noted that this approach is similar to the absolute approach above. Moreover, the
change in an entity’s credit underwriting limits may be driven by other factors that
are not related to a change in the credit risk of its borrowers (e.g. the entity may
incorporate favourable terms to maintain a good business relationship or to
increase lending), or are dependent on circumstances existing at the reporting date
that are not relevant to the particular vintages of financial instruments.
[IFRS 9.BC5.163, BC5.164, BC5.165].
Financial instruments: Impairment 3783
Similar to measuring ECLs, an entity may use different approaches when assessing
significant increases in credit risk for different financial instruments. An approach that
does not include PD as an explicit input can be consistent with the impairment
requirements as long as the entity is able to separate the changes in the risk of a default
occurring from changes in other drivers of ECLs (e.g. collateral) and considers the
following when making the assessment: [IFRS 9.B5.5.12]
• the change in the risk of a default occurring since initial recognition;
• the expected life of the financial instrument; and
• reasonable and supportable information that is available, without undue cost or
effort, that may affect credit risk.
In addition, because of the relationship between the expected life and the risk of default
occurring, the change in credit risk cannot be assessed simply by comparing the change
in the absolute risk of default over time, because the risk of default usually decreases as
time passes if the credit risk is unchanged. [IFRS 9.B5.5.11].
Entities that do not use probability of loss as an explicit input will have to use other
criteria to identify a change in the risk of default occurring. These might include
deterioration in a behavioural score, or other indicators, of a heightened risk of default.
A collective approach may also be an appropriate supplement or substitute for an
assessment at the individual instrument level (see 6.5 below).
A number of operational simplifications and presumptions are available to help entities
make this assessment (as described further below).
6.1.1
Impact of collateral, credit enhancements and financial guarantee
contracts
As already stressed, the staging assessment is based on the change in the lifetime risk of
default, not the amount of ECLs. [IFRS 9.5.5.9]. Hence the allowance for a fully
collateralised asset may need to be based on lifetime ECLs (because there has been a
significant increase in the risk of default) even though no loss is expected to arise. In
such instances, the fact that the asset is being measured using lifetime ECLs may have
more significance for disclosure than for measurement (see 15 below).
The interaction between collateral, assessment of significant increases in credit risk and
measurement of ECLs is illustrated in the following example from the standard.
[IFRS 9 IG Example 3 IE18-IE23].
Example 47.7: Highly collateralised financial asset
Company H owns real estate assets which are financed by a five-year loan from Bank Z with a loan-to-value (LTV)
ratio of 50 per cent. The loan is secured by a first-ranking security over the real estate assets. At initial recognition of the loan, Bank Z does not consider the loan to be credit-impaired as defined in Appendix A of IFRS 9.
Subsequent to initial recognition, the revenues and operating profits of Company H have decreased because
of an economic recession. Furthermore, expected increases in regulations have the potential to further
negatively affect revenue and operating profit. These negative effects on Company H’s operations could be
significant and ongoing.
As a result of these recent events and expected adverse economic conditions, Company H’s free cash flow is
expected to be reduced to the point that the coverage of scheduled loan payments could become tight.
3784 Chapter 47
Bank Z estimates that a further deterioration in cash flows may result in Company H missing a contractual
payment on the loan and becoming past due.
Recent third party appraisals have indicated a decrease in the value of the real estate properties, resulting in
a current LTV ratio of 70 per cent.
At the reporting date, the loan to Company H is not considered to have low credit risk in accordance with
paragraph 5.5.10 of IFRS 9. Bank Z therefore needs to assess whether there has been a significant increase in
credit risk since initial recognition in accordance with paragraph 5.5.3 of IFRS 9, irrespective of the value of
the collateral it holds. It notes that the loan is subject to considerable credit risk at the reporting date because
even a slight deterioration in cash flows could result in Company H missing a contractual payment on the
loan. As a result, Bank Z determines that the credit risk (i.e. the risk of a default occurring) has increased
significantly since initial recognition. Consequently, Bank Z recognises lifetime ECLs on the loan to
Company H.
Although lifetime ECLs should be recognised, the measurement of the ECLs will reflect the recovery
expected from the collateral (adjusting for the costs of obtaining and selling the collateral) on the property as
required by paragraph B5.5.55 of IFRS 9 and may result in the ECLs on the loan being very small.
