guarantor would either have to present a very
low credit risk or else the guarantee would itself need to be collateralised in order to
conclude that a reimbursement right can be recognised. In this case, care should also be
taken to ensure that there is no correlation between the credit risk of the loan and that
of the guarantor, as would be the case if the guarantor’s financial strength were to reduce
at the same time that the loan is likely to default. Applying this view, if a reimbursement
is considered virtually certain, there would probably be no need also to reflect the
guarantor’s credit risk in the measurement of the asset. In contrast, the second view
imposes a less stringent criterion for recognising an asset, but would reduce the
recognised asset to reflect the probability that the guarantor may be unable to meet its
obligation (perhaps by applying an ECL deduction, by analogy to IFRS 9).
An alternative approach for recording an asset in respect of the guarantee would be
to look to IFRS 3 – Business Combinations – and draw an analogy with
indemnification assets. First, IFRS 3 requires all contingent liabilities to be recognised
on a business combination, whether or not they are probable, which is closer to the
IFRS 9 notion of an expected credit loss than the contingent liability recognition
threshold under IAS 37. Second, IFRS 3 allows an indemnification asset to be
recognised, measured on the same basis as the indemnified asset or liability, subject
to any contractual limitations on its amount. Also, for an indemnification asset that is
not subsequently measured at its fair value, the measurement is subject to
management’s assessment of the collectability of the indemnification asset. [IFRS 3.57].
Adopting this indemnification asset approach, the credit risk of the guarantor becomes
a measurement, rather than a recognition issue. It would not be necessary to assess if
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the credit risk of the guarantor is very low, since credit risk is instead reflected in the
measurement of the guarantee.
Whether an analogy is made to a reimbursement right under IAS 37 or an indemnification
asset under IFRS 3, an asset may be recognised in respect of the guarantee, not exceeding
the amount of the provision. [IAS 37.53, IFRS 3.57]. Except for the possible treatment of the
guarantor’s credit risk, using either of these approaches, the overall effect on profit or loss
for the lender may be often the same as if the guarantee was included in the measurement
of the ECL of the guaranteed asset. The right would, however, be presented as an asset
rather than as a reduction of the impairment allowance.
Whereas it is relatively straightforward as to how to account for premiums paid for
guarantees that are considered integral to a loan (as discussed in the previous section),
it is less clear when the guarantee is not considered integral. If the entity who makes a
loan and, at the same time, pays for a guarantee, records both the unamortised cost of
the guarantee plus also a reimbursement or indemnification asset equivalent to the 12-
month ECLs, the total amount at which the guarantee is initially recorded in the
financial statements will exceed its fair value. This is because the
cost of the guarantee
will already include the guarantor’s expectations of future losses. One view is to
consider this to be ‘double counting’ and so, to restrict the reimbursement/
indemnification right to the excess (if any) of the ECL over the cost of the guarantee
that is already reflected in the balance sheet.
There is another view that recognising both the unamortised cost of the guarantee and
a reimbursement right/indemnification asset equal to the ECL is necessary to be
consistent with the accounting for the loan. Another way of expressing this is to say that
it is appropriate for the guarantee to be recorded at more than its initial fair value as the
guaranteed loan is recorded initially at less than its fair value by a similar amount, i.e.
the ECL. The subsequent amortisation of the cost of the guarantee would be balanced
by the recognition of the credit spread in the interest earned on the loan.
Whatever view is taken on this issue, if the lender acquires the guarantee subsequent to
making the loan and the loan has, in the meantime, increased in credit risk, it is likely
that the lender will pay more for the guarantee, to reflect this increase in credit risk. If
so, this additional amount will crystallise a loss for the lender and so should not be
recorded as a reimbursement/ indemnification right and a reversal of a previously
recognised impairment loss.
It should, however, be noted that IFRS 9 has been amended by IFRS 17 – Insurance
Contracts. The scope exclusion for financial guarantee contracts will change from those
contracts that meet the definition of insurance contracts to those that are in the scope
of IFRS 17. As the accounting by the holder of the guarantee is not in the scope of
IFRS 17, it will, by default, be in the scope of IFRS 9. The accounting treatment under
IFRS 9 for a financial asset that fails the ‘solely payment of principle and interest’ test is
to measure it at fair value through profit or loss. Hence, unless the Board first amends
IFRS 9, from years beginning on or after 1 January 2021 when IFRS 17 becomes
effective, it would appear to be no longer possible to recognise a reimbursement or
indemnification right for over and above the fair value of a guarantee that is not
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