The IFRS 9 Expected Credit Loss (ECL) model requires entities to consider how uncertain economic events, such as Brexit, could affect credit risk and ECL provisions. At the time of writing, it is expected that the ‘meaningful vote’ by the UK Parliament on the Brexit negotiations will take place in mid-January 2019. This gives rise to considerable additional uncertainty for entities preparing financial statements as at 31 December 2018.
Incorporating forward-looking information
At each reporting date, IFRS 9 requires that reasonable and supportable forward-looking information must be considered when assessing whether there has been a significant increase in credit risk (relevant for the general approach) and when measuring ECL (relevant for the general, simplified and purchased or originated credit-impaired approaches). While banks and other financial institutions are most significantly affected by the ECL requirements, corporates will also be affected. For example, trade receivables and contract assets will typically be subject to the simplified approach and related company loan receivables or issued financial guarantees will be subject to the general approach.
The ECL model requires that entities should calculate a probability-weighted measure of credit losses, which means that a range of different future economic scenarios will typically need to be considered. This is because the additional credit losses (or increases in credit risk) that arise in a downside scenario will often be greater than the reduced credit losses (or decreases in credit risk) in the equivalent upside scenario (ie the relationship between economic scenarios and credit losses - or credit risk - is often non-linear). In these cases, using only the most likely future scenario will not be sufficient. This requirement applies to both the general and simplified approaches.
Considering more than one scenario
In some cases, entities may obtain macro-economic forecasts that are based on a central or most likely economic scenario, for example, assuming a smooth Brexit as opposed to a disorderly ‘no-deal’ Brexit. As a matter of course, those entities would be expected to give due consideration to other possible upside and downside scenarios in order to ensure that their ECL provision is a probability-weighted measure of credit losses.
Given the lack of clarity around the Brexit negotiations as at 31 December 2018, management should pay particular attention to the requirement to consider other scenarios, such as a ‘no-deal’ Brexit and how this might affect the estimation of credit losses. This is important because even though a ‘no-deal’ Brexit may still be a less likely outcome, it could still give rise to significantly greater credit losses or increases in credit risk than the scenario of a smooth Brexit. Determining the relative likelihood of one scenario over another will be both difficult and highly judgmental and there will likely be a range of acceptable assumptions. Management should ensure that relevant judgments are appropriately documented and take into account the information available at 31 December 2018.
With the high levels of uncertainty that existed at 31 December 2018, management should also ensure that they include appropriate entity-specific disclosures in accordance with IFRS 7 in the 2018 financial statements. For example, entities should disclose the inputs, assumptions and estimation techniques used in applying the ECL model and should explain how forward-looking, macro-economic information has been incorporated. Significant estimates and judgments arising as a result of Brexit-related uncertainty should also be appropriately disclosed in accordance with IAS 1.
As significant Brexit-related uncertainty existed at 31 December 2018, and assuming that negotiations will continue in 2019, entities need to exercise their judgment in determining whether post year-end developments are considered to be adjusting or non-adjusting events in accordance with IAS 10.
This could be a challenging area as it may be difficult to determine which subsequent events provide evidence of conditions existing at 31 December 2018 and which are indicative of conditions that arose after that date. For example, if a decision is taken in early 2019 to exit the EU on a ‘no-deal’ basis, it would be considered a non-adjusting post balance sheet event because it would not be appropriate to remove the uncertainty that existed as at 31 December 2018 from the year-end ECL calculation.
However, it may be more difficult to conclude on other more subtle post-balance sheet developments as some might be argued to simply provide an indication of the status of the negotiations at the balance sheet date and thus provide evidence over the reasonableness of assumptions made at that date. Significant judgment may be required in these circumstances and management should ensure that this is appropriately disclosed.
Entities preparing financial statements as at 31 December 2018 should ensure that they give due consideration to Brexit-related uncertainties when calculating ECL provisions. This will be a challenging area for all entities and management should ensure that their assumptions and judgments are appropriately documented, especially when determining whether post year-end developments are considered to be adjusting or non-adjusting events. Careful consideration should also be given to the clarity and adequacy of disclosures.
For help and advice on IFRS 9, please get in touch with your usual BDO contact or Dan Taylor.