International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards

by International GAAP 2019 (pdf)

  credit risk. The challenge presented was how to determine when changes are

  sufficiently significant to result in a derecognition of the original facility and recognition

  of a new facility. The ITG members discussed some of the factors that might be taken

  into consideration in making that judgement, such as issuing a new card, revising credit

  limits or conducting credit reviews.

  It was noted that judgement would be required in making this assessment and that it

  would depend on the specific facts and circumstances. However, the following

  observations were made:

  (a) in some circumstances issuing a new card may be indicative that the original facility

  has been derecognised, but in other cases, this may be a purely operational process

  and thus would not indicate that a new facility has been issued; and

  (b) credit reviews in themselves may not indicate that a new facility has been issued.

  Although this discussion was on how to determine the reference date for assessing if

  there has been a significant increase in credit risk, the notion that it depends on the

  derecognition of one facility and the recognition of a new one would, presumably, be

  equally relevant for assessing the period over which to measure ECLs. This is especially

  relevant for corporate overdraft facilities which are considered to be in the scope of the

  exception (see 12.1 above). If, for instance:

  i)

  the facility has a clearly agreed contractual life of one year (in addition to a short

  cancellation notice period);

  ii) the bank goes through a thorough credit process each year, similar to that on

  original application and using detailed financial and other information specific to

  the customer, before deciding whether to continue with the facility, increase it,

  reduce it or withdraw it;

  iii) the bank will at that time revise the terms and conditions of the facility to reflect

  the up-to-date credit quality of the borrower; and

  iv) the bank derecognises the facility and recognises a new one, giving the associated

  required disclosures,

  Intuitively, it would seem that the bank is only exposed to credit risk for the period of a year.

  This is consistent with the Basis of Conclusions which confirms the general principle

  that, ‘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]. Also, while paragraph BC5.261, by starting with the word

  ‘however’, makes it clear that the revolving facilities amendment was an exception to

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  this principle, it does not explicitly state that it is an exception to the entire principle. It

  only says that ‘the entity’s contractual ability to demand repayment and cancel the

  undrawn commitment does not limit the entity’s exposure’ (emphasis added), remaining

  silent on an entity’s ability to renew or extend credit. On the other hand, some believe

  that an ability to withdraw or cancel is in substance sufficiently similar to an ability to

  renew or extend, that they should be treated the same. They also consider that the IASB

  webcast has made it clear that only expected reductions and withdrawals of facilities

  can be reflected in the assessment of the risk horizon. Consequently, a decision to

  maintain the facility, even if based on fully revised terms and conditions, would not be

  considered a risk management decision that shortens the life of the facility.

  There are also differences of view as to whether a revolving facility can be derecognised

  (and so the expected derecognition can be reflected in the ECL horizon) if the lender

  carries out an annual thorough periodic credit review at least equivalent to that when the

  facility was first granted, at which point it may revise the terms and conditions, but there

  is no contractual limit to the life of the facility, or if there is a contractual limit to the life

  of the facility but no thorough credit review at the point of renewal. In the first case, the

  contract allows for a periodic credit review equivalent to that on origination, performed

  on an individual rather than a collective basis and with an opportunity to revise the terms

  and conditions if the credit quality has changed, some believe that this could lead to

  derecognition of the facility and recognition of a new one. As a result, ECLs would only

  be measured over the period until the next periodic review. In the second case, the facility

  has a clearly agreed contractual life but its renewal is relatively automatic without a

  thorough review. Some believe that IFRS 9 is clear that a financial instrument is

  derecognised if it expires and therefore a thorough credit review is not required.

  It is important for banks to disclose the basis on which they have made their calculations.

  It should be stressed that this issue is of relevance mostly for those facilities that are

  measured using lifetime credit losses. The allowance for those assets in stage 1 will be

  calculated based only on losses associated with default in the next twelve months.

  12.3 Exposure at default (EAD)

  To measure ECLs on revolving facilities, such as credit cards, it will be necessary to

  estimate several components that make up the EAD:

  • the credit conversion factor, to determine the portion of the facility that is drawn

  down in any period (limited, for facilities in stage 1 to the next twelve months);

  • the speed at which drawn down facilities are paid off; and

  • the level of interest expected to be charged in the future on those facilities that are

  drawn down.

  These components will all need to be estimated based on past experience and future

  expectations, for sections of the portfolio that are segmented so that they have similar

  credit characteristics (see 6.5.2 above). The estimation of interest is addressed further

  in 12.4 below.

