IFRS 9 – Impairment of Financial Instruments

In my previous article I covered the basic principles of IFRS 9, the new standard on Financial Instruments.

Now, I think it’s time to elaborate on the new impairment model, which will have a huge impact on the banking sector.

During the examination of the financial crisis a key issue arose; the delayed recognition of credit losses. The problem with IAS 39 is based on the fact that it follows the so called ‘incurred loss model’, i.e., credit losses are not recognized until a credit loss event occurs.

IFRS 9 came to fix that with the implementation of a new forward looking impairment model, the so called ‘expected loss model’.

The expected credit loss model applies to:

  • Debt instruments recorded at amortized cost or at fair value through other comprehensive income;
  • Lease receivables;
  • Contract assets; and
  • Loan commitments and financial guarantee contracts that are not measured at FVTPL.

In applying the IFRS 9 impairment requirements, an entity needs to follow one of the approaches below:

  1. The general approach;
  2. The simplified approach;
  3. The purchased or originated credit-impaired approach.

General approach

Under the general approach credit losses should be recognized in three stages:

  • Stage 1 – On initial recognition. Credit losses recognized will be based on the 12-month expected credit losses. Calculation of effective interest will be based on the gross carrying amount.
  • Stage 2 – When credit risk increases significantly (rebuttable presumption if > 30 days past due*). Credit losses recognized will be based on lifetime expected credit losses. Calculation of effective interest will be based on the gross carrying amount
  • Stage 3 – When objective evidence of impairment exists at the reporting date. Credit losses recognized will be based on lifetime expected credit losses. Calculation of effective interest will be based on the carrying amount net of allowance for credit losses

The changes in the loss allowance balance are recognized in profit or loss as an impairment gain or loss.

Note: It may not be practical to determine for every financial instrument whether there has been a significant increase in credit risk, consequently, it may be necessary to assess ECLs on a collective basis.

*Typically, credit risk increases significantly before a financial instrument becomes past due. On the other hand, an entity can rebut the presumption if it has information that demonstrates that credit risk has not increased significantly even though contractual payments are more than 30 days past due (e.g. a missed non-payment is because of administrative oversight rather than financial difficulty of the borrower).

Lifetime expected credit losses

IFRS 9 defines lifetime ECLs as the ECLs that result from all possible default events over the expected life of a financial instrument (i.e., an entity needs to estimate the risk of a default occurring on the financial instrument during its expected life). The ECLs would be estimated as the difference between:

  • The contractual cash flows that are due to an entity under the contract; and
  • The cash flows that the holder expects to receive

12-month expected credit losses

12-month ECLs is defined as a portion of the lifetime ECLs that results from default events on a financial instrument that are possible within 12 months after the reporting date. The standard explains further that the 12-month ECLs are a portion of the lifetime ECLs that will result if a default occurs in the 12 months after the reporting date, weighted by the probability of that default occurring.


Example 1

ABC Bank originates 100 bullet loans with a total gross carrying amount of $2.000.000. ABC bank segments its portfolio into borrower groups (Groups D and E) on the basis of shared credit risk characteristics at initial recognition.

Group D – 60 loans with a total gross carrying amount $1.300.000.

Group E – 40 loans with a total gross carrying amount $700.000.

In order to develop its loss rates, ABC Bank considers samples of its own historical default and loss experience for those types of loans. In addition, it considers forward-looking information, and updates its historical information for current economic conditions.

At the reporting date, ABC Bank determines that there is not a significant increase in credit risk since initial recognition for the portfolios. On the basis of its forecasts, ABC Bank measures the loss allowance at an amount equal to 12-month expected credit losses as follows:

GROUPCarrying AmountLoss RatePV of Observed Loss
D$1.300.0000,5%$6.500
E$700.0000,6%$4.200

Simplified approach

The simplified approach does not require an entity to track the changes in credit risk, but, instead, requires the entity to recognize a loss allowance based on lifetime ECLs at each reporting date, right from origination.

An entity is required to apply the simplified approach for trade receivables or contract assets that result from transactions within the scope of IFRS 15 and that do not contain a significant financing component.

However, an entity has a policy choice to apply either the simplified approach or the general approach for the following:

  • All trade receivables or contract assets that result from transactions within the scope of IFRS 15 and that contain a significant financing component in accordance with IFRS 15.
  • All lease receivables that result from transactions that are within the scope of IAS 17.

Purchased or originated credit-impaired approach

On initial recognition of a financial asset, an entity is required to determine whether the asset is ‘credit-impaired’.

A financial asset is credit-impaired when one or more events that have a detrimental impact on the estimated future cash flows of that financial asset have occurred:

  • Significant financial difficulty of the issuer or the borrower;
  • A breach of contract, such as a default or past due event;
  • The lender(s) of the borrower, for economic or contractual reasons relating to the borrower’s financial difficulty, having granted to the borrower a concession(s) that the lender(s) would not otherwise consider;
  • It is becoming probable that the borrower will enter bankruptcy or other financial reorganization;
  • The disappearance of an active market for that financial asset because of financial difficulties;
  • The purchase or origination of a financial asset at a deep discount that reflects the incurred credit losses.

For financial assets that were credit-impaired on purchase or origination, in subsequent reporting periods an entity is required to recognise:

  • The cumulative changes in lifetime ECLs since initial recognition as a loss allowance;
  • In profit or loss, the amount of any change in lifetime ECLs as an impairment gain or loss. An impairment gain is recognised if favourable changes result in the lifetime ECLs estimate becoming lower than the original estimate that was incorporated in the estimated cash flows on initial recognition when calculating the credit-adjusted EIR.

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