IFRS 9 requires recognition of impairment losses on a forward-looking basis, which means that impairment loss is recognised before the occurrence of any credit event. These impairment losses are referred to as expected credit losses (‘ECL’).
In general, impairment losses are recognised on receivables, loan commitments and financial guarantee contracts (see detailed list).
Three approaches to impairment
Overview of the three approaches to impairment
IFRS 9 sets out three approaches to impairment:
- general approach,
- simplified approach for certain trade receivables, contract assets and lease receivables,
- specific approach for purchased or originated credit-impaired financial assets.
The general IFRS 9 approach to impairment follows a three stage model (sometimes referred to as three-bucket model):
As we can see, under the general approach, an entity recognises expected credit losses for all financial assets. ECL can be 12-month ECL or lifetime ECL depending on whether there was a significant increase in credit risk (IFRS 126.96.36.199).
Changes in the loss allowance are recognised in P/L as impairment gains/losses (IFRS 188.8.131.52).
To assist entities that have less sophisticated credit risk management systems, IFRS 9 introduced a simplified approach under which entities do not have to track changes in credit risk of financial assets (IFRS 9.BC5.104). Instead, lifetime ECL are recognised from the date of initial recognition of a financial asset (IFRS 184.108.40.206).
The simplified approach is required for trade receivables or contract assets that result from transactions that are within the scope of IFRS 15 and do not contain a significant financing component (or are accounted for under the one-year practical expedient as per IFRS 15.63). For trade receivables or contract assets that do contain a significant financing component, it is the entity’s choice to apply simplified approach. Similarly, the entity can choose to apply simplified approach to lease receivables accounted for under IFRS 16 (IFRS 220.127.116.11). See also the practical approach to simplified loss rate approach (provision matrix).
Specific approach for purchased or originated credit-impaired financial assets
IFRS 9 sets out a specific approach for purchased or originated credit-impaired financial assets (often abbreviated to ‘POCI’ assets). For these assets, entity recognises only the cumulative changes in lifetime ECL since initial recognition of such an asset (IFRS 18.104.22.168-14). Purchased or originated credit-impaired financial asset is an asset that is credit-impaired on initial recognition (IFRS 9.Appendix A).
It is important to note that an asset is not credit impaired merely because it has high credit risk at initial recognition (IFRS 9.B5.4.7).
See the section on measurement of ECL below that expands points mentioned above.
Measurement of expected credit losses (ECL)
Definition of credit losses
Credit loss is the difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flows that the entity expects to receive, discounted at the original effective interest rate (EIR) or credit-adjusted EIR (IFRS 9.Appendix A).
Cash flows used in ECL measurement
When estimating cash flows for ECL measurement, the entity takes into account (IFRS 9.Appendix A):
- expected life of a financial instrument,
- all contractual terms of the financial instrument (e.g. prepayment, extension, call and similar options),
- collaterals held,
- other credit enhancements integral to the contractual terms.
Lifetime expected credit losses (ECL)
Lifetime ECL are ECL that result from all possible default events over the expected life of a financial instrument (IFRS 9.Appendix A). Lifetime ECL are therefore the present value of the difference between (IFRS 9.B5.5.29):
- the contractual cash flows that are due to an entity under the contract; and
- the cash flows that the entity expects to receive.
See this example.