AASB 9 and the Expected Credit Loss Model

AASB 9 introduces a significant change in the way impairment is calculated and recognised compared to previous requirements.  This has created confusion as to how to apply these requirements to financial assets of organisations.  This article provides practical guidance for entities struggling to apply the new requirements.

Three approaches to impairment exist under AASB 9:
  • The general approach;
  • The simplified approach; and
  • The originated credit impaired approach
 
The general approach

The general approach establishes a three-stage model whereby:

Stage 1
 
  • No increase in credit risk since initial recognition
  • Recognise 12 months of expected credit losses
  • Interest calculated on the gross carrying value
Stage 2
 
  • Significant increase in credit risk since initial recognition
  • Recognise a lifetime of expected credit losses
  • Interest calculated on the gross carrying value
Stage 3
 
  • Objective evidence of impairment at reporting date
  • Recognise a lifetime of expected credit losses
  • Interest calculated on the net carrying value (i.e. gross value less loss allowance)
There is no prescribed approached to calculating expected credit losses except it should be based on:
 
  • Reasonable and supportable evidence
  • A probability-weighted amount (which considers all possibilities)
  • Incorporating the time value of money

Therefore, if a delay in payments (or realising collateral on a loan) is predicted then this will result in an expected credit loss when the time value of money is considered.

Other practical issues include:
 
  • What is the difference between 12 months and a lifetime of expected credit losses?
  • What events trigger an increase in credit risk?

What is the difference between 12 months and a lifetime of expected credit losses?

For example, a 3-year $100,000 loan may have a 2% chance of default in the first 12 months and a 4% chance of default in the 2nd and 3rd years combined.
 
  • 12 months of expected credit losses would be 2%*100,000 = $2,000
  • A lifetime of expected credit losses would be 2%*100,000 + 4% * 100,000 = $6,000

What events trigger an increase in credit risk?

Paragraph 5.5.11 states that there is a rebuttable presumption that the credit risk on a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due. Paragraph B5.5.17 contains a non-exhaustive list of other information that may be relevant in assessing changes in credit risk, some examples of these are:
 
  • changes in the rates or terms of an existing financial instrument that would be significantly different if the instrument was newly originated or issued at the reporting date (such as more stringent covenants, increased amounts of collateral or guarantees, or higher income coverage)
  • other market information related to the borrower, such as changes in the price of a borrower’s debt and equity instruments.
  • existing or forecast adverse changes in business, financial or economic conditions that are expected to cause a significant change in the borrower’s ability to meet its debt obligations, such as an actual or expected increase in interest rates or an actual or expected significant increase in unemployment rates.
  • an actual or expected significant change in the operating results of the borrower. Examples include actual or expected declining revenues or margins, increasing operating risks, working capital deficiencies, decreasing asset quality, increased balance sheet leverage, liquidity, management problems or changes in the scope of business or organisational structure (such as the discontinuance of a segment of the business) that results in a significant change in the borrower’s ability to meet its debt obligations.
  • an actual or expected significant adverse change in the regulatory, economic, or technological environment of the borrower that results in a significant change in the borrower’s ability to meet its debt obligations, such as a decline in the demand for the borrower’s sales product because of a shift in technology.
 
Paragraph 5.5.10 allows an entity may assume that the credit risk on a financial instrument has not increased significantly since initial recognition if the financial instrument is determined to have low credit risk at the reporting date.  Financial instruments are considered low risk for the purposes of paragraph 5.5.10, if the financial instrument has a low risk of default, the borrower has a strong capacity to meet its contractual cash flow obligations in the near term and adverse changes in economic and business conditions in the longer term may, but will not necessarily, reduce the ability of the borrower to fulfil its contractual cash flow obligations (p. B5.5.22).
 
The simplified approach

The simplified approach requires an entity to always measure the loss allowance at an amount equal to lifetime expected credit losses (p 5.5.15). 
This approach is mandated for the following items that do not contain a significant financing component:
 
  • trade receivables;
  • contract assets that result from transactions that are within the scope of AASB 15
This approach is optional for the following items that do contain a significant financing component:
 
  • trade receivables;
  • contract assets; and
  • lease receivables.
According to p 5.5.16 an entity may select its accounting policy for trade receivables, lease receivables and contract assets independently of each other.

Whilst it makes sense to require short term trade receivables to be assessed using the simplified approach (12 month versus a lifetime of losses will be the same in most cases) the issue is how to assess these expected credit losses.  Is a general allowance acceptable?

Most entities are likely to apply the practical expedient of calculating of the expected credit losses on trade receivables using a provision matrix. Under this approach an entity would use its historical credit loss experience to estimate the lifetime of expected credit losses. Whilst this sounds simple a general % is unlikely to be enough.  The matrix would need to consider:
 
  • the ageing of the receivables;
  • sub groupings of its customer base say into:
    • geographical region;
    • customer rating;
    • collateral or trade credit insurance;
    • wholesale or retail;
    • industry;
    • product type; and
    • size.
  • If using historical data current conditions must be considered, such changes in:
    • economic conditions;
    • changes in unemployment rates;
    • changes in property prices;
    • changes in commodity prices; and
    • methodology and assumptions used for estimating expected credit losses to reduce any differences between estimates and actual credit loss experience.

It remains to be seen how small to medium business will cope with these additional requirements imposed by AASB 9.
 
The originated credit impaired approach

The paper does not go into detail regarding this approach other than to highlight that AASB 9 states:
  • that for purchased or originated credit-impaired financial assets an entity shall only recognise the cumulative changes in lifetime expected credit losses since initial recognition as a loss allowance for purchased or originated credit-impaired financial assets at each reporting date (p 5.5.13);
  • at each reporting date, an entity shall recognise in profit or loss the amount of the change in lifetime expected credit losses as an impairment gain or loss. An entity shall recognise favourable changes in lifetime expected credit losses as an impairment gain, even if the lifetime expected credit losses are less than the amount of expected credit losses that were included in the estimated cash flows on initial recognition (p 5.5.14); and
  • gains are not limited to the reversal of previously recognised losses.