FRS 109 – Expected Credit Losses

The impairment requirement under FRS 109

In 2014, the International Accounting Standards Board (IASB) issued IFRS 9 Financial Instruments to replace IAS 39 Financial Instruments: Recognition and Measurement, which was subsequently issued by the Singapore Accounting Standards Council (ASC) as Financial Reporting Standards (FRS) 109 Financial Instruments. This standard introduces an expected credit loss (ECL) impairment approach that eliminate the threshold that was in IAS 39. FRS 109 applies for annual periods beginning on or after 1 January 2018.

FRS 39, as adopted by the ASC, requires recognition of an impairment loss on a financial asset only when it has been incurred as triggered by events providing objective evidence that the financial asset is impaired. However, this approach resulted in ‘too little too late’ impairment recognition which became apparent during the global financial crisis. Thus, IASB intend to simplify and provide more timely information on impairment loss by introducing a more forward looking impairment approach. The new approach requires an entity to recognise ECL at all times and to update the amount of ECL recognised at each reporting date to reflect changes in the credit risk of financial instruments.

Recognition of expected credit losses

General approach

Under the FRS 109 expected credit loss general approach, three impairment stages are introduced which intends to reflect the deterioration in the credit quality of the financial instrument: stage 1 recognises the “12-month expected credit losses” and stages 2 and 3 recognises the full “lifetime expected credit losses”.

Stage 1

(e.g. performing loans)

12-month expected credit losses are recognised as soon as a financial instrument is originated
Stage 2

(e.g. under-performing loans)

Full lifetime expected credit losses are recognised if the credit risk of a financial asset increases significantly and the resulting credit quality is not considered to be low credit risk
Stage 3

(e.g. non-performing loans)

If the credit risk of a financial asset increases to the point that it is considered credit-impaired the full lifetime expected credit losses continue to be recognised. The financial assets in this stage will generally be individually assessed

 

The 12-month expected credit losses is defined as a portion of the lifetime expected credit losses resulting from default events on a financial instrument that are occurring within the next 12 months after the reporting date.

 

FRS 109 include examples to illustrate the application of the recognition and measurement requirements. We have included below one of the examples for illustration purposes.

Example 1: Estimating expected credit losses

 

Entity A originates a single 10 year amortising loan for CU1 million. Taking into consideration the expectations for instruments with similar credit risk (using reasonable and supportable information that is available without undue cost or effort), the credit risk of the borrower, and the economic outlook for the next 12 months, Entity A estimates that the loan at initial recognition has a probability of default (PD) of 0.5 per cent over the next 12 months. Entity A also determines that changes in the 12-month PD are a reasonable approximation of the changes in the lifetime PD for determining whether there has been a significant increase in credit risk since initial recognition.

 

At the reporting date (which is before payment on the loan is due), there has been no change in the 12-month PD and Entity A determines that there was no significant increase in credit risk since initial recognition. Entity A determines that 25 per cent of the gross carrying amount will be lost if the loan defaults. Entity A measures the loss allowance at an amount equal to 12-month expected credit losses using the 12-month PD of 0.5 per cent. Implicit in that calculation is the 99.5 per cent probability that there is no default.

 

At the reporting date the loss allowance for the 12 month expected credit losses is CU1,250 (0.5% × 25% × CU1,000,000).

 

The lifetime expected credit losses are the expected shortfalls in contractual cash flows, taking into account the potential for default at any point during the life of the financial instrument.

 

In determining whether credit risk has increased significantly since initial recognition, an entity will need to rely on reasonable and supportable forward-looking information that is available without undue cost or effort, such as past due status, to assess the change in the risk of default on the financial asset.

 

FRS 109 include examples to illustrate the application of the recognition and measurement requirements. We have included below one of the examples for illustration purposes.

