IFRS 9 Explained – the new expected credit loss model

In this article, we take a look at the new expected credit loss (ECL) model for impairment which may result in earlier recognition of impairment charges.

Currently

Under IAS 39, provisions for credit losses are measured in accordance with an incurred loss model. This results in credit losses being recognised only once there has been an incurred loss event. Entities are prohibited from taking into account expectations of future credit losses. In addition, different impairment models are applied to financial assets measured at amortised cost, debt instruments classified as available for sale and equity instruments classified as available for sale.

How will this change on adoption of IFRS 9?

IFRS 9 replaces the existing incurred loss model with a forward-looking ECL model. Entities will now be required to consider historic, current and forward-looking information (including macro-economic data). This will result in the earlier recognition of credit losses as it will no longer be appropriate for entities to wait for an incurred loss event to have occurred before credit losses are recognised. IFRS 9 also expands the scope of the impairment requirements – for example, certain issued loan commitments and financial guarantees will now be within the scope of these new requirements. In addition, in contrast to the position under IAS 39, all instruments within the scope of the new impairment requirements will be subject to the same single ECL model. However, there are three different approaches to applying that new model:

The ‘simplified approach’ which is applied to trade receivables, contract assets and lease receivables. This approach was covered in the April 2017 edition of Business Edge.
The ‘general approach’ which is applied to all financial assets classified at amortised cost or fair value through other comprehensive income for debt (other than those that fall in 3 below) as well as issued loan commitments and financial guarantees that are within the scope of the new requirements.
The ‘purchased or originated credit impaired approach’ which is applied to financial assets that are credit impaired at initial recognition.

How does the general approach to ECL work?

Under the general approach, an entity must determine whether the financial asset is in one of three stages in order to determine both the amount of ECL to recognise as well as how interest income should be recognised.

Stage 1 is where credit risk has not increased significantly since initial recognition. For financial assets in stage 1, entities are required to recognise 12 month ECL and recognise interest income on a gross basis – this means that interest will be calculated on the gross carrying amount of the financial asset before adjusting for ECL.

Stage 2 is where credit risk has increased significantly since initial recognition. When a financial asset transfers to stage 2 entities are required to recognise lifetime ECL but interest income will continue to be recognised on a gross basis.

Stage 3 is where the financial asset is credit impaired. This is effectively the point at which there has been an incurred loss event under the IAS 39 model. For financial assets in stage 3, entities will continue to recognise lifetime ECL but they will now recognise interest income on a net basis. This means that interest income will be calculated based on the gross carrying amount of the financial asset less ECL. The table below summarises the general approach.

	*Stage 1*	*Stage 2*	*Stage 3*
*Recognition of ECL*	12 month ECL	Lifetime ECL	Lifetime ECL
*Recognition of interest*	EIR on gross carrying amount	EIR on gross carrying amount	EIR on net carrying amount

Which entities are likely to be affected?

While it is widely accepted that the major impact of the new ECL model will be felt by financial institutions with large lending portfolios, it also affects both the timing of recognition and the measurement of bad debt provisions by corporate entities. For example, trade receivables, third party and intercompany loans, investments in government bonds and issued loan commitments and financial guarantees will all be within the scope of the new requirements with ECL being recognised.