This blog is written by Mr. Zahid Mehmood, ACA, FCCA, Partner, Khilji and Co. Please read this blog and provide your valued comments.
- In July 2014, the International Accounting Standards Board (IASB) issued IFRS 9 “Financial Instruments effective for annual periods beginning on or after July 01, 2018.
- In Pakistan, the Standard was adopted and notified by Securities and Exchange Commission of Pakistan (SECP) as effective for accounting periods beginning on or after July 01, 2018. Later on to facilitate implementation, subsequently the SECP through SRO 229 (14-02-2019) modified the effective date for applicability of IFRS 9 as ‘Reporting period / Year ending on or after June 30, 2019 (earlier application is permitted).
- Furthermore, through SRO 985(I)/2019 (02-09-2019) , in respect of companies holding financial assets due from the Government of Pakistan, the requirements contained in “IFRS 9 (Financial Instruments) with respect to application of Expected Credit Losses method” shall not be applicable till 30th June, 2021, provided that such companies shall follow relevant requirements of IAS 39 – Financial Instruments: Recognition and Measurement, in respect of above referred financial assets during the exemption period.
- SBP has vide BPRD Circular 4 of 2019 (October 23, 2019) has notified IFRS 9 for banks, DFIs and MFBs effective from January 1, 2021.
- One of the key difference between IAS 39 and the new IFRS 9 is that the new standard requires a recognition of credit loss allowances on initial recognition of financial assets based on expected loss model, whereas previously under IAS 39, impairment is recognized at a later stage, when a credit loss event has occurred. The new model applies to debt instruments, loans, lease receivables, contract receivables, and trade receivables and to off balance sheet credit exposures such as financial guarantees and loan commitments.
- There are two approaches under the Standard to calculate the amount of expected credit loss:
- The approach is mostly applied by financial institutions for long term financial assets.
- In general approach, there are 3 stages of a financial asset and the impairment loss should be recognized depending on the stage of a financial asset in question.
- For credit exposures for which there has not been a significant increase in credit risk since initial recognition, entities are required to provide for default events that are possible within next twelve months (Stage 1 ECL).
- For credit exposure where there has been a significant increase in credit risk since initial recognition, loss allowance is required for credit losses expected over remaining life of the exposure, irrespective of timing of default (Stage 2 ECL).
- The credit exposure which are impaired the loss is provided for on the basis of best estimate of estimated future cash flows (Stage 3 ECL).
- The simplified approach does not require the tracking of credit risk but instead requires the recognition of life time ECL for all receivables. This approach is relevant for non-financial sector trade receivables / contract receivables which do not contain significant financing component.
- In simplified approach, there is no need to determine the stage of a financial asset because the impairment loss is measured at lifetime ECL for all assets.
- IFRS 9 permits using a few practical expedients and one of them is a provision matrix.
- Provision matrix is a calculation of the impairment loss based on the default rate percentageapplied to the group of financial assets.
- There are two important elements:
- Group of financial assets e.g. receivables may be grouped into retail customers (individuals) are less reliable and slower in payments than business customers (companies). Or, maybe you sell in a few geographical regions and you noted that customers from the capital city pay more reliably than customers in the rural areas. Depending on the circumstances, below are some of suggestion for segmenting:
- By product type;
- By geographical region;
- By currency;
- By customer rating;
- By dealer type or sales channel; etc
The important point here is that the customers within one group should have the same or similar loss patterns.
- Default rates
Default rates should be derived from historical credit loss experience which need to adjust for forward-looking information.
- The period of selection should not be too short in order to make sense and it also should not be too long because market changes quickly and long period might incorporate market effects that are no longer valid.
- They are all information that could affect the credit losses in the future, for example macroeconomic forecasts of unemployment, housing prices, etc.
- The historical default rates should be adjusted for the information that is relevant for the financial assets. For example, unemployment rates are important factor affecting the payment rate of individual customers.
- There is choice of either of the approach for the following financial assets:
- Trade receivables WITH significant financing component,
- Contract assets under IFRS 15 WITH significant financing component, and
- Lease receivables (IAS 17 or IFRS 16)
- One entity can apply both of the models but not for the same type of financial assets.
Zahid Mehmood, ACA, FCCA