Approaches for assessing credit risk

Approaches for assessing credit risk

Drivers of expected credit loss

The Standard explains that an entity may apply various approaches to determine whether the credit risk on a financial instrument has increased significantly since initial recognition or when measuring expected credit losses. The entity is also allowed to apply different approaches for different financial instruments. The approach should normally include an explicit PD as an entity. However, even where such an input is not included, the approach may still be considered to be as per the requirements of Ind AS 109 provided the entity is able to separate the changes in the risk of a default occurring from changes in other drivers of expected credit losses, such as collateral, etc. The entity in such a situation should also consider the following factors while making such assumption:

  1. The change in the risk of default occurring since initial recognition;
  2. The expected life of the financial instrument; and
  3. The reasonable and supportable information affecting the credit risk.

Changes in the 12-month risk of default

The characteristics of the financial instruments and the historically default patterns for a comparable financial instrument should be considered to identify a significant increase in credit risk. For financial instruments for which the historically default patterns are not concentrated at a specific point during the expected life of the financial instrument, changes in the 12-month risk of default may be considered to be a reasonable approximation of the changes in the lifetime risk of a default occurring.

For some financial instruments, changes in the risk of default occurring in the next 12 months may not be a suitable basis for determining whether credit risk has increased on the financial instrument with a maturity of more than 12 months. The examples provided in the Standard are as follows:

  • The financial instrument only has significant payment obligations beyond the next 12 months;
  • Changes in relevant macroeconomic or other credit-related factors occur that are not adequately reflected in the risk of a default occurring in the next 12 months; or
  • Changes in credit-related factors only have an impact on the credit risk of the financial instrument (or have a more pronounced effect) beyond 12 months.

Collateral

For the purpose of measuring expected credit losses, the estimate of expected cash shortfalls shall reflect the cash flows expected from collateral and other credit enhancements that are part of the contractual terms and are not recognised separately by the entity. The estimate of expected cash shortfalls on a collateralised financial instrument reflects the amount and timing of cash flows that are expected from foreclosure on the collateral less the costs of obtaining and selling the collateral, irrespective of whether foreclosure is probable (ie, the estimate of expected cash flows considers the probability of a foreclosure and the cash flows that would result from it). Consequently, any cash flows that are expected from the realisation of the collateral beyond the contractual maturity of the contract should be included in this analysis. Any collateral obtained as a result of foreclosure is not recognised as an asset that is separate from the collateralised financial instrument unless it meets the relevant recognition criteria for an asset in this or other Standards.

Credit loss & Treatment of POCI Assets

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 (ie, all cash shortfalls), discounted at the original effective interest rate (or credit-adjusted effective interest rate for purchased or originated credit-impaired financial assets). An entity shall estimate cash flows by considering all contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) through the expected life of that financial instrument. The cash flows that are considered shall include cash flows from the sale of collateral held or other credit enhancements that are integral to the contractual terms. There is a presumption that the expected life of a financial instrument can be estimated reliably. However, in those rare cases when it is not possible to reliably estimate the expected life of a financial instrument, the entity shall use the remaining contractual term of the financial instrument.

Treatment for POCI Assets

Purchased or originated credit impaired financial assets are financial assets that are credit impaired on initial recognition. For purchased or originated credit impaired (POCI) financial assets, an entity should recognise the cumulative changes in lifetime expected credit losses since initial recognition as a loss allowance. At each reporting date, the amount on change in lifetime expected credit losses should be recognised in the profit and loss account as an impairment gain or loss. It should be noted that an entity is entitled to recognise even favourable changes in lifetime expected credit losses as an impairment gain. In spite of the fact that the lifetime expected credit losses are less than the amount of expected credit losses that were included in the estimated cash flows on initial recognition. For POCI asset, the interest rate that should be used for computation of interest revenue should be calculated as credit adjusted effective interest rate. Credit adjusted effective interest rate is defined in the Standard as follows.

Credit-adjusted effective interest rate

The rate that exactly discounts the estimated future cash payments or receipts through the expected life of the financial asset to the amortised cost of a financial asset that is a purchased or originated credit-impaired financial asset. When calculating the credit-adjusted effective interest rate, an entity shall estimate the expected cash flows by considering all contractual terms of the financial asset (for example, prepayment, extension, call and similar options) and expected credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate, transaction costs, and all other premiums or discounts. There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be estimated reliably. However, in those rare cases when it is not possible to reliably estimate the cash flows or the remaining life of a financial instrument (or group of financial instruments), the entity shall use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments).

When an entity revises its estimates of payments or receipts, the gross carrying amount of the financial instrument is adjusted to reflect the actual and revised estimated contractual cash flows. The gross carrying amount of the financial instrument is re-calculated to reflect the present value of the estimated future contractual cash flows discounted at the financial instrument’s originally effective interest rate. In the case of purchased or originated credit impaired financial assets, the contractual cash flows are discounted using the credit adjusted effective interest rate.

Financial assets acquired at deep discount

When a financial asset is acquired at a deep discount, the financial asset may be considered to be credit impaired if the credit risk is very high at the time of purchase. In such a case, the entity is required to include the initially expected credit losses in the estimated cash flows when calculating the credit adjusted effective interest rate for POCI assets at initial recognition. However, this does not mean that a credit adjusted effective interest rate should be applied solely because the financial asset has high credit risk at initial recognition.

For a financial asset that is credit-impaired at the reporting date, but that is not a purchased or originated credit-impaired financial asset, an entity shall measure the expected credit losses as the difference between the asset’s gross carrying amount and the present value of estimated future cash flows discounted at the financial asset’s original effective interest rate. Any adjustment is recognised in profit or loss as an impairment gain or loss.

Ind AS Accounting Standards