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IFRS Technical Update
The big IFRS 9 mindset change – from incurred loss to expected loss model
By KC Rottok Chesaina
IASeminars Faculty Member
You may well remember the Global Financial Crisis (GFC) of 2007-2008 which began with an increase in default rates in the subprime mortgage market in the United States. This developed into a financial crisis involving the collapse of some international financial institutions, such as the investment bank, Lehman Brothers. To avert the possible collapse of the world financial system, governments bailed out financial institutions and introduced monetary and fiscal policies to sustain the world economy. Despite these measures a global economic downturn followed, stock markets plummeted, housing prices tumbled, businesses failed and unemployment increased.
With such far-reaching consequences for many economies, questions were asked as to who was to blame and what actions were necessary to reduce the risks of future instability. Accounting standards set by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), were identified as deficient in failing to provide for losses on financial assets soon enough. This resulted in political pressure to revise their accounting standards on financial instruments, and the IASB formed the Financial Crisis Advisory Group (FCAG) to discuss various technical issues including how impairments of financial assets could be accounted for.
It was argued that IAS 39’s incurred loss model which only recognised impairment losses on loan assets after a default, or other loss event had occurred, meant that losses were recognised too late to be useful.
IAS 39 has been replaced by IFRS 9, effective for annual periods beginning on or after 1 January 2018, a mere ten years later. The new standard is a product of FCAG thinking, and it prescribes the expected loss model which requires a more forward-looking approach. This represents a complete shift in mindset when it comes to accounting for impairment of financial instruments.
The Expected Credit Loss (ECL) model covers financial assets measured at amortised cost, financial assets measured mandatorily at fair value through other comprehensive income, loan commitments and financial guarantee contracts not covered under fair value through profit/loss under IFRS 9. It also applies to contract assets under IFRS 15 Revenue from Contracts with Customers and lease receivables under IAS 17 Leases (IFRS 16 from 2019).
A credit loss is defined as the difference between all contractual cash flows due to an entity in accordance with the contract, and all the cash flows that the entity expects to receive (i.e. it represents all cash shortfalls) discounted at the original effective interest rate. As these relate to present values, losses may arise on late payment even if the amount is fully paid.
The general approach in applying the ECL model is that ECLs are recognised from the point at which the instrument is acquired. ECLs are measured at an amount equal to:
- Lifetime ECLs – the present value of all cash shortfalls over the remaining useful life of the instrument; or
- 12-month ECLs – portion of lifetime ECLs associated with the probability of default within 12 months of the reporting date.
IFRS 9 applies a three-stage model for impairment depending on changes in credit quality since initial recognition. These stages are as follows:
- Stage 1 – This is applicable to instruments that have not had a significant increase in credit risk since initial recognition. For these instruments, 12-month ECLs are recognised although interest revenue is calculated on the gross carrying amount without deduction of the 12-month ECL. The instrument is transferred to stage 2 or stage 3 if the credit quality deteriorates significantly and can be returned to stage 1 if credit quality later improves.
- Stage 2 – This is applicable to instruments whose credit quality deteriorates to such a point that it is no longer considered low risk at the reporting date. The assets do not, however, have objective evidence of impairment. Unlike stage 1, lifetime rather than 12-month ECLs are recognised, although as in stage 1, interest revenue is still calculated on the gross carrying amount without deduction of ECL.
- tage 3 – Finally we have stage 3 financial instruments which are those that have objective evidence of impairment at the reporting date. For these instruments, lifetime ECLs are recognised, and interest revenue is calculated on the net carrying amount, i.e. after deduction of the lifetime ECL.
IFRS 9 implementation has proved particularly challenging for banks given that they must invest in new systems and data to correctly account for impairment of their financial assets. The change in thinking is needed for all accountants applying IFRS, and the hope is that the change will be worth the pain by helping organisations to manage their risks better and to report relevant information to users of financial statements more promptly. Hopefully, this may help to prevent a recurrence of the circumstances that led to the devastating GFC.
IASeminars offers the following courses on the topic of IFRS 9:
Read more articles by KC Rottok Chesaina:
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