When the International Accounting Standards Board (IASB) released IFRS 9—Financial Instruments—it completely changed the accounting landscape. Perhaps the most significant and challenging element of IFRS 9 is financial asset impairment, which substituted IAS 39's long-standing "incurred loss" method with a more prospective Expected Credit Loss (ECL) model. Here, we analyze the key components of the IFRS 9 impairment model in order to enable finance professionals and business companies to understand its framework, usage, and significance better.
What Is IFRS 9 Impairment?
IFRS 9 Impairment is the measurement and recognition of credit losses that occur on financial assets. Unlike the prior standard, which employed the incidence approach in recognizing impairment losses only when a credit event occurs, IFRS 9 mandates provisioning with expected credit losses—proactive and forward-looking. The change was partly because of the 2008 global financial crisis and aimed at providing greater transparency and timeliness in recognizing credit risks.
Scope of IFRS 9 Impairment
Impairment model under IFRS 9 is applied to:
- Financial assets (such as trade receivables and loans) held at amortised cost
- Fair-valued financial assets held through other comprehensive income (FVOCI)
- Loan commitments and financial guarantee contracts which are measured at other than fair value
- Lease receivables and contract assets under IFRS 15
The Expected Credit Loss (ECL) Model
At the core of IFRS 9 impairment is the Expected Credit Loss model. It will acknowledge future credit losses along financial asset lives, rather than looking forward to defaults occurring. The three-stage model will be valued as follows:
Stage 1: 12-Month ECL
When the financial asset is initially recognized, it's assumed there's no significant credit risk increase. 12-month expected credit losses are realized in this case. Losses from default events that are anticipated to happen within a year are referred to here.
Stage 2: Lifetime ECL (Significant Increase in Credit Risk)
The asset enters Stage 2 if the material increase in credit risk (SICR) occurs at initial recognition. Entities are now required to recognize lifetime ECL, or expected losses over the asset's remaining life. The full carrying amount is still being used to calculate the revenue from interest.
Stage 3: Credit-Impaired Assets
When the asset is credit-impaired (i.e., in default), it moves to Stage 3. Lifetime ECL is still to be accounted for, but interest revenue is determined using net carrying amount (i.e., gross value minus ECL).
Identification of Significant Increase in Credit Risk (SICR)
Identification of SICR is one of the more judgmental parts of IFRS 9. Entities are required to take into account quantitative as well as qualitative factors such as:
- Default history data
- Macro-economic conditions
- Internal risk assessment procedures
There is a general presumption exists that payments which are overdue for 30 or more days increase chances for a significant deterioration of credit risk.
Measuring Expected Credit Losses
The ECLs is a credit loss probability-weighted estimate, at the original effective interest rate of the asset. Measurement comprises:
1. Probability of Default (PD): Probability of default by the borrower.
2. Loss Given Default (LGD): Loss expected in default.
3. Exposure at Default (EAD): Amount outstanding at default.
Simplified Approach for Trade Receivables
IFRS 9 provides an easy solution for trade receivables, lease receivables, and contract assets. In this case, entities are not required to take SICR into consideration but always take lifetime ECL into consideration. Most firms use provision matrices based on history with forward-looking adjustment to determine ECLs on such assets.
Disclosures Under IFRS 9
Transparency is one of the central goals of IFRS 9 and, as such, entities are to make complete disclosure in their financial reports, including:
- Reconciliation of loss allowance between opening and closing balances
- Assumptions used when calculating ECL
- Changes during estimation methods or inputs
- Breakdown in credit risk stage
Such disclosures enable users to be informed of the nature and quality of the credit risk and how it is being accounted for.
Effect on Businesses
The adoption of IFRS 9 has had the following real-world effects:
- Increased provisions: Particularly on long-term loans, now for losses immediately.
- Sophisticated models: Sophisticated credit risk modeling by means of data analytics, macroeconomic projections, and probability assessments.
- Additional disclosures: Which necessitates proper documentation and audit trails.
Organizations must ensure that their internal processes, policies, and controls are capable of dealing with the requirements of IFRS 9.
Conclusion
IFRS 9 impairment is a significant change in the way financial institutions and corporates need to measure credit risk. In moving from an incurred loss model to an expected loss model, it captures financial risk timelier and better. Although more judgment, data, and disclosure is required under the standard, overall financial reporting transparency and strength are improved.
Adoption and implementation of IFRS 9 impairment are significant, not merely to be in line with the requirements but also to support good decision-making and risk management in the current volatile financial environment.