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Impairment under IFRS 9: A Cross-Functional Challenge
15-May-2019
The advent of IFRS 9 Financial Instruments has impacted the business world profoundly. One of the most challenging and contentious provisions of the standard is the recognition of expected credit losses (ECL) for the impairment on financial assets. Formerly under IAS 39, credit losses were only recognized to the extent that there was objective evidence of impairment. In other words, a loss event needed to have occurred, before an impairment loss could be recognized. But IFRS 9 introduces a new impairment model based on ECL, resulting in the recognition of a loss allowance before the loss event occurs. Under this approach, entities require to book ECL based on its historic default rates, adjusting for current conditions with forward-looking macro-economic information. IMPACT ON BANKING SECTOR IFRS 9 prescribes two approaches for recognizing and measuring the ECL, namely, General Approach and Simplified Approach. General Approach is largely applicable to banks and financial institutions.
This approach outlines a 'three-stage' model for impairment based on changes in credit quality since initial recognition to compute '12-month loss' or 'lifetime loss'. Banks for many years have been subject to Basel Accords and have been using credit risk-weighted assets to test capital adequacy. Hence for them the infrastructure to compute the ECL has already been in place.
The data, models and the processes used for risk disclosure can now be used for ECL computation with necessary fine-tuning and be incorporated into the financial statements. IMPACT ON NON-BANKING SECTOR This is not the case for all other nonbanking businesses, which have to use the Simplified Approach to compute ECL on trade receivables, due from related parties, cash and bank balances. Though the standard prescribes lifetime ECL under the Simplified Approach, it provides neither any model nor methodology to compute the ECL. Unlike the banks, these entities do not have their own models nor any data structure to compute ECL. However, IFRS 9 provides very vaguely that ECL shall reflect an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes; time value of money; and forecasts of future economic conditions. Moreover, IFRS 9 does not directly define the term 'default'. Instead it provides that there is a rebuttable presumption that default does not occur later than when a financial asset is 90 days past due unless an entity has reasonable and supportable information to demonstrate that a more lagging default criterion is more appropriate.
As entities generally face a huge delay in collection these days, they invariably rebut this presumption to justify a delay as long as one or two years. COMPLEX SIMULATIONS IFRS 9 does not directly prescribe how the simplified approach is to be applied to determine ECL, instead it provides a practical expedient to use a provision matrix.
A provision matrix might specify fixed provision rates depending on the number of days a trade receivable is past due. But IFRS 9 remains silent on how to compute these rates used in the provision matrix.
The standard also requires the estimate of ECL to reflect an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes. In practice, this may be a complex exercise involving detailed simulations of multiple scenarios.
Another requirement for ECL computation is the adjustment for forward-looking macroeconomic factors such as property prices, commodity prices, etc. This may involve applying intricate statistical models which fall outside the scope of accounting function. CROSS-FUNCTIONAL APPROACH Thus, the impairment provisions under IFRS 9 require a cross-functional approach synthesizing finance and risk methodologies. Ironically finance function is driven by facts and figure while risk function is driven by stochastic statistics making ECL computation all the more complex.
As the management is bracing itself to meet these challenges for the first time in the preparation of financial statements, they invariably seek the help of external consultants. In the coming years, they should be in a position to build their own models and data structure with in-house skillset to comply with the requirements of ECL under IFRS 9.
Oman Daily Observer
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