By Tim Follett
31 July 2019
AASB 139 Financial Instruments: Recognition and Measurement previously required impairment allowances be measured according to an incurred loss model. Under this model, the recognition of credit loss allowances was triggered by loss event subsequent.
However, the new AASB 9 Financial Instruments (applicable for reporting periods beginning on or after 1 January 2018) impairment model requires impairment allowances to be based on the deterioration of credit risk since initial recognition. There is now a requirement to consider historic, current and other forward-looking information to consider the expected credit losses of financial assets. This assessment now requires use of quantitative criteria and experienced credit risk judgement. It does not require a loss to have already been incurred.
This new model appears to take a step back to the future, of general provisioning for loss allowances.
There are three different approaches to applying the new model under AASB 9:
- Simplified approach – applied to trade receivables, contract assets and lease receivables.
- General approach – applied to all financial assets classified at amortised cost or at fair value through other comprehensive income.
- Purchased or originated credit-impaired approach – applied to financial assets that are credit impaired at initial recognition.
Let’s have a look at the practicalities of the simplified approach, which most trading entities will adopt. In this approach, we apply a simple five step provision matrix using an example of an entity with two categories of receivables:
Step 1 – group receivables by similar risks
- Category (A) $400. Foreign based receivables with political risks.
- Category (B) $600. Domestic trading receivables with limited risks.
Step 2 – determine period of historical loss rates
- Category (A) new customer base. Therefore, use last one year of data.
- Category (B) no change in customer base for last 10 years, therefore, use last 10 years of data.
Step 3 – determine historical loss rates over period in Step 2
- Category (A) 10% of debtors lost over last year.
- Category (B) 5% of debtors lost over last 10 years.
Step 4 – consider forward-looking information and conclude on loss rate (judgement)
- Category (A) anticipated future 20% loss rate. Therefore apply 15% (10% past and 20% future).
- Category (B) anticipated future 5% loss rate. Therefore apply 5% (5% past and 5% future).
Step 5 – calculate expected credit loss
- Category (A) 15% at $400 = $60 provision.
- Category (B) 5% at $600 = $30 provision.
In this example, a total debtor’s provision is recorded of $90 ($60 + $30).
The result of this new standard is that credit losses will be recognised earlier. It will no longer be appropriate for entities to wait for an incurred loss event to have occurred before credit losses are recognised. Debtor provisions are expected to increase for reporting periods ending 30 June 2019.
For now, it is back to the future for debtor provisions.