IFRS 9 (ii): impairment of financial assets

Banks and companies lend money and sell on credit, and some borrowers do not pay. The old rule waited until a loss had actually happened before recording it. By then, the damage was done and the lender’s profits had been overstated for years. International Financial Reporting Standard (IFRS) 9 changed this. It asks the lender to look ahead.

From the day a loan or a receivable is recorded, the lender sets aside an allowance for the credit losses it expects, and increases it as the borrower’s position worsens.

This topic covers the expected credit loss model: what it applies to, the definitions, the three stages, how a significant increase in credit risk is assessed, how the loss is measured, the simplified approach, assets bought or originated already credit-impaired, undrawn commitments, presentation and disclosure. The previous topic covered classification and measurement. The next topic covers hedge accounting.

Key terms in plain English

Syllabus check

IFRS 9 is examinable under syllabus area B (financial assets). This topic covers:

• the impairment model and the three stages;
• measurement of expected credit losses and the simplified approach;
• credit-impaired and purchased or originated credit-impaired assets;
• presentation and disclosure.

CAMA 2020 and impairment of financial assets

The Companies and Allied Matters Act 2020 (CAMA 2020) requires statements that follow IFRS and give a true and fair view.

What the model applies to

• financial assets at amortised cost;
• debt assets at fair value through other comprehensive income (not equity);
• lease receivables (IFRS 16) and contract assets (IFRS 15);
• loan commitments not at fair value through profit or loss; and
• financial guarantee contracts within IFRS 9.

Equity investments and assets at fair value through profit or loss are not tested. Their fair value already shows any loss.

The three-stage general approach

On day one an allowance equal to 12-month expected credit loss is recognised. At each reporting date the entity reassesses the stage. If credit risk improves, the asset moves back to Stage 1.

Significant increase in credit risk

Compare the risk of default over the expected life at the reporting date with the risk at initial recognition, using reasonable and supportable information available without undue cost or effort (past events, current conditions and forecasts). The assessment is relative, not an absolute rating level.

There are two rebuttable presumptions: credit risk has increased significantly if payments are more than 30 days past due, and default is presumed to occur no later than when payments are 90 days past due (a backstop). An instrument with low credit risk at the reporting date (for example investment grade) may be assumed not to have increased significantly.

Credit-impaired

Evidence includes significant financial difficulty of the borrower, a breach of contract such as default or being past due, a concession granted because of the borrower’s difficulty, probable bankruptcy, the disappearance of an active market because of financial difficulty, and purchase at a deep discount that reflects incurred credit losses.

Measuring expected credit loss

The measure must be:

1. unbiased and probability-weighted, from a range of outcomes (not the best or worst case);
2. discounted at the original effective interest rate (or credit-adjusted rate for purchased or originated credit-impaired assets); and
3. based on reasonable and supportable information, including forecasts of future conditions.

A credit loss can arise even if the entity expects to be paid in full, if payment is expected later than the contract requires, because of the time value of money. Collateral and credit enhancements that are part of the contract and enforceable are taken into account. For a simple exposure:

Expected credit loss = probability of default × loss given default × exposure at default, discounted.

The simplified approach

For trade receivables and contract assets that have no significant financing component, the entity must recognise lifetime expected credit loss from the start. There is no need to track the stages. For trade receivables and contract assets with a significant financing component, and for lease receivables, the entity chooses this approach as a policy.

A provision matrix applies loss rates, based on history and adjusted for current and forward-looking information, to ageing buckets.

Purchased or originated credit-impaired assets

These have a credit-adjusted effective interest rate that already includes the expected credit losses in the expected cash flows. There is no day-one allowance. Afterwards only the cumulative changes in lifetime expected credit loss since initial recognition are recognised as an allowance. A favourable change is an impairment gain.

Undrawn commitments, presentation and write-off

• Loan commitments follow the same stages. Stage 1 uses the 12-month expected loss on the part expected to be drawn. Stage 2 uses lifetime expected loss. The loss on a commitment is shown as a provision.
• The allowance for an asset at amortised cost is a contra-asset that reduces the gross carrying amount. For a debt asset at fair value through other comprehensive income (FVOCI) the carrying amount stays at fair value. The impairment expense goes to profit or loss and the allowance is accumulated in other comprehensive income.
• Write-off: the gross carrying amount and the allowance are reduced when there is no reasonable expectation of recovering the asset. A write-off is a derecognition event.
• Movements in the allowance are recognised in profit or loss as an impairment loss or gain.

Disclosure

IFRS 7 requires a reconciliation of the opening to the closing loss allowance by class, an explanation of the inputs, assumptions and estimation techniques, the definitions of default and write-off, credit risk management practices, and information on collateral and credit enhancements.

The rules in more depth

Why the model is forward-looking

Waiting for a loss meant that losses appeared late, in a crisis, when it was too late to build reserves. The model recognises a loss earlier and in line with the credit risk the lender is bearing.

