How New Impairment Rules in IFRS 9 Affect You
In July 2014, the standard IFRS 9 was finally completed and the latest amendments brought us new impairment rules (besides the other things).
In my humble opinion, new impairment rules will cause a lot of headaches for mainly financial institutions.
Why?
Well, they will have a hard time to adjust or upgrade their own information systems in order to provide just the right information and calculate loss provision in line with the new requirements.
But – even if you’re not working in a financial institution, don’t celebrate that much.
Do you have some trade receivables?
In such a case, you ARE affected as well.
How?
You need to change the way of calculating “bad debt” provision related to your receivables. Let me show you how.
Expected Credit Loss Model – the basics
IFRS 9 introduces so-called “general model” of recognizing impairment loss. This model requires recognizing impairment losses in line with the stage in which the financial asset currently is. There are 3 stages:
Stage 1: Performing financial assets
Here, we have financially healthy financial assets that are expected to perform normally in line with their contractual terms and there are no signs of increased credit risk.
IFRS 9 requires recognizing impairment loss amounting to 12-month expected credit losses.
What is 12-month expected credit loss?
It is the expected credit loss resulting from default events on a financial instrument that are possible within 12 months after the reporting date.
In this case, the interest revenue is recognized based on effective interest rate method on gross carrying amount, so no loss allowance is taken into account.
Stage 2: Financial assets with significantly increased credit risk
When the credit risk of certain financial asset significantly increased and the resulting credit quality is NOT low risk, then an entity needs to recognize full lifetime expected credit losses.
What are they?
They are present value of losses that arise if a borrower defaults on their obligations throughout the life of the financial instrument.
In fact, 12-month expected credit losses are just the portion of the life time expected credit losses.
Now, please be careful, because expected credit losses are in fact a difference between:
- The present value of cash flows based on the contract of a financial instrument; and
- The present value of cash flows that an entity really expects to obtain from the financial instrument.
As a result, the timing of payments from the financial instrument directly affects their present value and thus the amount of an impairment loss.
In practice, if you expect that debtor will pay you in full, but later than in line with the contract, there IS an impairment loss!
Interest revenue for stage 2 assets is calculated exactly in the same way as in stage 1 (on gross carrying amount).
Stage 3: Credit-impaired financial assets
When your financial asset has already become credit impaired (meaning that certain default events have occurred), then an entity still recognizes lifetime expected credit losses.
However, this time, interest revenue is calculated and recognized based on the amortized cost (that is gross carrying amount less loss allowance).
In this stage, financial assets might need to be individually assessed.
Why is this model so demanding?
Maybe it’s not apparent immediately, but the correct application of this model requires lots of reliable information, for example:
- Information for estimating debtor’s credit risk and identifying its significant increase;
- Information for estimating occurrence of default events within 12 months from the reporting date;
- Information for estimating occurrence of default events within the life of the instrument, their probable outcomes and weights;
and many more.
Even slight change in 1 parameter can affect the resulting amount of recognized impairment loss and thus financial results of an entity. Therefore, it’s everything else but NOT easy to adopt these newest requirements.
However, the good news is that unless you work for a financial institution like bank, you don’t have to follow the above general model.
Great exception for non-financial companies: trade receivables
There are many entities whose primary business is simply NOT providing loans or finances, but for example selling goods or services. These companies might have huge portfolios of trade receivables in their accounts.
Of course, trade receivables do meet the definition of a financial instrument and as a result, they are subject to IFRS 9 as well.
And exactly as I wrote above – if you expect your customer will pay you a bit later than agreed, you have an impairment loss on your trade receivable that you need to recognize!
But don’t worry, you don’t need to go from stage 1 to stage 3, calculate probabilities of default events and recognize 12-month expected credit losses first, followed by life time expected credit losses.
That would be enormous burden for the companies whose focus is something very different.
Instead, standard IFRS 9 permits the use of simplification.
If your trade receivables do not contain significant financing component, you can recognize lifetime expected credit losses right on initial recognition.
Moreover, as a simplification, you can use so-called provision matrix.
Let’s take a look at our example to clarify that.
Example: bad debt provision
ABC, a trading company, has trade receivables with gross carrying amount of CU 500 000 at the end of 20X4. Careful analysis of the trade receivables showed the following:
- One of ABC’s customers, debtor A, filed for bankruptcy proceedings during 20X4. ABC’s receivable to debtor A amounts to CU 2 200 and ABC expects to recover close to nil.
