Cloud across Atlantic: Loan provisioning under IFRS

Often the clouds across Atlantic clash with each other and cause
torrential downpour across civilisations that lie on its shore. Often it stays
cloudy for days and then suddenly the sun comes out brightly forcing the
clouds to retreat, but a prudent man would always reach for the umbrella
since one never knows. In the wonderland of accountants we see such a
cloud growing in strength arising out of the loss provisioning norms
suggested under exposure draft of IFRS 9 and consequent industry
reactions coupled with the differential view taken by FASB. This article
takes a look into the provisions and impact that can be felt at the desk of
the accountants.
The IASB exposure draft on financial instruments expected credit losses
was issued 7th March, 2013 bringing in amendments as to recognition,
measurement, presentation, and disclosure of expected credit losses.
Salient aspects of the suggestions put forward in the draft included the
following:
1) Scope: The standard requires providing for a credit loss provision for
all financial instrument that are subject to erosion in value arising out
of credit risk The proposed approach will apply to all financial assets
carrying credit loss risk on them. Some loan commitments and financial
guarantee contracts will also be covered by the approach. Following
financial instruments are covered by the proposal:
a) Originated, purchased, reclassified or modified debt instruments
that are measured at amortised cost in accordance with IFRS 9
Financial Instruments
b) Financial assets measured at fair value through other
comprehensive income
c) Loan commitments unless measured at fair value through profit or
loss
d) Financial guarantee contracts unless measured at fair value through
profit or loss
e) Lease receivables within the scope of IAS 17 Leases.
2) Methodology: The expected credit loss estimate should reflect two
aspects:

a) Probability Adjustment: An unbiased and probability weighted

amount which would encompass a range of possible outcomes. This
can be described by a matrix comprising of extent of loss in lifetime
cash flow on default and probability of such loss arising. We will
describe this matrix in greater details later in the article.
b) Time Value Adjustment: Adjustment for time value of money
arising out of payment delayed beyond contracted schedule. This is
essentially the present value of the lifetime cash flow due and the
amount the entity now expects to receive. The relevant discounting
rate should be between the risk free rate and effective interest rate
of the financial asset, though the range may be violated on period
after initial recognition due to changes in risk free rate. In case of
undrawn loan commitments and financial guarantee contracts, the
discount rate should reflect the current market assessment of the time
value of money and risks specific to the cash flows. In cases of purchased
or originated credit impaired financial assets, credit adjusted effective
interest rate should be used to discount cash flows.

3) Recognition: Recognition of the expected credit loss is broken up in a

three-stage. In the first stage an entity will apply portfolio approach to
provide for such losses unless any individual asset demonstrates signs
of specific impairment. In such cases the individual asset will be
marked separately and move on to the second or third stage, as the
case may be. An overview of the three-stage approach is stated below:
a) First stage: We will identify all financial instruments with low credit
risk or whose credit quality has not deteriorated significantly since
initial recognition. A 12 month expected credit loss will be
recognised for these assets which is essentially a product of
probability of default over a 12 month period following the reporting
date and the total expected credit loss arising out of the default.
Interest revenue, wherever required, would be computed on the
gross value and not after adjusting the provision. Trade receivables
which do not constitute a financing transaction will follow a
simplified approach and provide for credit loss using a provision
matrix depending on days overdue. Since most of such receivables

will have a lifetime of less than 12 months, the 12-month credit

provision and lifetime credit provision will be the same. Long term
trade receivables and lease rent receivable can follow either the
three-bucket approach or the simplified approach.
b) Second stage: At this stage we will identify financial instruments
excluding those rated as investment grade as on the reporting
date, that has suffered significant loss in credit quality since initial
recognition. A lifetime expected credit loss would be recognised.
This will be computed by using the probability of default occurring
anytime over the lifetime of the instrument. Interest revenue,
wherever required, would continue be computed on the gross value.
c) Third stage: Financial instruments as this stage would manifest
demonstrate objective evidence of impairment on the reporting
date. A lifetime expected credit loss is to be recognised for all such
instruments and interest revenue, wherever applicable, will be
computed on the net carrying amount that is gross carrying amount
reduced by the lifetime allowance for credit loss. All purchased
credit impaired asset will have the same treatment.
4) Disclosure: The proposed disclosure seeks to identify and state the
impact of expected credit losses amounts on the financial statements
and the effect of deterioration and improvement in the credit risk of
relevant financial instruments.
The three-stage impairment approach would be extended to off-balance
sheet items like loan commitments, financial guarantees, and others.
While estimating the 12 month loss provision, the reporting entity will
consider the portion of the loan commitment expected to be drawn down
within the next 12 months. Similarly while estimating lifetime expected
credit losses the portion of loan commitment expected to be drawn over
the remaining life the commitment when is to be considered. This
provision has a far reaching impact as we are reflecting a probable loss
against an unrelated revenue stream and would be presented as a
separate liability line item.
It must be accepted that all interest earnings includes a premium for
credit risk of the borrower and charging of a loss allowance effectively