Why interest changes to the net basis in Stage 3

For an asset that is already credit-impaired, interest on the gross amount would include income that the lender does not expect to collect.

Why the effective rate ignores expected losses

The effective rate comes from contractual cash flows. Expected losses are recorded in the allowance. Doing both would count them twice.

Judgement and ethics

The model needs judgement: the staging threshold, probabilities and forecasts. An entity could delay moving assets to Stage 2 or adjust forecasts to lift profit. Accountants must apply the assumptions faithfully and document them.

Effect on analysis

Loss allowances can be large for banks. Analysts check the proportion in Stage 2 and 3, the coverage ratio (allowance divided by gross exposure) and the movement in the charge.

Worked examples

1. Stage 1 (12-month):
   ₦1,000,000 × 40% × 2% × 0.9259 = ₦7,407.
2. Stage 2 (lifetime):
   ₦400,000 × (0.02 × 0.9259 + 0.03 × 0.8573 + 0.04 × 0.7938) = ₦400,000 × 0.07599 = ₦30,396.
3. If the loan moves from Stage 1 to Stage 2, the allowance rises by ₦22,989. Dr impairment loss (profit or loss) ₦22,989; Cr loss allowance ₦22,989. Interest stays on the gross amount.

Dr impairment expense ₦11,500; Cr loss allowance ₦11,500 (adjusted for any opening allowance).

Net effect on profit or loss over the life = 1.00 + 0.50 − 0.30 − 1.20 = nil, because no loss occurred. Interest income each year is on the gross amount, and the allowance does not change the effective rate.

Note: ICAN’s journal summary for this bond labels the year 1 increase as an impairment gain and the later releases as impairment losses. An increase in the allowance is always a loss and a decrease is a gain, so ours is slightly different from ICAN’s. In the exam, label the direction clearly.

1. Expected cash flows.
   year 3 ₦70,000 × 60% = ₦42,000.
   Year 4 ₦1,070,000 × 60% = ₦642,000.
2. Present value at 5.942%: ₦42,000 × 0.9439 + ₦642,000 × 0.8910 = ₦39,644 + ₦572,022 = ₦611,666.
3. Required allowance.
   ₦1,019,407 − ₦611,666 = ₦407,741.
   Additional charge = ₦407,741 − ₦100,000 = ₦307,741.
4. Dr impairment loss (profit or loss) ₦307,741; Cr loss allowance ₦307,741.
5. The asset is now Stage 3.
   Interest in year 3 = net carrying amount ₦611,666 × 5.942% = ₦36,345.

Note: ICAN’s journal for this example writes the financial asset down directly by ₦407,741. The lender still expects to recover 60%, so there is a reasonable expectation of recovery and the asset is not written off. The loss is recorded by increasing the loss allowance, so ours is slightly different. In the exam, use an allowance unless the question says the asset is written off.

1. Dr impairment loss (profit or loss) ₦200,000; Cr other comprehensive income (loss allowance) ₦200,000.
2. The carrying amount stays at the fair value of ₦50,000,000. No allowance is shown against the asset.

How to score full marks

• Name the approach: general (three stages) or simplified.
• State the stage and quote the evidence (change in probability of default, days past due, rating, forecasts).
• Compute the loss as probability × loss given default × exposure, discounted at the original effective rate, and show the workings.
• Say where the entry goes: profit or loss for the charge, contra-asset for amortised cost, other comprehensive income for the FVOCI allowance.
• Get the interest basis right: gross for Stages 1 and 2, net for Stage 3.
• Use the right direction: an increase in the allowance is a loss.
• Link to disclosure (reconciliation, inputs, definitions).

Common mistakes in the exam

• Waiting for a loss event before recognising any allowance.
• Using 12-month expected loss for a Stage 2 asset.
• Calculating interest on the net amount for Stages 1 and 2.
• Discounting at a market rate instead of the original effective rate.
• Ignoring forward-looking information.
• Applying the three stages to trade receivables that qualify for the simplified approach.
• Testing equity investments or assets at fair value through profit or loss.
• Labelling an increase in the allowance as a gain.
• Writing off an asset that the entity still expects to recover in part.

Quick revision

• Scope: amortised cost, debt at FVOCI, lease receivables, contract assets, commitments, guarantees.
• Stage 1: 12-month loss, interest on gross. Stage 2: lifetime loss, gross. Stage 3: lifetime loss, net.
• Presumptions: more than 30 days past due is a significant increase, more than 90 days is default.
• Measure: probability-weighted, discounted at the original effective rate, forward-looking.
• Simplified approach: lifetime loss from day one, provision matrix.
• Purchased or originated credit-impaired: credit-adjusted rate, no day-one allowance.
• FVOCI debt: expense in profit or loss, allowance in other comprehensive income.
• CAMA 2020: ss. 377(1), 378, 374(1), 385, 404(7).

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

The real ICAN paper has no multiple-choice section. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

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