- Aging structure of remaining trade receivables is as follows:
Past due days | Amount in CU | % of expected credit loss |
Within maturity | 392 200 | 0.50 |
1-30 days | 52 300 | 0.80 |
31-90 days | 27 600 | 5.60 |
91-180 days | 13 200 | 8.90 |
181-365 days | 7 500 | 20.30 |
365+ days | 5 000 | 70.00 |
Debtor A | 2 200 | 100.00 |
Total | 500 000 | n/a |
The last column of the table contains percentages of expected credit loss in the individual aging groups. ABC estimated these percentages based on the historical experience and adjusted it, where necessary, for forward-looking estimates.
How should ABC calculate bad debt provision in line with IAS 39 and IFRS 9?
Bad debt provision in line with IAS 39
Firstly, let’s try to calculate bad debt provision in the old way, in line with IAS 39.
IAS 39 requires recognizing the impairment loss to the extent it has already been incurred. So you are not looking to future expectations or anything like that. Instead, you need to examine just the events leading to impairment loss already incurred.
In the ABC company’s trade receivables portfolio, there’s only one such a receivable with incurred impairment loss. Here, bankruptcy proceedings against debtor A would probably represent the default event causing that ABC will not recover its trade receivable.
As ABC assumes the recovery close to nil, it can recognize bad debt provision amounting to 100% of the receivable’s gross carrying amount of CU 2 200.
Although past experience shows that some percentage of other receivables might not be recovered (look to the 3rd column of the table), ABC can’t recognize any bad debt provision to remaining receivables, as there’s no evidence of impairment loss really incurred.
Thus the statistics in the 3rd column is irrelevant for IAS 39 and total bad debt provision in line with IAS 39 is CU 2 200.
Bad debt provision in line with IFRS 9
Here, the things totally change.
Of course, bad debt provision to debtor A’s receivable of CU 2 200 will not be any different. This receivable has already been credit impaired and full lifetime expected credit loss is simply 100% of this receivable – CU 2 200.
However, what about remaining receivables?
Well, based on the statistics in the 3rd column it seems that ABC can reasonably expect some credit loss in the future, although no loss events have happened yet.
However, ABC’s past experience shows that ABC can expect 0.5% credit loss on the trade receivables that are totally healthy and performing normally in line with the contractual terms. The percentages increase with increasing days that the receivables are overdue.
As a result, ABC needs to recognize bad debt provision based on provision matrix, as this simplification is permitted by IFRS 9.
Bad debt allowance is then calculated as:
(392 200 x 0.5%) + (52 300 x 0.8%) + (27 600 x 5.6%) + (13 200 x 8.9%) + (7 500 x 20.3%) + (5 000 x 70%) =
1 961 + 418.4 + 1 545.6 + 1 174.8 + 1 522.5 + 3 500 = CU 10 122.30.
Add provision to debtor A of CU 2 200 and the total bad debt provision in line with IFRS 9 is CU 12 322.30.
Hmhm. That’s quite different from IAS 39 provision, isn’t it?
When to apply new IFRS 9 impairment model
OK, so maybe you have just found out that IFRS 9 can hurt you pretty much. What to do? Is there some time to get ready?
IFRS 9 will be mandatorily applicable for periods starting 1 January 2018 or later, so you still have some time.
However, you can adopt IFRS 9 earlier, if you want.
In this case, if you adopt IFRS 9 before 1 February 2015, you can adopt previous versions of IFRS 9, meaning that you can continue with impairment rules under older IAS 39.
But not after 1 February 2015 – after that date, your only option is to apply new IFRS 9 in its entirety, if you opt to apply it early.
Did you like the article? Do you have anything to say? Please do so in the comment below and help me share this article with your friends. Thank you!
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How to apply ECL to lease receivables?
Hi Silvia,
Hope all is good, Please stay safe and stay healthy
I have one basic question for ECl, When to recognized it? Standard says Maximum 12 month since initial recognition. right ? whether this mean on Balance sheet date (Reporting date) or date when you purchased asset? and what about the Probability of default? whether from purchase date to next 12 month or from reporting date to next 12 month ? can u please quote some example? suppose we have to published our balance sheet on monthly basis, I purchased one Financial asset on 15 April so my balance sheet date is 30 April, so now when recognize ECL ? on 15 April or 30 April? what is timing of PD from 15 April to next 12 month or from 30 April to next 12 month? Thanks waiting for your response?
Hey. As long as i know, we book expected credit losses at day1. That is, when the asset is purchased.
The ECL should be recognized at balance sheet date not at the time of purchase because valuation. Here the ELC is recognized at the reporting date but since the date of the purchase of financial instruments.