nullifies the effect. However inclusion of the accrued amount without any
adjustment for the credit risk is unlikely to provide an accurate measure of
the realisable value. At the same time, interest accrual is made on gross
amount - thus effectively offsetting any adverse impact on performance
measure.
Major difference between IASB and FASB lies in that FASB considers all
contractual cash flows that are unlikely to be collected instead of the 12
month and lifetime credit loss approach preferred by IASB and
consequently the exposure draft of FASB do not have a transition criteria.
In addition as against no recognition exception proposed by IASB, FASB
provides for recognition exception to financial assets measured at fair
value through profit and loss if the fair value exceeds amortised cost and
expected credit loss is insignificant.
Having discussed the proposed standard let us look into the three major
steps necessary for operationalising the model.
1) Definition of significant deterioration in credit quality: This
appears to be subjective in some sense. One can use proxies like
number of days overdue to signify significant deterioration. IASB has
considered a rebuttable presumption that any delay beyond 30 days
signifies a significant deterioration in credit quality and entities may
consider any other time frame that can be so established.
2) Identification of point in time when credit quality deteriorated:
This is necessary essentially because we need to recognise the event
in our financial reports and also to define the time period over which
present value adjustment will be carried on. We will need to define
triggers that will allow us to identify such time. For example we need to
define whether the deterioration takes place on expiry of 30 days
overdue or 30 days overdue manifests that credit deterioration has
taken place on the due date of payment.
3) The future expected cash flow from impaired asset: Present
value of difference between this amount and contractual cash flow will
define the extent of expected loss.

Let us now have a look at the credit risk estimation models that may be
useful in determining the loss allowance. An effective model will be one
which includes a set of variables which contributes towards the
performance of a credit exposure. These variables are to be identified
primarily based on domain expertise and then validated using statistical
processes. In my personal experience supported by collective experience
of risk modelling experts, one of the critical data in designing the model
is the transactional behaviour of the counterparty. Other variables may
include financial parameters like sales, profit ratio, market share,
incremental revenue, leverage ratio, loan to value, and others along with
economic indicators. If the lender entity is not privy to regular operational
update from the borrower entity, the model will depend mostly on
publicly available information which would generally include quarterly
statements, press reports, and third party credit rating. These variables
are then examined to identify whether they evidence any causal relation
with the default event. The model will then assign various weights to
various variables signifying the extent by which they influence the default
event. Once the casual relation is established, the model can be
extrapolated over new credit events.
Though various models can have different designs but looking at the time
and expertise that a non-banking institution is likely to have for such
complex computation and interpretation process, my personal favourite
are the models that provides a probability of default using the multiple
variable driven model described earlier. Thus we will have a single value
ranging from 0% to 100% denoting the probability of default. The data
analysis necessary to arrive at this probability of default value will allow
us to find the expected loss, as a percentage of the exposure value, that
the entity may suffer given a default. All we now need is to identify the
discounting rate.
This is how these data will be used:
Consider a company have customers from two regions - Middle East and
Europe with total customers numbering 200 and 250 respectively. Past
evidence suggests that expected default rate to be 10% and 8%

respectively. Following table shows the computation procedure required

to find out the loss rate.

Region

No.
of
Clien
t
A

Middle
East

200

Europe

250

Total
Expos
ure
B
16843
6
23898
2

Averag
e
Exposu
re

Probabi
lity
of
Default

C=B/A

Exposur
e
at
Default
E=C x A
xD

842

10%

16840

956

8%

19120

PV
of
Los
s
E
131
35
152
96

Expect
ed
Loss
F = E/B
8%
6%

It is evident from the table above, that computation framework for

arriving at expected loss is dependent on assessment of the probability of
default and discounting rate. We have earlier described the conceptual
framework of arriving at these. Financial institutions have significant
investment in risk management department and are likely to have the
computational infrastructure for computing these values. Non-financial
entities will need to choose between making an investment on building
up the infrastructure or deploy a simple spreadsheet based solution by
investing in designing a model and then merely update the same for
future period. Increasingly such solutions are being available on the cloud
or being provided by external experts. The decision will be entirely driven
by the complexity and volume of the business. Corporate houses in the
Middle East Asia will have an additional challenge in terms of recognising
the unique trade conditions that may make a ready-made model
inappropriate.
No matter how the company addresses the issue, the 1st January 2015
deadline is closer than it may seem on the calendar considering the
complexity of model design. It may be sensible to start rolling out the
enablers. Even without regulatory requirement, it is a good practice to
adopt. In face of a dark cloud, an umbrella is always handy.