Consider a financial instrument asset accounted for at amortized cost in accordance with IAS 39. The allowance rules under IAS 39 mean:
- No loss is allowed to be recognized when a financial instrument is initially recorded; and
- After initial recognition, a loss is allowed only if (i) there is objective evidence of impairment; and (ii) that evidence has to be due to a past event (that is, after the asset was recognized and before the balance sheet date).
Therefore, losses as a result of future events, even events that have already occurred in the period subsequent to the report date, are not allowed to be included in the provision.
An impairment loss under IFRS is calculated as the difference between the present value of the future cash flows expected from the asset (discounted at the effective interest rate) and its carrying amount at the report date.
The above criteria for recognizing an impairment loss under Accounting Standards for Private Enterprises (ASPE) is consistent, in that an entity must only consider “whether a significant adverse change has occurred during the period in the expected timing or amount of future cash flows.”
When the new IFRS 9 is adopted, which is for years commencing after January 1, 2018 at the latest, the loss provision will look quite different and the new standard will mean a significant divergence in IFRS from ASPE.
Without getting bogged-down in the details, under IFRS 9:
- An impairment allowance is recognized for all financial instrument assets, and not just after their initial recognition. For an asset recognized on the last day of the reporting period, an impairment allowance is also required to be set up.
- The impairment loss calculated is based on the credit risk, or more accurately changes in credit risk, since the asset was initially recognized:
- If the credit risk has not increased significantly since the asset was recognized, then the allowance set up is equal to the 12-month expected credit loss.
- If the credit risk has increased significantly, then the allowance is equal to the lifetime expected credit loss.
- The assessment of changes in credit risk between initial recognition and the report date is based on the change in the risk of default occurring over the expected life of the asset, and that assessment must consider:
- reasonable and supportable information;
- including forward looking information;
- that is available without undue cost or effort; and
- that is indicative of significant increases in credit risk.
- If reasonable and supportable information is available, an entity cannot rely solely on past-due information.
- There is a rebuttable presumption that risk has increased significantly when contractual payments are more than 30 days past due.
Our observations of the new impairment rules are:
- Recognition of impairments under the new rules are aligned with the business model and the pricing of risk.
- The new test is future looking, which is explicitly disallowed under the current rules.
- Furthermore, the impairment must be based on ‘evidence,’ so there has to be some fact or information that proves or corroborates the impairment – management cannot hide behind an estimate.
- In looking for indicative information entities are required to look for data that is correlated with historical losses and to use that information in IFRS 9 loss allowances. For example, if there is an upswing in unemployment rates in advance of increased credit losses historically, then forecasts of future unemployment could be identified as the relevant forward looking information on which to base impairment losses under IFRS 9.
When entities are adopting the new rules in a downward economic cycle impairment losses could be expected to increase. Clearly, however, this depends on what factors an entity identifies as being correlated with its historic losses.