If we have won legal case to collect money from customer how will we treat it in ECL model
Hi Silvia,
Whether employee advances are financial assets and if yes, how we will calculate impairment on that
Hello Silvia, thank you for your wonderful work. I have a government receivable. Payment is often delayed, but always made. I also have confidence and evidence that full payment will be made of the outstanding receivables balance, after which the government won’t have to owe me anymore (payment model will change). Do I have enough grounds not to recognise an impairment on the government receivable?
Hi Bukola, there is probably some impairment, but immaterial, since probability of default within 12 months is close to zero for most governments. S.
what difference between ECL aging report
ECL is the type of provision for loss. While aging report means outstanding days of receivables.
Hi Silvia
i am implementing IFRS effective 2018, is it permitted under IFRS 9 to route the provision resulting from ECL calculation through P&L in 2018 and not through adjusting opening Retained Earnings for those receivables were outstanding as of 31st December 2017?
Hi Silvia,
Do we need to differentiate between “credit risk” and “dispute risk” when applying the expected credit loss model for provisioning of trade receivables. Essentially, any risk of recovery on account of disputed bills by the customers owing to delivery/performance issues by the entity will be treated differently from actual credit risk? In which case for dispute risk- the treatment may be provision created as a net from revenue.
Let me know your thoughts.
Hi Ashraf, I haven’t thought about it, but if you have more dispute cases, then I would probably separate or segment the receivables to disputed and undisputed and calculated ECL separately for each segment. It makes sense.
Dear Silvia
This is a brilliant web-site and is extremely useful and clear to understand. Your ability to simplify complex concepts is a gift.
Thank you 🙂
Hi Silvia,
Thank you for always updating the changes in IFRS in simple way.
A quick question.
Should we include trade receivables from a fully owned subsidiary company for ECL computation ( at consolidation level as well as parent company’s stand alone financial level)
Hi Silvia.
First of all, I want to celebrate all of you with welcomed New 2019 year.
Also Thanks for amazing article.
I have a couple of question relating to impairment AR.
a) how we account for inter-group loans in line with IFRS 9, especially its impairment. As you know, Intra-group loans within the scope of IFRS 9 are required to be measured at fair value on initial recognition. Intragroup loans are often either interest-free or they are provided at below-market interest rate. The amount lent is, therefore, not fair value. In this case, how we account for impairment loss on inter-company loans?
b) According to the IFRS 9, simplification of impairment on trade receivables is allowed but after calculating provision matrix, it would be adjusted based on forward-looking estimates if correlations exist between AR and macro-economic factors. Ok, but how we can calculate correlation between those. Can you describe briefly this calculation? Because, I am required to do provision matrix in line with IFRS 9.
Thanks for your cooperation!
Dear Silva, please can you help with an illustration on practical application and how to obtain required information for ifrs 9 expected loan loss provisioning for Banks.
Thanks
Hi Dickson, this is a very specific topic, so I would kindly recommend checking out our online advisory service my Helpline. S.
Dear Silva,
Could you please provide me with a practical example on loan loss impairment calculation for development banks?
Thanks a lot for helping me out.
Kind regards,
Tirfu Adhanom
Hi Tirrfu,
well, this would be too elaborate to do this online, but we have a great online advisory service, so drop me an e-mail if interested. S.
Hi Silvia,
Stage 3 model is similar to the individual impairment which was discussed under IAS 39 ? Can we apply stage 3 for credit impaired retail loans which are not individually significant ?
Thank You
Kosala
Hi Silivia,
Do we need to calculate impairment on advance against which we will receive inventory?
Hi Fahad, well, advances for inventory are not financial instruments, unless you expect to receive cash. But, you should still assess the advance paid for the impairment in case that your supplier is bankrupt or so.
“IFRS 9 requires recognizing impairment loss amounting to 12-month expected credit losses immediately at initial recognition of these assets.”
Silvia, why do you think that impairment loss shall be recognised at initial recognition? IFRS 9 states that at initial recognition a financial asset shall be measured at fair value plus transaction costs, isn’t it?
IFRS9, 5.1 Initial measurement
5.1.1 Except for trade receivables within the scope of paragraph 5.1.3, at initial recognition, an entity shall measure a financial asset or financial liability at its fair value plus or minus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability.
BC5.84 In developing a model that depicts expected credit losses, the IASB observed that:
(a) when an entity prices a financial instrument, part of the yield, the credit risk premium, compensates the entity for the credit losses initially expected (for example, an entity will typically demand a higher yield for those instruments with higher expected credit losses at the date the instrument is issued). Consequently, no economic loss is suffered at initial recognition simply because the credit risk on a financial instrument is high at that time, because those expected credit losses are implicit in the initial pricing of the instrument.
