## Learning Outcomes

- Explain why IFRS 9 uses an expected credit loss model rather than waiting for actual default.
- Distinguish between 12-month expected credit losses and lifetime expected credit losses.
- Apply the three-stage impairment approach for financial assets measured at amortised cost or FVOCI.
- Identify when a significant increase in credit risk has occurred.
- Calculate simple loss allowances using probability of default, loss given default and exposure at default.
- Explain the simplified lifetime ECL approach for trade receivables and contract assets.
- Describe the main IFRS 7 disclosures relating to credit risk and expected credit losses.

## ACCA Financial Reporting (FR) Syllabus

In ACCA FR, financial instruments questions usually test whether you can apply the main principles of IFRS 9 and explain the effect on the financial statements. Expected credit loss questions may appear as objective test questions or as part of a wider financial instruments scenario involving receivables, loan assets, debt instruments or disclosures.

- Identify financial assets subject to IFRS 9 impairment.
- Distinguish amortised cost, FVOCI and FVTPL assets for impairment purposes.
- Explain 12-month expected credit losses and lifetime expected credit losses.
- Apply the three-stage model based on changes in credit risk.
- Recognise impairment losses and reversals in profit or loss.
- Apply the simplified lifetime ECL model to trade receivables.
- Explain how credit risk and impairment are disclosed under IFRS 7.
- Avoid confusing IFRS 9 ECL with the incurred loss model used before IFRS 9.

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. What is the difference between a 12-month expected credit loss and a lifetime expected credit loss?
2. When does a financial asset move from Stage 1 to Stage 2 under the IFRS 9 impairment model?
3. Does a 12-month ECL allowance mean the entity only estimates cash shortfalls expected in the next 12 months?
4. How is the simplified approach for trade receivables different from the general three-stage approach?
5. What types of information should IFRS 7 disclosures provide about expected credit losses?

## Introduction

IFRS 9 Financial Instruments requires many financial assets to be tested for impairment using an expected credit loss model. This is different from waiting until there is clear evidence that a debtor has defaulted. The aim is to recognise credit losses earlier, using current and forward-looking information.

For ACCA FR, the key exam skill is to decide whether the allowance should be based on 12-month expected credit losses or lifetime expected credit losses. You also need to understand how this links to credit risk, profit or loss, and IFRS 7 disclosures.

> **Key Term: Expected credit loss**
> A probability-weighted estimate of credit losses, measured as the present value of expected cash shortfalls over the relevant period.

Credit losses arise when an entity does not expect to collect all contractual cash flows due from a financial asset. For example, if a company lends $100,000 and expects to recover only $90,000, there is an expected cash shortfall of $10,000, adjusted for probability and the time value of money.

### Scope of the IFRS 9 expected credit loss approach

The IFRS 9 expected credit loss model applies to financial assets where credit risk is relevant and where fair value changes do not already go through profit or loss.

The main assets within the impairment model are:

- debt instruments measured at amortised cost, such as many loan assets and held-to-collect debt investments;
- debt instruments measured at fair value through other broad income;
- trade receivables;
- contract assets under IFRS 15;
- lease receivables;
- some loan commitments and financial guarantee contracts.

Equity investments are not tested for expected credit losses. This is because equity instruments do not create a contractual right to fixed or determinable cash flows in the same way as a loan or receivable. Financial assets measured at fair value through profit or loss are also outside the ECL impairment model because changes in fair value are already recognised in profit or loss.

> **Test Tip:**
> In FR questions, first identify the type of financial asset and its measurement category. Do not start calculating an impairment allowance until you know whether IFRS 9 impairment applies.

For an amortised cost asset, the loss allowance reduces the carrying amount of the asset in the statement of financial position. The impairment loss, or reversal, is recognised in profit or loss.

For a debt asset measured at FVOCI, the asset continues to be shown at fair value in the statement of financial position. However, the expected credit loss is still recognised in profit or loss, with the other side recorded in other broad income. This avoids reducing the asset below fair value while still reporting the credit loss in profit or loss.

### The three-stage model: 12-month and lifetime ECL

The general IFRS 9 model uses three stages. The stage depends on how credit risk has changed since initial recognition.

