Financial instruments – the devil is not so black? Part 5.

Aleksandra SYSIAK
Audit Manager at RSM Poland

MSSF 9 and the impairment of receivables

Coming back to the topic of financial instruments, I present below – in the form of questions and replies – a set of crucial related issues.

Will the current financial condition of our contractors be reflected in our financial statements?

Due to the current situation being the result of the COVID-19 pandemic, it becomes necessary to consider impairment of receivables. IFRS 9 orders the analysis of future losses related to a given asset, and, therefore, we have to consider if there is an actual risk that the recognised receivables will not be paid.

As a rule, upon initial recognition of a financial asset (that is our receivable), it is measured at amortised cost (transaction price), in compliance with the requirements related to impairment. 

What is the approach to impairment in IFRS 9?

According to the general rule, the standard orders to recognise the impairment as 12-month expected credit losses – if as at the reporting date the credit risk related to a given financial asset did not increase significantly compared to the initial recognition; or as expected credit losses throughout the full lifetime, if a significant increase in credit risk can be observed (variant A).

For trade receivables the standard provides for a simplified approach, i.e. there is no obligation to conduct the abovementioned analysis of the credit risk nor measure the impairment of the expected credit losses in the amount equal to the expected credit losses throughout the full lifetime of a given receivable (variant B).

Choosing either of the above variants depends on the accepted accounting principles (policy). It should be noted that applying the general model will result in the need for more frequent monitoring of changes in the credit standing of our contractors, however, as at the initial recognition of impairment it will be lower than when using a simplified model of the provision matrix.

How to determine impairment using the provision matrix

When recognising impairment as expected credit losses it may be useful to apply a practical approach i.e. build a provision matrix. To build such a provision matrix an entity may rely on own historical data on credit losses, adjusted in certain cases by information related to the future (e.g. the impact of the COVID 19 on the operations of our contractors, crisis in the industry, change in the clients profile). To determine the expected credit losses, trade receivables should be broken down taking into account the similarity of the characteristics of the credit risk e.g. based on the manner of securing liabilities, the selling segment, or region. The below scheme is a proposed approach to determining the value of the expected credit loss.

Expected credit loss   =  Impairment probability  x  Exposure value at the moment of impairment  x  Impairment loss

Impairment probability should reflect the best achievable estimate of the expected future losses for a given sector (group) and should be reconciled with historical ratios of non-collectible receivables. It should be noted that the historical data should be adjusted so as to reflect the current circumstances in a given sector (financial situation of the given group of contractors) and rational future expectations. The effects of the conditions in the historical period which are irrelevant for future cash flows resulting from the contract should be eliminated.

In the provision matrix it is possible to determine, e.g., fixed provision rates depending on the number of days by which a given  trade receivable is overdue (e.g. 1% if the receivable is not overdue, 2% if it is overdue by less than 30 days, 3 percent, if it is overdue by more than 30 days but less than 90 days, 20 percent, if it is overdue by 90–180 days, etc.). Estimates of changes in the expected credit losses should reflect the changes in related observable data in consecutive periods, such as changes in unemployment levels, real estate prices, prices of goods, payment status or other factors indicating credit losses related to a financial instrument or in the group of financial instruments. The entity regularly reviews the methodology and the assumptions applied when estimating the expected credit losses, in order to reduce any discrepancies between the estimates and the actual data regarding credit losses.

The expected credit loss will be then the exposure value, understood as the balance of receivables at nominal value, that will be adjusted by the probability of impairment determined in the manner described above and the estimated loss in the event of impairment (i.e. the percentage of receivables that will not be recovered if a loss occurs). For each group of receivables, the value of the expected credit loss should be determined separately.

How to recognise the expected credit loss in account books?

The credit loss calculated as above is recognised in the financial result corresponding directly with the account receivables or through the impairment of receivables account (this decision depends on the accounting policy).

To sum up

Applying the practical approach specified in the IFRS 9 may considerably simplify the process of recognising impairment as the expected credit losses. The impairment, as a rule,  is an estimation, however, applying the right methodology and assumptions will allow us to determine the expected credit losses in reliable amounts. The standard brings forth new challenges for many entities, as it is also key in devising the approach and methodology  to  develop and implement appropriate models for the estimation of the expected credit losses that will be accordingly integrated with process of the credit risk management as well as processes related to the budgeting and financial planning.

Follow our next publications on financial instruments available on our blog – in the next article we will discuss doubts raised by our clients regarding the exact definition of financial instruments.