In the second of our 'IFRS 9 explained' series we introduce the change in impairment model that IFRS 9 brings about and take a look at when the simplified approach to impairment can be applied.
Under IAS 39: Financial Instruments: Recognition and Measurement, financial assets such as trade receivables, loan receivables and investments are subject to different impairment rules depending on how they are classified. Trade receivables, for example, are impaired under IAS 39 when there is objective evidence of a loss. In practice, most entities monitor the age profile of these balances and recognise an impairment only when there is objective evidence of default or a particular balance is past due beyond a certain point.
How will this change on adoption of IFRS 9?
Under IAS 39, an entity only considers those impairments that arise as a result of incurred loss events. The effects of possible future loss events cannot be considered, even when they are expected.
IFRS 9 introduces a new expected credit loss (‘ECL’) model which broadens the information that an entity is required to consider when determining its expectations of impairment. Under this new model, expectations of future events must be taken into account and this will result in the earlier recognition of larger impairments.
There are two main approaches to applying the ECL model. The general approach involves a three stage approach and introduces some new concepts such as ‘significant increase in credit risk’, ‘12-month expected credit losses’ and ‘lifetime expected credit losses’. IFRS 9 recognises that implementing these requirements can be complex in practice and, therefore, entities are permitted (and in some cases are required) to apply a simplified approach to trade receivables, contract assets and lease receivables.
What does applying the simplified approach look like?
Under the simplified approach, there is no need to monitor for significant increases in credit risk and entities will be required to measure lifetime expected credit losses at all times. However, impairments will still be higher because historical provision rates will need to be adjusted to reflect relevant, reasonable and supportable information about future expectations.
Is there a choice?
The standard requires the application of the simplified approach to trade receivable and contract assets that do not contain a significant financing component. There is an accounting policy choice when it comes to finance lease receivables, operating lease receivables, and trade receivables and contract assets that do contain a significant financing component. The accounting policy for these four may be selected independently of one another. An entity cannot apply the simplified approach to any other type of financial asset.
For help and advice on accounting for financial instruments please contact Dan Taylor.
See also IFRS 9 Explained – Available For Sale Financial Assets
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