What is the new Expected Credit Loss Model
What is the new ECL Model?
Ind AS 109 is the converged version of IFRS 9, as it stood as of 24 July, 2014 when the revised IFRS 9 was announced by the International Accounting Standards Board (IASB). It is pertinent to note that the IASB agreed to disagree with Financial Accounting Standards Board (FASB), the US counterpart. As per the new requirement, it is no longer necessary for a credit event to have occurred before credit losses are recognised. As per the revised requirements, an entity should always account for the expected credit losses and changes in those expected credit losses. The amount of expected credit losses is computed at each reporting period to reflect changes in the credit risk since initial recognition. This is expected to provide more timely information about the expected credit losses as opposed to ‘incurred credit loss model’ which provide for the loss allowance that was considered to be too little and too late.
The expected credit loss is required to be applied on day one for all types of financing assets. The expected credit losses are the present value of all cash short falls over the expected life of the financial instrument. It is the weighted average of credit losses with the respective risks of a default occurring as the weights. The credit loss is the difference between all contractual cash flows that are due to an entity as per the contract and all the cash flows that the entity expects to receive, discounted at the original effective interest rate. For estimating the cash flows, the entity should consider all contractual terms of the financial instrument, e.g., pre-payment, extension, call or other similar options throughout the expected life of that financial instrument. For this purpose, the cash flow includes cash flows from the sale of collateral held or other credit enhancements that are integral to the contractual terms. There is also a presumption that the expected life of the financial instrument can be estimated reliably. Where it is not possible to reliably estimate the expected life of the financial instrument, the entity should use the remaining contractual term of the financing instrument.
As per the new impairment model, the impairment losses would be recognised even for financial assets that are newly originated or acquired. It may be noted that this is significantly different from the requirements outlined in the predecessor standard namely IAS 39 which requires the impairment losses to be recognised only upon the occurrence of the credit event.
Overview of the impairment model
The accounting standard requires entities to estimate and account for expected credit losses for all financial assets. This estimation happens when the financial asset is first originated. For the purpose of measuring the expected credit losses, the entity should use all relevant information available, of course, without undue cost or effort. The effect of this requirement is that for the purpose of considering the expected credit losses the entity should use not only the historical losses and other relevant current information, but should also apply judgments in using reasonable and supportable forward looking information. This is a marked change from the previous requirements where the impairment losses are considered based on the incurred credit losses without considering any forward looking information available with the entity. Effectively, this means that the recognition of impairment which was criticised is being too little and too late is now dispensed with and a more realistic provision for impairment loss is recognised even before the occurrence of any apprehended credit event, even though it may be futuristic.
For the purpose of providing impairment loss, the new requirement treats all financial assets on the same footing irrespective of their classification. The effect of this improvement is that it does away with the confusion caused for providing impairment loss based on different parameters depending upon how the financial asset is classified, eg, market rates or contractual cash flows, etc. The new impairment model ensures that the measurement of impairment will be the same regardless of the type of financial asset held or the way it is classified.
As per the new requirement, the key factor for providing impairment loss is now based on whether the financial asset is performing as expected or not, which means that the changes in the credit risk of the financial instrument plays a significant role in determining the impairment loss.
At the first stage, a portion of the expected credit loss is recognised on day one for all financial assets. This is calculated as the present value of cash short falls occurring over the entire life of the asset with the weighted probability of the default happening over the next 12 months. The cash short falls represent the difference between the expected contractual cash flows as reduced by the expected cash flows. During this stage, the interest revenue is recognised based on the gross carrying value of the financial asset by applying the effective interest rate.
In the second stage – during subsequent reporting periods – the financial instrument is assessed to find out if there has been a significant increase in the credit risk since it was first acquired. If so, the impairment loss is recognised as the present value of cash short falls occurring over the entire life of the asset with the probability weighted default occurring over the entire life of the asset. In this stage also, interest revenue is recognised based on applying the effective interest rate to the gross carrying value of the asset.
In the third stage when an apprehended credit event occurs and the financial asset actually becomes credit impaired, the impairment loss is computed in the same way as in stage two. However, the interest revenue in this stage is recognised by applying the effective interest rate to the amortised cost of the financial asset which is the gross carrying value as reduced by the impairment loss allowance.