The ITG (see 1.5 above) discussed in April 2015 whether an entity should consider the
ability to recover cash flows through a financial guarantee contract that is integral to the
contract when assessing whether there has been a significant increase in the credit risk
of the guaranteed debt instrument since initial recognition. IFRS 9 requires that
measurement of the ECLs of the guaranteed debt instrument includes cash flows from
the integral financial guarantee contract (see 5.8.1 above). [IFRS 9.B5.5.55]. However, some
ITG members commented that IFRS 9 is clear that recoveries from integral financial
guarantee contracts should be excluded from the assessment of significant increases in
credit risk of the guaranteed debt instrument. [IFRS 9.5.5.9]. This is because the focus of
the standard is about the risk of the borrower defaulting when making such an
assessment, as highlighted in the examples in B5.5.17 of the standard. These examples
clarify that information about a guarantee (or other credit enhancement) may be
relevant to assessing changes in credit risk, but only to the extent that it affects the
likelihood of the borrower defaulting on the instrument (see 6.2.1 below for the list of
examples). [IFRS 9.B5.5.17]. Furthermore, excluding recoveries from the financial
guarantee contract, when assessing significant increases in credit risk, would be
consistent with the treatment of other forms of collateral.
While the value of collateral does not normally affect the assessment of significant
increases in credit risk, if significant changes in the value of the collateral supporting the
obligation are expected to reduce the borrower’s economic incentive to make
scheduled contractual payments, then this would have an effect on the risk of a default
occurring. The standard provides an example where, if the value of collateral declines
because house prices decline, borrowers in some jurisdictions have a greater incentive
to default on their mort
gages. [IFRS 9.B5.5.17(j)].
The other examples provided by the standard of situations where the value of a credit
enhancement could have an impact on the ability or economic incentive of the
borrower to repay relate to guarantees or financial support provided by a shareholder,
parent entity or other affiliate and to interests issued in securitisations:
• a significant change in the quality of the guarantee provided by a shareholder (or
an individual’s parent) if the shareholder (or parent) has an incentive and financial
ability to prevent default by capital or cash infusion; [IFRS 9.B5.5.17(k)] and
Financial instruments: Impairment 3785
• significant changes, such as reductions, in financial support from a parent entity or
other affiliate or an actual or expected significant change in the quality of credit
enhancement, that are expected to reduce the borrower’s ability to make
scheduled contractual payments. For example, such a situation could occur if a
parent decides to no longer provide financial support to a subsidiary, which as a
result would face bankruptcy or receivership. This could, in turn, result in that
subsidiary prioritising payments for its operational needs (such as payroll and
crucial suppliers) and assigning a lower priority to payments on its financial debt,
resulting in an increase in the risk of default on those liabilities. Credit quality
enhancements or support include the consideration of the financial condition of
the guarantor and/or, for interests issued in securitisations, whether subordinated
interests are expected to be capable of absorbing ECLs (for example, on the loans
underlying the security). [IFRS 9.B5.5.17(l)].
6.1.2
Contractually linked instruments (CLIs) and subordinated interests
The last example in the previous section, referring to the effect of subordinated interests
in a securitisation deserves some comment. IFRS 9 sets out rules to determine whether
an investment in a CLI such as a tranche of a securitisation, qualifies to be measured at
amortised cost or at fair value through other comprehensive income (see Chapter 44
at 6.6). [IFRS 9.4.1.2-4.1.2A, B4.1.20-B4.1.26]. While some CLIs may pass the contractual cash
flow characteristics test and consequently may be measured at amortised cost or fair
value through other comprehensive income, the contractual cash flows of the individual
tranches are normally based on a pre-defined waterfall structure (i.e. principal and
interest are first paid on the most senior tranche and then successively paid on more
junior tranches). To this extent, CLIs do not default. Meanwhile, Appendix A of IFRS 9
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, discounted at the original effective interest rate’. Under the contract, the
issuer of a CLI only passes cash flows that it actually receives, so the contractually
defined cash flows under the waterfall structure are always equal to the cash flows that
a holder expects to receive. Accordingly, one could argue that CLIs never give rise to a
credit loss, and so would never be regarded as impaired.
Consistent with recording these assets at amortised cost because they meet the SPPI
criterion, the contractual terms of the CLI are deemed to give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal amount
outstanding. Hence, we believe that for the purposes of the impairment requirements of
IFRS 9, the lender needs to consider the deemed principal and interest payments as the
contractual cash flows when calculating ECLs, instead of the cash flows determined under
the waterfall structure. Accordingly, any failure of the instrument to pay the investor the
full amount deemed to be due must be treated as a default and an estimation of the amount
of any losses that will be incurred must be reflected in the credit loss allowance.