  At its meeting on 16 September 2015, the ITG (see 1.5 above) discussed how an entity

  should estimate future drawdowns on undrawn lines of credit when an entity has a

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  history of allowing customers to exceed their contractually set credit limits on

  overdrafts and other revolving credit facilities.

  The ITG members noted that:

  • The exception for some types of revolving credit facilities set out in

  paragraph 5.5.20 of IFRS 9 relates to the contractual commitment period and does

  not address the contractual credit limit. The standard was clear in this regard and

  consequently, it would not be appropriate to analogise this specific exception to

  the contractual credit limit.

  • Some members of the ITG pointed out that, in practice, the tenor and amount of

  revolving credit facilities are inextricably linked, because banks not only extend

  credit for a period in excess of their maximum contractual commitment period but

  also allow customers to make drawdowns in excess of the maximum contractually

  agreed credit limit as notified to the customer. Consequently, if amounts in excess

  of the maximum contractually agreed credit limits are not taken into account, there

  would be a potential disconnect between the accounting and credit risk

  management view.

  • However, it was
concluded that IFRS 9 limits the estimation of future drawdowns

  to the contractually agreed credit limit.

  12.4 Time value of money

  The time value of money is important in measuring ECLs for revolving facilities since

  interest rates (when interest is charged) are high. Hence it is important that any interest

  that is expected to be charged on drawn balances is included in the EAD and that an

  appropriate rate is used to discount ECLs. An additional complexity is introduced by

  credit cards, because they typically have a grace period in which no interest is charged

  as long as the amount drawn down is repaid within a specified period of time.

  The standard is silent on this topic, however, the ITG discussion on the use of floating-

  rates of interest to measure ECLs in December 2015 (see 5.7 above) established a useful

  principle, that there should be consistency between the rate used to recognise interest

  revenue, the rate used to project future cash flows (including shortfalls) and the rate

  used to discount those cash flows. While the high rates charged by a credit card issuer

  are sometimes fixed in the contract, the fact that the rate charged (nil or the high rate)

  depends on how quickly the customer repays the amount drawn, means that the rate

  can be thought of as ‘floating’, even if it does not vary with a benchmark rate of interest.

  This is important since otherwise it would be necessary to assess the EIR on original

  recognition and keep this fixed unless the facility is derecognised, ignoring any changes

  in customer behaviour.

  Applying this principle, for a credit card customer that is a ‘transactor’, that is, one who

  repays any amount drawn down within the specified short period and so is charged no

  interest, it would not be appropriate to discount expected losses. On the other hand, for

  a credit card customer who is a ‘revolver’ and who only pays off the minimum amounts

  permitted by the issuer (in effect, using the card to borrow money), the high rate of

  interest should be included in the forecast cash flows and in the discount rate.

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  However, any transactor who goes on to default is likely to begin paying off less than

  the full amount for a period of time before they default. To estimate the expected losses

  for this scenario, it will be necessary to include any interest that will be charged in this

  period. A consistent discount rate will then be a blended rate, of nil for the period over

  which the customer is expected to pay no interest and the high rate over the period in

  which they will pay.

  According to the guidance for ‘normal’ loan commitments, the expected credit losses on

  a loan commitment must be discounted using the effective interest rate, or an

  approximation thereof, that will be applied when recognising the financial asset

  resulting from the loan commitment. [IFRS 9.B5.5.47]. Applying this approach, the losses on

  the currently undrawn portion of a revolving facility should be discounted based on the

  rate that is likely to be charged if it is drawn down. If it is expected that interest will be

  charged at the high rate – which is likely for most facilities that are already ‘revolvers’

  – then the discount rate is likely to be the high rate. This approach is consistent with a

  view expressed at the ITG meeting that the drawn and undrawn balances should be

  viewed as one unit of account and so discounted at the same rate. If it is projected that

  a transactor will at some stage become a revolver before it defaults then it may be

  appropriate to calculate a blended discount rate.

  Because the choice of interest rate used to project cash flows and to discount losses will

  depend on expectations of the borrower’s behaviour, it will need to be made separately

  for segments of the portfolio with similar credit and payment characteristics.