Scope of the impairment requirements
The following instruments are within the scope of Ind AS 109:
Financial assets that are debt instruments measured at amortised cost or at fair value through other comprehensive income. These instruments include loans, trade receivables and other debt securities like financial guarantee contract.
- Loan commitments issued by the entity that are not measured at fair value through profit or loss.
- Lease receivables that are within the scope of Ind AS 116.
- Contract assets that are within the scope of Ind AS 115.
Out of Scope
- Equity investments
- Loan commitments that are issued by the entity that are measured at fair value through profit or loss.
- Other financial instruments that are measured at fair value through profit or loss.
It is pertinent to note that Ind AS 109 has a single impairment model that applies to all financial instruments within its scope. As per the previous version of IFRS 9, viz, IAS 39, there were different models for assets classified as held-to-maturity (amortised cost), available-for-sale debt instruments and available for sale equity instruments and equity instruments measured at fair value through profit or loss. Impairment on account of loan commitments and financial guarantee contracts were accounted for under IAS 37. However, the impairment loss now is aligned with the credit risk on loans and other financial guarantees thereby creating uniformity for accounting purposes as well.
As per Ind AS 109, financial assets classified as FVOCI and financial assets classified as at amortised cost are treated in the same way for the purpose of applying the impairment model.
Investments in equity instruments that are measured either at FVTPL or FVOCI are now outside the scope of Ind AS 109. Accordingly, the equity investments are not tested for impairment any longer. The concept of recognising the impairment loss when the equity investments are subject to significant or prolonged decline in their fair value is now not relevant. This has been criticised on the ground that the test of other than temporary impairment (OTTI) is difficult to apply in practice.
Significant or prolonged decline in the fair value of investments
As per Para 41 of Ind AS 28, the impairment requirement is applicable to the entity’s other interests in the associate or joint venture that are in the scope of Ind AS 109 and that do not constitute part of a net investment. In other words, the Standard requires the use of certain criteria for considering impairment losses where there is an objective evidence for impairment for a net investment in an associate or joint venture. The criteria include the combined effect of several events that may have caused the impairment. In particular, the criteria of a significant or prolonged decline in the fair value of an investment in an equity instrument below its cost is also an objective evidence of impairment in respect of the investment in equity instruments of an associate or joint venture of the entity.
Impairment testing for debt instruments – FVOCI
Debt instruments that are classified as fair value through other comprehensive income are also subjected to impairment test. This is because while the financial asset classified as FVOCI is shown in the balance sheet at fair value, the changes in the fair value of such instruments are taken to the other comprehensive income.
Fair valuing a debt instrument does not consider the impairment of the instrument. Fair value of a debt instrument is arrived at by discounting of the contractual cash flows at the current interest rate and recognising the differences in fair value in other comprehensive income. However, impairment loss allowance is required to be calculated based on the present value of the cash short falls expected to occur over the entire life of the instrument based on the probability of default (PD) occurring over the next 12 months which essentially is a forward looking model.
The loss allowance is taken to the profit and loss account and may even be a write back of the loss allowance depending upon the changes in the expected cash short falls. It should be noted that the impairment loss allowance is not considered while computing fair value of the instrument, and hence, debt instruments that are classified and measured at fair value through other comprehensive income are subjected to impairment testing.
Impairment practices prohibited by Ind AS 109
It is usual to find certain practices hitherto observed by entities for recognising losses on certain financial assets. The following are some of the extant practices that are expressly prohibited by the new impairment requirements of Ind AS 109.
- To recognise a provision based on a pre-defined percentage of accounts receivable as provision for loss from financial assets.
- To recognise either on ad-hoc absolute value or a pre-defined percentage in respect of the expected cash short falls on non-performing assets.
- To sustain interest accruals based on the performance or otherwise of financial assets.
- To recognise an impairment loss which has the effect of providing a loss allowance greater than the impairment loss allowance computed as per the new requirements of impairment. In other words, the profit and loss account cannot be debited with an amount in excess of the impairment loss allowance to be provided based on the requirements of Ind AS 109. The corollary of this is that the carrying amount of the financial assets cannot be reduced by more than the loss allowance determined as per the impairment requirements.