It also follows that paragraph B5.5.17(l) should be interpreted as saying that the
investment should be measured based on lifetime ECLs if there are sufficient losses
expected on the instruments underlying the securitisation such that they may not be
absorbed by subordinated interests in the structure, and so there is a significantly
increased risk that the investor will suffer loss.
3786 Chapter 47
6.1.3
Determining change in the risk of a default under the loss rate
approach
Under the loss rate approach, introduced at 5.4.2 above, an entity develops loss-rate
statistics on the basis of the amount written off over the life of the financial assets rather
than using separate PD and LGD statistics. Entities then must adjust these historical
credit loss trends for current conditions and expectations about the future.
The standard is clear that although a loss rate approach may be applied, an entity needs
to be able to separate the changes in the risk of a default occurring from changes in
other drivers of ECLs for the purpose of assessing if there has been a significant increase
in credit risk. [IFRS 9.B5.5.12]. Under the loss rate approach, the entity does not distinguish
between a risk of a default occurring and the loss incurred following a default. This is
not so much of an issue for measuring 12-month or lifetime ECLs. However, under the
loss rate approach, an entity would not be able to implement the assessment of
significant increases in credit risk that is based on the change in the risk of a default.
Therefore, entities using the loss rate approach would need an overlay of measuring and
forecasting the level of defaults, as illustrated in the extract of Example 9 from the
Implementation Guidance (see Example 47.4 above). For entities that currently use only
expected loss rates it may be easier to develop a PD approach than to use the method
described in this example.
6.2
Factors or indicators of changes in credit risk
Similar to measuring ECLs (see 5 above), when assessing significant increases in credit
risk, an entity should consider all reasonable and supportable information that is
available without undue cost or effort (see 5.9.1 above) and that is relevant for an
individual financial instrument, a portfolio, portions of a portfolio, and groups of
portfolios. [IFRS 9.B5.5.15, B5.5.16].
The IASB notes that it did not intend to prescribe a specific or mechanistic approach to
assess changes in credit risk and that the appropriate approach will vary for different
levels of sophistication of entities, the financial instrument and the availability of data.
[IFRS 9.BC5.157]. It is important to stress that the assessment of significant increases in
credit risk often involves a multifactor and holistic analysis. The importance and
relevance of each specific factor will depend on the type of product, characteristics of
the financial instruments and the borrower as well as the geographical region.
[IFRS 9.B5.5.16]. The guidance in the standard is clear that in certain circumstances,
qualitative and non-statistical quantitative information may be sufficient to determine
that a financial instrument has met the criterion for the recognition of lifetime ECLs.
&nbs
p; That is, the information does not need to flow through a statistical model or credit
ratings process in order to determine whether there has been a significant increase in
the credit risk of the financial instrument. In other cases, the assessment may be based
on quantitative information or a mixture of quantitative and qualitative information.
[IFRS 9.B5.5.18].
Financial instruments: Impairment 3787
6.2.1
Examples of factors or indicators of changes in credit risk
The standard provides a non-exhaustive list of factors or indicators which an entity
should consider when determining whether the recognition of lifetime ECLs is required.
This list of factors or indicators is, as follows: [IFRS 9.B5.5.17]
• significant changes in internal price indicators of credit risk as a result of a change in
credit risk since inception, including, but not limited to, the credit spread that would
result if a particular financial instrument, or similar financial instrument with the same
terms and the same counterparty were newly originated or issued at the reporting date;
• other changes in the rates or terms of an existing financial instrument that would
be significantly different if the instrument was newly originated or issued at the
reporting date (such as more stringent covenants, increased amounts of collateral
or guarantees, or higher income coverage) because of changes in the credit risk of
the financial instrument since initial recognition;
• significant changes in external market indicators of credit risk for a particular financial
instrument or similar financial instruments with the same expected life. Changes in
market indicators of credit risk include, but are not limited to: the credit spread; the
credit default swap prices for the borrower; the length of time or the extent to which
the fair value of a financial asset has been less than its amortised cost; and other market
information related to the borrower (such as changes in the price of a borrower’s debt
and equity instruments). The IASB noted that market prices are an important source
of information that should be considered in assessing whether credit risk has changed,
although market prices themselves cannot solely determine whether significant
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 748
