IFRS Tip of the month

As an exception to the general model, if the credit risk of a financial instrument is low at the reporting date, the client can measure the expected credit loss (‘ECL’) using the 12-month ECL and does not have to assess if there has been a significant increase in credit risk. An important paragraph to consider in this instance is paragraph 5.5.10 of IFRS 9. 

IFRS 9 is very specific on the circumstances when a financial instrument is considered to have low credit risk and when this exception can be applied.

Audit teams need to be aware of this exception when assessing ‘low credit risk’ assumptions made by their clients.  The credit risk of a financial instrument is low in this context only if:

• The instrument has a low risk of default;
• The borrower demonstrates and has a strong capacity to meet its contractual cash flow obligation in the near term (i.e. in the short-term); and
• The lender expects that in the long term, any changes adverse in economic and business conditions, may but will not necessarily, reduce the borrower’s ability to fulfil its obligations. [IFRS 9.B5.5.22]

An example of a financial instrument that is considered to have a low risk of default would be a financial instrument with an ‘investment grade’, either determined using an internal or external rating.  IFRS 9, however, further explains that the use of an internal or external ‘investment grade’ must be in line with the globally understood definition of low credit risk for the type of financial instrument being assessed. Such a rating must also not take into account an increase in credit risk.  [IFRS 9.B5.5.23]

Be careful: low credit risk is not…

A financial instrument is not considered to have low credit risk simply because the value of collateral reduces its expected loss.  The value of collateral reduces the amount to be recovered and not the risk of default.  A financial instrument is also not considered to have low credit risk if it has a lower risk of default than other financial instruments or is lower relative to other financial instruments in the jurisdiction which the client operates in. [IFRS 9.B5.5.22]

Audit teams must also note that this exception is not an automatic trigger for the recognition of lifetime expected credit losses when at the reporting date, the financial instrument is no longer considered to be a high-quality financial instrument.  The client needs to assess the extent of increase in credit risk and recognise lifetime credit losses only when the increase since initial recognition is significant in accordance with paragraphs 5.5.9 – 5.5.11 of IFRS 9.

Paragraphs IE24 – IE28 of the IFRS 9 illustrative examples provides some illustrative examples on the low credit risk instruments.

Author

Karolina Martin, IFRS Director

02 November 2022