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IND-AS: The Expected Credit Loss Model

Published on Wed, Jul 29,2015 | 18:50, Updated at Wed, Jul 29 at 18:50Source : Moneycontrol.com 

By: Charanjit Attra, Partner in a member firm of EY Global

During the financial crisis, it was observed that there was a weakness in the existing accounting standards on recognition of credit losses on loans (and other financial instruments) as the existing incurred loss model delayed the recognition of credit losses till the occurrence of a trigger event. Accordingly the International Accounting Standards board introduced the expected credit loss model which forms a critical part of IND-AS 109 on financial instruments and is expected to have a significant impact on the financial results of reporting entities.

IND-AS 109 requires entities to recognise loss allowances on loans (and other financial assets) at an amount equal to the lifetime expected credit loss or the 12 month expected credit loss based on the increase in the credit risk of the borrower. The standard prescribes a dual measurement approach that reflects the general pattern of deterioration or improvement in the credit quality of financial instruments.

An entity is required to recognise a credit loss allowance of 12-month expected losses on the initial recognition of a financial asset, except when the simplified approach is applied. Subsequently, 12-month expected losses are replaced by lifetime expected losses if the credit risk increases significantly since initial recognition (the lifetime expected credit losses criterion). The credit losses allowance or provision will revert to 12-month expected losses if the credit quality subsequently improves and the lifetime expected credit losses criterion is no longer met.

Lifetime expected credit losses are required to be estimated based on the present value of all expected cash shortfalls over the remaining life of the financial instrument. Lifetime expected credit losses are an expected present value measure of losses that arise if a borrower defaults on their obligation throughout the life of the financial instrument. They are the weighted average credit losses with the probability of default as the weight.

12-month expected credit losses are the portion of lifetime expected credit losses that represent the expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date. It is not the expected cash shortfalls over the next twelve months as it is the effect of the entire credit loss on an asset weighted by the probability that this loss will occur in the next 12 months. Also it is also not the credit losses on assets estimated to actually default in the next 12 months.

Credit loss (ie cash shortfall) arises even if the entity expects to be paid in full but later than when contractually due because expected credit losses consider the amount and timing of payments. Credit losses are required to be computed based on the present value of all cash shortfalls. Expected credit losses are an estimate of credit losses over the life of the financial instrument. Accordingly, an entity should consider the following for measuring expected credit losses,:

(a) the probability-weighted outcome: expected credit losses should represent neither a best or worst-case scenario. Rather, the estimate should reflect the possibility that a credit loss occurs and the possibility that no credit loss occurs;

(b) the time value of money: expected credit losses should be discounted to the reporting date; and

(c) reasonable and supportable information that is available without undue cost or effort.

An entity is required to use reasonable and supportable information that is available at the reporting date without undue cost or effort, and that includes information about past events, current conditions and forecasts of future conditions.

Although the model is forward-looking, historical information is always considered to be an important anchor or base from which to measure expected credit losses. However, historical data should be adjusted on the basis of current observable data to reflect the effects of current conditions and forecasts of future conditions.

IND-AS 109 requires lifetime expected credit losses to be recognised when there are significant increases in credit risk since initial recognition. Expected credit losses are updated at each reporting date for new information and changes in expectations even if there has not been a significant increase in credit risk.

When credit is first extended the initial creditworthiness of the borrower and initial expectations of credit losses are taken into account in determining acceptable pricing and other terms and conditions. As such, recognising lifetime expected credit losses from initial recognition disregards the link between pricing and the initial expectations of credit losses.

A true economic loss arises when expected credit losses exceed initial expectations (ie when the lender is not receiving compensation for the level of credit risk to which it is now exposed). Recognising lifetime expected credit losses after a significant increase in credit risk better reflects that economic loss in the financial statements.

The assessment of whether lifetime expected credit losses should be recognised is based on a significant increase in the likelihood or risk of a default occurring since initial recognition. Generally, there will be a significant increase in credit risk before a financial asset becomes credit-impaired or an actual default occurs.

IND-AS 109 does not mandate the use of an explicit probability of default to make this assessment. An entity may apply various approaches when assessing whether the credit risk on a financial instrument has increased significantly. An entity should consider reasonable and supportable information that is available without undue cost or effort when determining whether the recognition of lifetime expected credit losses is required.

Credit risk analysis is a multifactor and holistic analysis—whether a specific factor is relevant, and its weight compared to other factors will depend on factors such as the type of product, characteristics of the financial instruments and the borrower.

