There’s been much commentary on how COVID-19 impacts on the application of IFRS 9, Financial Instruments
There are various aspects to this, but for today let’s just focus on the application of the impairment model. The general approach, you recall, is to recognize expected credit losses on loans and other financial assets, updating the amount of the expected losses at each reporting date to reflect changes in credit risk since initial recognition. As a broad premise, if the credit risk on an instrument hasn’t increased significantly since its initial recognition, the entity measures the loss allowance for the instrument at an amount equal to 12-month expected credit losses. If the credit risk has increased significantly, it measures the loss allowance at an amount equal to the lifetime expected credit losses. COVID-19 may clearly increase the credit risk on some instruments, and therefore change that assessment. On the measurement of estimated credit losses, this is how PWC, to take one example, summed up the possible impacts:
- the credit risk (risk of default). For example, this may increase if the debtor’s business is adversely impacted by COVID-19;
- the amount at risk if the debtor defaults (exposure at default). For example, debtors affected by COVID-19 may draw down on existing unused borrowing facilities, or cease making discretionary over payments, or take longer than normal to pay resulting in a greater amount at risk; and
- the estimated loss as a result of default (loss given default). For example, this may increase if COVID-19 results in a decrease in the fair value of a non-financial asset pledged as collateral.
They noted that even when a borrower is expected to repay all amounts owed but later than contractually required, there will be a credit loss if the lender is not compensated for the lost time value of money.
The IASB recently issued a document to emphasize, among other things, “that IFRS 9 does not provide bright lines nor a mechanistic approach in accounting for ECLs (estimated credit losses). Accordingly, companies may need to adjust their approaches to forecasting and determining when lifetime losses should be recognized to reflect the current environment.” Among many others, the European Securities and Markets Authority (ESMA) also issued a public statement on the area – here’s some what they had to say on estimating ECLs:
- Issuers should assess the extent to which, amongst other facts, the high degree of uncertainty and any sudden changes in the short-term economic outlook are expected to result in impacts over the entire expected life of the financial instrument. Such considerations are integral to the functioning of the ECL model under IFRS 9 and ESMA highlights that the Standard does not envisage any automatism as to how such contextual factors should impact on the loan loss provisioning. In particular, given the scarcity of available and reliable information in the current context, issuers will face problems in generating reasonable and supportable short-term economic forecasts.
- In this context, ESMA highlights the recent (European Central Bank) supervisory measures taken in reaction to the coronavirus in this area (i.e. the recommendation that, given the current state of uncertainty linked to the COVID-19 outbreak, within the framework provided by IFRS, issuers give a greater weight to long-term stable outlook as evidenced by past experience and take into account the relief measures granted by public authorities – such as payment moratoria).
- Finally, in ESMA’s view, when making forecasts, issuers should consider the nature of this economic shock (i.e. whether the COVID-19 effect is expected to be temporary) and the impact that the economic support and relief measures (including debt moratoria) will have on the credit risk over the expected life of the instruments, which include, depending on the instruments’ maturities, longer-term estimates.
“Does not envisage any automatism as to how such contextual factors”…? Must be thanks to Google Translate. Anyway, the European Central Bank, in making the recommendation cited above, had noted that “particularly in these times of pronounced uncertainty, IFRS 9 model outcomes may be excessively variable and procyclical.” In this of course we sense the eternal debate about the virtue of fair value accounting and its attendant volatility (we recently addressed this here, thanks to Warren Buffett). The overriding question, as much an existential as an accounting one at the current time, is whether giving “a greater weight to long-term stable outlook as evidenced by past experience” continues to constitute a sound basis for anticipating, well, anything at all…
No doubt we’ll return to this topic. Ending on a lighter note, if you’re wondering how to cope with self-isolation, here’s a ‘lockdown to-do list” I found on Twitter (presented here verbatim):
- Clean all my shoes
- Flag and highlight all of my IFRS and Auditing standards
- Finish 2 books
- Become a self-care king by lotioning every part of me and not just the exposed skin
- GROW A MOERSE AFRO
I mean, what else would you need, let alone have time for…?
The opinions expressed are solely those of the author