(b) for most financial instruments, the pricing is not adjusted for changes in expected credit losses in subsequent periods. Consequently, subsequent changes in expected credit losses are economic losses (or gains) of the entity in the period in which they occur.
Oh yes, you are right of course, the last part of sentence was referring to purchased credit impaired assets because you recognize the impairment loss on these assets right at initial recognition. I forgot to delete it. Thanks for the correction!
Do we need to provide ECL even for the receivables from the Government (such receivables being sovereign debts)
Hi Silvia
My query relates to the Stage 3 ECL provision and interest income being based on the net carrying amount of the financial asset (as opposed to the gross carrying amount for Stages 1 and 2).
From an IFRS 9 recognition requirements perspective, I understand that interest income needs to be recognised on the net carrying amount of the financial asset. However, from a business/commercial perspective, the customer/debtor is still billed interest based on the gross carrying amount of the financial asset. As a result, I would imagine that an adjustment needs to be made to interest income (i.e. reducing the business/commercial interest income recognised to reflect the IFRS 9 stage requirements).
The adjusting journal would probably be something like:
Dr Interest income (I/S) xxx
Cr Debtors/Suspense account (B/S) xxx
However, my concern is when the customer/debtor pays their account which was provided for (ECL provision based on stage 3).
When such payment is received and it is for the full balance billed (i.e. interest income based on the gross carrying amount of the financial asset), how should one account for the difference between such payment and the customer/debtor balance recognised (i.e. based on the IFRS 9 stage 3 requirements, particularly the reduced interest income)?
As a very simple example, say the gross balance was R100 and the ECL provision R20 (Net carrying amount being R80).
The interest billed would have been R100 x 5% = R5, but interest recognised would have been R80 x 5% = R4.
When the customer pays the R105 (R100 + R5 interest), the journal entry would be:
Dr Bank (B/S) R105
Cr Debtor (B/S) R104
Cr ???? R1 (What is this contra entry?)
My assumption would be that the contra account is interest income since it was understated as a result of the IFRS 9 stage 3 requirement to use the net balance to calculate interest, but this is only an assumption.
Do you perhaps know one should go about the accounting of my concern raised?
Apologies for the long-winded scenario but I needed to be as clear as possible.
Thanks so much.
Hi silvia,
Please discuss about how bank make provision based on IFRS 9 with practical illustration??
Hi Ank, well, this is really not for an article, because it’s not that easy. But maybe you can find some inspiration here (although not for a bank).
Hi Silvia, Regarding for the example given above, would it be possible the “% of expected credit loss” for all the aging category would be “Zero” based on the ABC assessment and conclude that none of the customers are not paid in the past and ABC is confident that all the outstanding amounts are collectible (included long-overdue invoices) in the future?
Hypothetically yes, as soon as you also can say that the forward looking information confirms the trend.
Then, what about money time value?
???
Dear Silvia
Good Day and Thanks for your positive cooperation,
This IFRS 9 give an entity to adjust its profit by applying an adjusted percentage for each line of ARs Past due days, Does this approach allow companies to manipulate the profit figure (especially for Tax purposes)?
Hi Silvia,
Now Q1 2018 finished and the auditor asked us to provide impairment for deposits in banks and cash!! most of the deposits are short term. my question is how come dposits impaired? please note that Central Bank of Kuwait guarantee all client’s deposits in Kuwait.
Hi Ahmad, if these deposits are current… then you should probably ask your auditor for the explanation. S.
Most of the deposits are current because they are in Money Market Fund, we have asked the auditor and he said once its amortized cost there should be an impairment
Dear Ahmad, as soon as you are not expecting any troubles with recovering the deposits, then the present value of the expected amount to receive should be the same as the present value of the contractual amount, hence there’s no impairment. That’s why I asked for the reasoning of your auditor…
I have a query:
1) Is the Default rate / Loss rate to be calculate on yearly basis and apply or fixed initial time and use in future periods?
2) And in case our assumptions are went wrong and Company recovered full amount (no Bad debt) in subsequent period, can we reverse the Impairment, if so as what line like income?. Thanks in advance for your reply.
By the way, here’s the article where you can learn more about setting the default rates. S.
Hi Neelakantam,
1) You should revise and update your estimates including the default rates periodically, so yes, annually.
2) Sure, you can reverse the impairment loss. S.