Assessment of significant increases in credit risk may be done on a collective basis, for example on a group or sub-group of financial instruments. This is to ensure that lifetime expected credit losses are recognised when there is a significant increase in credit risk even if evidence of that increase is not yet available on an individual level.

Lifetime expected credit losses are expected to be recognised before a financial instrument becomes delinquent. Typically, credit risk increases significantly before a financial instrument becomes past-due or other lagging borrower-specific factors (for example, a modification or restructuring) are observed.

However, depending on the nature of the financial instrument and the credit risk information available, an entity may not be able to identify significant changes in credit risk for individual financial instruments before delinquency. It may be necessary to group financial instruments to capture significant increases in credit risk on a timely basis (such as by identifying particular geographical regions that have been most adversely affected by changing economic conditions).

Regardless of the way in which an entity assesses significant increases in credit risk, there is a rebuttable presumption that the credit risk on a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due.

The rebuttable presumption is not an absolute indicator, but is presumed to be the latest point at which lifetime expected credit losses should be recognised even when using forward-looking information.

The standard however provides an exception for purchased or originated credit-impaired financial assets ie; financial assets that already have objective evidence of impairment on their origination or acquisition. Accordingly for purchased or originated impaired financial assets No credit loss allowance will be provided on day one as the initial lifetime expected credit losses are required to be reflected in a credit-adjusted effective interest rate (EIR). Subsequently, a credit loss allowance is recognised based on changes in lifetime expected losses following initial recognition. A gain may be recognised if favourable changes result in the lifetime expected losses estimate being lower than the original estimate that is incorporated in the EIR. IND-AS 109 also provides a simplified approach is also introduced for trade receivables and lease receivables.

Under the standard, except for credit-impaired financial assets, interest revenue is required to be calculated using the effective interest method on the gross carrying amount, unless there is objective evidence of impairment at the reporting date. If such evidence exists, an entity will instead calculate the interest revenue based on the carrying amount net of the credit loss allowance in subsequent reporting periods

In addition, under IND-AS 109 the same impairment model is applied to all financial instruments that are subject to impairment accounting. This includes financial assets classified as amortised cost and fair value through other comprehensive income, lease receivables, trade receivables, and commitments to lend money and financial guarantee contracts.
The impairment has to be computed in the following three stages

Stage 1
As soon as a financial instrument is originated or purchased, 12-month expected credit losses are recognised in profit or loss and a loss allowance is established. This serves as a proxy for the initial expectations of credit losses. For financial assets, interest revenue is calculated on the gross carrying amount (ie without adjustment for expected credit losses).

Stage 2
If the credit risk increases significantly and the resulting credit quality is not considered to be low credit risk, full lifetime expected credit losses are recognised. Lifetime expected credit losses are only recognised if the credit risk increases significantly from when the entity originates or purchases the financial instrument. The calculation of interest revenue on financial assets remains the same as for Stage 1.

Stage 3
If the credit risk of a financial asset increases to the point that it is considered credit-impaired, interest revenue is calculated based on the amortised cost (ie the gross carrying amount adjusted for the loss allowance). Financial assets in this stage will generally be individually assessed. Lifetime expected credit losses are still recognised on these financial assets

If a financial instrument is determined to have low credit risk at the reporting date an entity may assume that the credit risk of the financial instrument has not increased significantly since initial recognition.

Credit risk is considered low if the financial instrument has a low risk of default, the borrower has a strong capacity to meet its contractual cash flow obligations in the near term and adverse changes in conditions in the longer term may, but will not necessarily reduce the ability of the borrower to fulfil its obligations.

An example of a low credit risk instrument is one that has an investment grade rating (although an external rating grade is not a prerequisite for a financial instrument to be considered low credit risk)

The main objective of the new impairment requirements is to provide users of financial statements with more useful information about an entity’s expected credit losses on financial instruments. The model requires an entity to recognise expected credit losses at all times and to update the amount of expected credit losses recognised at each reporting date to reflect changes in the credit risk of financial instruments.

This model is forward-looking and it eliminates the threshold for the recognition of expected credit losses, so that it is no longer necessary for a trigger event to have occurred before credit losses are recognised. Consequently, more timely information is required to be provided about expected credit losses. The requirements in IND AS 109 broaden the information that an entity is required to consider when determining its expectations of credit losses.

Specifically, IND-AS 109 requires an entity to base its measurement of expected credit losses on reasonable and supportable information that is available without undue cost or effort, and that includes historical, current and forecast information.

The expected loss impairment model would apply to loans, debt securities, and trade receivables measured at amortised cost or at FVOCI. The model is also intended to apply to lease receivables, irrevocable loan commitments and financial guarantee contracts not accounted for at FVPL.
 
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