4.4 Impairment of financial assets

Financial assets can lose value, and accounting rules help track these losses. This section covers how to spot and measure impairment using the Expected Credit Loss model. It's a key part of managing financial instruments and their risks.

The rules differ based on how assets are classified and measured. For some, you'll use a three-stage model, while others need simpler approaches. Understanding these methods is crucial for accurate financial reporting and risk assessment.

Impairment Models for Financial Assets

Expected Credit Loss (ECL) Model Overview

• IFRS 9 introduced ECL model replaced incurred loss model from IAS 39
• ECL model requires entities to recognize expected credit losses at all times
• Entities must update expected credit loss amounts at each reporting date
• Three main approaches for measuring expected credit losses
  • General approach
  • Simplified approach
  • Credit-adjusted effective interest rate approach

General Approach: Three-Stage Model

• Based on changes in credit quality since initial recognition
• Stage 1: 12-month ECL for financial instruments without significant increase in credit risk
• Stage 2: Lifetime ECL for financial instruments with significant increase in credit risk
• Stage 3: Lifetime ECL for credit-impaired financial assets
• Movement between stages based on relative credit risk changes

Simplified and Credit-Adjusted Approaches

• Simplified approach used for trade receivables, contract assets, and lease receivables
  • Always recognize lifetime ECL
  • Typically utilizes provision matrix based on historical loss rates
• Credit-adjusted effective interest rate approach applied to purchased or originated credit-impaired assets
  • Incorporates lifetime ECL into effective interest rate calculation
  • Used for assets already credit-impaired at initial recognition (distressed debt)

Indicators of Impairment

Financial Distress and Market Indicators

• Significant financial difficulty of issuer or borrower indicates potential impairment
  • Negative cash flows, declining revenues, increasing losses
• Breach of contract signals possible impairment
  • Default on payments, violation of debt covenants
• Disappearance of active market for financial asset due to financial difficulties
  • Sudden illiquidity of previously traded bonds
  • Delisting of company shares from stock exchange

Lender Concessions and Economic Factors

• Lender granting concessions to borrower due to economic or contractual reasons related to financial difficulties
  • Debt restructuring, extended payment terms, interest rate reductions
• Observable data indicating measurable decrease in estimated future cash flows
  • Changes in economic conditions correlating with defaults (rising unemployment, industry downturns)
  • Negative changes in borrower's credit rating
• For equity instruments, significant or prolonged decline in fair value below cost
  • Market price consistently below purchase price for extended period (6-12 months)
  • Substantial price drop (20-30% below cost)

Impairment Methodology for Financial Assets

Amortized Cost and Fair Value Through Other Comprehensive Income (FVOCI)

• Financial assets measured at amortized cost subject to general or simplified approach for ECL calculation
  • Loans, held-to-maturity investments
• Debt instruments measured at FVOCI follow general approach for ECL calculation
  • Impairment gains or losses recognized in profit or loss
  • Carrying amount not reduced in statement of financial position
• Equity instruments measured at FVOCI not subject to impairment accounting
  • All fair value changes recognized in other comprehensive income

Fair Value Through Profit or Loss (FVTPL) and Off-Balance Sheet Items

• Financial assets measured at FVTPL do not require separate impairment assessment
  • Fair value changes inherently reflect credit risk (trading securities, derivatives)
• Loan commitments and financial guarantee contracts not measured at FVTPL subject to ECL model
  • Consider exposure period for ECL calculation
  • May require recognition of provision liability
• Impairment methodology must align with asset classification and characteristics
  • Ensures appropriate risk assessment and loss recognition

Impairment Loss Recognition

Calculation Methods

• For amortized cost assets, impairment loss calculated as difference between:
  • Asset's carrying amount
  • Present value of estimated future cash flows discounted at original effective interest rate
• General approach: Calculate 12-month ECL (Stage 1) or lifetime ECL (Stages 2 and 3)
  • Consider multiple economic scenarios and probability-weighted outcomes
• Simplified approach: Calculate lifetime ECL using provision matrix
  • Based on historical credit loss experience
  • Adjusted for forward-looking factors (economic forecasts, industry trends)

Recognition and Presentation

• Recognize impairment losses through loss allowance account
  • Presented as reduction of gross carrying amount in statement of financial position
• For FVOCI debt instruments, recognize impairment loss in profit or loss
  • Corresponding adjustment to other comprehensive income
  • No reduction in carrying amount on statement of financial position
• Subsequent changes in expected credit losses recognized as impairment gain or loss in profit or loss
• For credit-impaired assets, calculate interest revenue using effective interest rate on amortized cost
  • No longer use gross carrying amount for interest calculation