Further to our earlier explanation of IFRS 9 (click here to read), our analyst Shalini Tibe comments on the exposure draft of IFRS 9. We hope the information is useful to you.

Exposure Draft (ED) proposes to replace Incurred Loss Model for the assessment of impairment of financial assets measured at amortized cost currently included in IAS 39 with Expected Loss Approach that enables earlier recognition of credit risk.

Incurred Loss Model has been criticized because of following reasons:

 Expected losses are implicit in initial measurement of assets but are not taken into account when determining the Effective Interest rate used for subsequent measurement.

This results in a systematic overstatement of interest revenue in the period before a loss event occurs. In effect, subsequent impairment losses are in part reversals of inappropriate revenue recognition in earlier periods.

If suppose ABC Bank has given loan of Rs.100, 000 @ of 10 percent P.A. for 5 years then following will the schedule for interest repayment:

Year Interest to be accounted

in P & L a/c (Rs.)
1 10,000
2 10,000
3 10,000
4 10,000
5 10,000

 

Under Incurred loss approach 10 percent interest rate includes expected loss factor which is accounted in Profit and Loss account as interest revenue.

Impairment loss is accounted only after a loss trigger is indicated. Thus there is an overstatement of interest revenue in the period before a loss event occurs.  

.

Thus ED has come out with Expected Loss Approach.

 

Expected Loss Approach (ELA)

  •  An entity would have to estimate the expected credit losses over the life of asset on initial measurement of the asset.
  •  No gain or loss would be recognized at inception of the asset.
  •  The expected credit loss would be incorporated into Effective Interest rate (EIR) and consequently reduces EIR.
  • Expected Cash flows (ECF) have to be determined at each measurement date and any gain or loss on subsequent reassessment would have to be recognized immediately in statement of Comprehensive income i.e. Profit and Loss a/c.

 

The proposed impairment model of ELA generates changes in Effective Interest rate (EIR) to include Expected loss rate in EIR calculation. Mingling of credit risk and credit rate would be difficult and costly to implement and generate significant operational challenges when it comes to practical implementation.

The operational aspects of applying the expected loss approach that requires historical information may not be available with all the entities.

ED proposes that Expected cash flows may be estimated on a Portfolio basis or on Individual basis.

A financial asset can be moved from Portfolio basis to Individual basis or vice versa. Whatever basis chosen, it shall provide the best estimate of Expected cash flow as per ED.

In case of Portfolio basis, Financial assets shall be grouped with similar credit risk characteristics that are indicative of the debtors ability to pay all the contractual amounts when due.

Amount of Expected credit loss would be more reliable when determined on portfolio basis and when based on statistical assessment. Loan portfolio contains a global credit risk exposure that can be estimated with certainty where as for each individual loan granted it will remain unpredictable.

Practically also expected losses can be determined at portfolio level. Because when we are looking at portfolio having similar credit risk characteristics, we can determine that some contractual cash flow will not be received although it may not be known at that point of time which specific asset will not perform.

In contrast entities in respect of individual loan at inception will estimate that it will receive full contractual payment over its term.

Thus International Accounting Standard Board (IASB) shall consider applying Expected loss model on portfolio basis.

IASB plans to issue final standard on amortized cost and impairment in the forth quarter of 2010. However the IFRS implementation date for is January 1, 2013.

 

Author: CA Shalini Tibe