Every business that reports under IFRS has financial instruments. Reporting under IFRSs will be impacted by the new standard on financial instruments, IFRS 9 that has an effective date of 1 January 2018.
The major impact of FRS 9 arises from its new impairment model. IFRS 9 provides more visibility for credit risk management as compared to its IAS 39. Under IFRS 9 a single set of impairment requirements applies to all financial instruments in the scope of IFRS 9 that are not accounted for at Fair Value through Profit or Loss (FVPL). Hence, financial assets that are debt instruments measured at amortized cost or at fair value through other comprehensive income will be under the scope of impairment that include financial assets such as debt securities, loans and advances, trade receivables etc.
Impairment model of IFRS 9
IFRS 9 has replaced the incurred loss model of IAS 39 (the standard that it is replacing) with expected credit loss (ECL) model; and introduces ECLs over the entire life of financial instruments from the date of initial recognition (i.e. from day one).
Financial instruments carrying a low credit risk at the reporting date after their initial recognition shall be considered for 12-month ECLs (Stage 1) and a loss allowance would be measured, while still these financial assets would remain 'performing' or 'standard' or 'active' or 'good' financial assets.
Under IFRS 9 it will be vital to carefully monitor for deterioration of credit quality (i.e. any significant increase in credit risk) over lifetime of financial instruments (Stage 2) as it changes from Stage 1 to Stage 2, while such financial assets are sometimes referred to as 'under-performing' financial assets.
While credit-impaired financial instruments include financial assets that have objective evidence of impairment at the reporting date which are also labelled as 'non-performing' or 'bad' financial assets and shall be considered for Stage 3 impairment loss recognition.
A simplified approach is available for trade receivables, contract assets (under IFRS 15) and lease receivables (under IAS 17) to directly consider for lifetime ECLs (Stage 2) while contract assets and lease receivables with significant financing component may choose to recognize ECLs from Stage 1.
The ECL model of impairment is forward-looking, for example it is possible to consider anticipated risk and provision for higher losses in the future. In practice, this depends a lot on the availability and relevance of forward-looking (macro-economic) data. The requirements address the change in specific credit risk profile of a debt instrument.
Implementation of IFRS 9 will not only affect the calculation of ECL allowances but also increase the volatility of profit or loss due to anticipated impairments.
IFRS 9 implementation challenges
It is therefore important for key management personnel to understand and manage the business-wide impact of these changes on product design and pricing strategies, departments' operational efficiency, capital and ultimately the impact on shareholders value. For financial institutions, the changes may result in demand for the enhancement of capital.
Although, the impairment approach is sound and robust at a conceptual level, in reality, there are multiple implementation challenges especially for the financial institutions that will have to be addressed such as:
- Significant deterioration and link to more than 30 days past due rebuttable presumption
- 90 days past due rebuttable presumption of default
- Reflecting macro-economic forecast factors into quantitative estimates of ECL
- Estimating an IFRS 9 based probability of default (particularly for financial institutions)
- Development of practical expedient for low credit risk financial assets (and portfolios)
- Application to modified debt instruments and credit-impaired financial assets
- Complexity in data and its availability for reporting and disclosures
Adopting the ECL model of impairment will significantly increase transparency (such as through enhanced credit risk disclosures) and benefit users of financial statement and stakeholders, besides bringing long-term benefits on the credit risk management.
Arqam Ayubi, Director, Crowe Horwath Oman