  In practice, it is likely that credit card issuers will often adopt procedures to discount

  their ECLs that may be less sophisticated than set out above, due to operational

  constraints and because the objective of the standard is to discount ECLs at an

  approximation of the EIR. [IFRS 9.B5.5.44]. However, it is necessary to understand what is

  theoretically required by IFRS 9 in order to be able to assess whether a pragmatic

  approach is a reasonable approximation.

  12.5 Determining significant increase in credit risk

  As already mentioned at 12.2 above, at its April 2015 meeting, the ITG discussed the

  starting reference date when assessing significant increases in credit risk for a portfolio

  of revolving credit facilities. There will typically be a diverse customer base, ranging

  from long-standing customers who have been with the bank for many years, to new

  customers who have only recently opened an account. The standard’s general rule is

  that the starting reference date is the date of original recognition. Consequently the date

  of initial recognition for this purpose is the date the facility was issued and this should

  only be changed if there has been a derecognition of the original facility. As discussed

  at 12.2 above, it is not altogether clear what would qualify as a derecognition within the

  context of the revolving facility exception. If the lender derecognises a facility at the

  end of its contractual term and recognises a new one when it decides to renew or extend

  credit, consistent with the Basis of Conclusions, it would be consistent to assess if there

  has been a significant increase in credit risk from when the current facility was first

  recognised. [IFRS 9.BC5.260]. Similarly, it may make sense to use the date that the limit was

  increased if a facility is now far larger than would have been granted on original

  recognition. There is also a view that the credit risk on the date that the facility was last

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  increased may be a useful proxy for the credit risk on the date of original recognition.

  There is a particular challenge on transition to IFRS 9, since entities may have limited

  data on the credit risk at the date of original recognition. (See 5.9 above).

  However, as discussed at 12.2 above, another view is that only a reduction or

  cancellation of the facility would lead to the revolving facility being derecognised. In

  some circumstances, issuing a new card may be indicative that the original facility has

  been derecognised (e.g. replacement of a student credit card with a new credit card

  upon graduation), but in other cases, this may be a purely operational process and thus

  would not indicate that a new facility has been issued.

  The ITG did not conclude further on this issue and it was not discussed in the IASB’s

  May 2017 webcast. Consequently, at the date of writing this issue had not been resolved.

  13 INTERCOMPANY

  LOANS

  For those entities that prepare stand-alone IFRS financial statements, or consolidated

  financial statements for part of a wider group, one of the challenges in complying with

  the IFRS 9 impairment requirements is the application to intercompany loans.

  Many intercompany loans are structured so as to be on an arm’s length basis, often for

  tax purposes, or because they involve transactions with special purpose entities (SPEs)

  that are consolidated since the group retains control. For these loans, application of
/>   IFRS 9 will be similar to loans to third parties. It is more likely that these loans are clearly

  documented and priced at market rates which will reflect the PD and LGD. One of the

  challenges for applying IFRS 9 to intercompany loans is that money is often lent by one

  group company to another on terms that are not ‘arm’s length’ or even without

  documented terms at all. It is strongly recommended that the implementation of IFRS 9

  is used as an opportunity to determine the terms of such arrangements and document

  them so as, where possible, to reflect their substance. This is because it is particularly

  difficult to apply IFRS 9 to arrangements where the terms are unknown or the legal form

  (if documented) differs from their substance. Examples of the latter include:

  1)

  loans that may be documented as on demand, and interest free, but which are

  intended to be either a capital investment unlikely to be repaid, or a loan to be

  repaid after a number of years; and

  2) loans that are structured between group companies on terms whereby there is

  an implicit guarantee of credit risk by a parent company, but this is never

  explicitly documented.

  In some cases (subject, of course to consideration of the implications for tax and

  distributable profits), it may be possible to restructure intercompany arrangements on

  an arm’s length basis (and documented them accordingly) and so better enable the

  application of the standard.

  All intercompany loans are in the scope of IFRS 9. It is possible that a group company is

  financed entirely by debt rather than partly through equity, so that the substance of the loan

  (at least in part) may be closer to an equity investment in that company. This raises the

  question as to whether loans to group companies can ever be regarded as an ‘investment’ in

  them, which could be accounted for under IAS 27– Separate Financial Statements – at cost,

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  rather than a loan accounted for under IFRS 9. ‘Investments’ are not defined for this

  purpose. Although IAS 27 is usually read to refer to investments in shares, an argument might

  be made that it can also cover intercompany arrangements which are, in substance, capital

  investments. However, the IFRIC in September 2016 seem to have ruled against this. IFRIC