Example 2: Assessing increases in credit risk based on probability of default

 

Entity B acquires a portfolio of 1,000 five year bullet loans for CU1,000 each (i.e. CU1million in total) with an average 12-month PD of 0.5 per cent for the portfolio. Entity B determines that because the loans only have significant payment obligations beyond the next 12 months, it would not be appropriate to consider changes in the 12-month PD when determining whether there have been significant increases in credit risk since initial recognition. At the reporting date, Entity B therefore uses changes in the lifetime PD to determine whether the credit risk of the portfolio has increased significantly since initial recognition.

Entity B determines that there has not been a significant increase in credit risk since initial recognition and estimates that the portfolio has an average loss given default (LGD) of 25 per cent. Entity B determines that it is appropriate to measure the loss allowance on a collective basis. The 12-month PD remains at 0.5 per cent at the reporting date. Entity B therefore measures the loss allowance on a collective basis at an amount equal to 12-month expected credit losses based on the average 0.5 per cent 12-month PD. Implicit in the calculation is the 99.5 per cent probability that there is no default. At the reporting date the loss allowance for the 12-month expected credit losses is CU1,250 (0.5% × 25% × CU1,000,000).

 

Simplified approach for trade receivables, contract assets and lease receivables

 

FRS 109 includes the following simplifications which means the entity is not required to determine whether credit risk has increased significantly since initial recognition.

 

Trade receivables and contract assets (within the scope of FRS 115 Revenue from Contracts with Customers) of one year or less or that do not contain significant financial component The entity shall always measure the loss allowance at an amount equal to lifetime expected credit losses, i.e. the simplified approach
Trade receivables and contract assets that contain significant financial component in accordance with FRS 115 The entity is allowed to choose as its accounting policy the simplified approach or the full three-stage model
Lease receivables (within the scope of FRS 17 Leases) The entity is allowed to choose as its accounting policy the simplified approach or the full three-stage model

 

Under the simplified approach, entities will recognise the lifetime expected credit losses from the first reporting period. These are the expected credit losses over the term of the receivables which closely resemble the ‘general’ doubtful debt provisioning methods used prior to the adoption of IFRS as can be illustrated from Example 3 where Company M recognises a provision of CU45,000 on its CU15 million trade receivables that are not past due, which would not be recognised under the current FRS 39.

FRS 109 include examples to illustrate the application of the recognition and measurement requirements. We have included below one of the examples for illustration purposes.

Example 3: Use of provision matrix

 

Company M, a manufacturer, has a portfolio of trade receivables of CU30 million in 20X1 and operates only in one geographical region. The customer base consists of a large number of small clients and the trade receivables are categorised by common risk characteristics that are representative of the customers’ abilities to pay all amounts due in accordance with the contractual terms. The trade receivables do not have a significant financing component in accordance with FRS 115.

 

To determine the expected credit losses for the portfolio, Company M uses a provision matrix. The provision matrix is based on its historical observed default rates over the expected life of the trade receivables and is adjusted for forward-looking estimates. At every reporting date the historical observed default rates are updated and changes in the forward-looking estimates are analysed.

 

On that basis, Company M estimates the following provision matrix:

 

  Default rate
Current 0.3%
1–30 days past due 1.6%
31–60 days past due 3.6%
61–90 days past due 6.6%
More than 90 days past due 10.6%

 

The trade receivables from the large number of small customers amount to CU30 million and are measured using the provision matrix.

  Gross carrying amount Lifetime expected credit loss allowance (Gross carrying amount x lifetime expected credit loss rate)
Current CU15,000,000 CU45,000
1–30 days past due CU7,500,000 CU120,000
31–60 days past due CU4,000,000 CU144,000
61–90 days past due CU2,500,000 CU165,000
More than 90 days past due CU1,000,000 CU106,000
  CU30,000,000 CU580,000

 

What now?

 

As FRS 109 is effective 1 January 2018, companies will need to start gathering information about existing contracts in order to assess the credit quality, estimate the probability of default and to decide whether how to group them together based on credit profile. Management will also need to review the standard’s impact on its financial ratios.

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