> **Key Term: 12-month ECL**
> The portion of lifetime expected credit losses that results from default events possible within 12 months after the reporting date.
>
> **Key Term: Lifetime ECL**
> Expected credit losses arising from all possible default events over the expected life of a financial instrument.

A 12-month ECL is not the cash shortfall expected in the next 12 months. It is the expected loss from defaults that may occur in the next 12 months, even if the cash shortfalls from those defaults happen later. This is a frequent source of exam errors.

In Stage 1, the asset has not suffered a significant increase in credit risk since initial recognition. The entity recognises a 12-month ECL allowance. Interest revenue is calculated on the gross carrying amount of the asset.

For example, if an entity buys a debt investment and the debtor remains financially stable, the asset usually stays in Stage 1. The entity still recognises an allowance because IFRS 9 requires expected losses to be recognised from day one.

In Stage 2, credit risk has increased significantly since initial recognition, but the asset is not credit-impaired. The entity recognises a lifetime ECL allowance. Interest revenue is still calculated on the gross carrying amount.

In Stage 3, the asset is credit-impaired. The entity continues to recognise lifetime ECL. However, interest revenue is calculated on the net carrying amount, meaning the gross carrying amount less the loss allowance.

> **Key Term: Significant increase in credit risk**
> A rise in the risk of default since initial recognition that is large enough to require a move from 12-month ECL to lifetime ECL.

The assessment is based on the change in the risk of default, not merely on the size of the expected loss. IFRS 9 requires comparison of credit risk at the reporting date with credit risk at initial recognition.

Indicators of a significant increase in credit risk may include:

- actual or expected deterioration in the borrower’s operating results;
- worsening economic conditions affecting the borrower;
- adverse changes in business, financial or regulatory conditions;
- reduced credit rating;
- requests for extended credit terms;
- payments becoming more than 30 days past due.

There is a rebuttable presumption that credit risk has increased significantly when contractual payments are more than 30 days past due. “Rebuttable” means the entity may use reasonable evidence to show that credit risk has not significantly increased, but this should not be ignored without support.

> **Exam Warning:**
> Do not assume that every overdue balance is credit-impaired. More than 30 days past due suggests a significant increase in credit risk, while default is often associated with a more serious event, such as being 90 days past due or clear evidence that the debtor cannot pay.
>
> **Key Term: Credit-impaired financial asset**
> A financial asset for which one or more events have occurred that have a detrimental effect on the estimated future cash flows of the asset.

Examples of credit-impaired indicators include significant financial difficulty of the borrower, breach of contract, default, bankruptcy, or concessions granted by the lender because of the borrower’s financial difficulty.

IFRS 9 also includes a low credit risk practical relief. If a financial instrument has low credit risk at the reporting date, an entity may assume that credit risk has not increased significantly. Investment-grade debt is a common example. This does not mean no allowance is recognised; it normally means the asset remains in Stage 1 with a 12-month ECL allowance.

### Measuring expected credit losses in exam questions

Expected credit loss measurement is based on three main ideas:

- the probability of default;
- the amount exposed to loss if default occurs;
- the proportion of that exposure not expected to be recovered.

A simplified formula often used in exam-style calculations is:

$$
\text{Expected credit loss} = \text{Probability of default} \times \text{Loss given default} \times \text{Exposure at default}
$$

> **Key Term: Probability of default**
> The likelihood that a borrower will default over a specified period.
>
> **Key Term: Loss given default**
> The proportion of the exposure that is expected not to be recovered if default occurs.
>
> **Key Term: Exposure at default**
> The estimated amount outstanding at the time of default.

For example, assume an entity has a loan asset with a gross carrying amount of $100,000. The probability of default in the next 12 months is 3%. If default occurs, the entity expects to lose 40% of the balance after recoveries. Ignoring discounting, the 12-month ECL is:

$$
3\% \times 40\% \times \$100,000 = \$1,200
$$

The journal entry is:

- Dr impairment loss in profit or loss $1,200
- Cr loss allowance $1,200

Now assume that, at the next reporting date, credit risk has increased significantly. The lifetime probability of default is assessed at 12%, while loss given default remains 40% and the exposure remains $100,000. The lifetime ECL is:

$$
12\% \times 40\% \times \$100,000 = \$4,800
$$

If the existing allowance is $1,200, the additional impairment loss recognised is $3,600.

> **Test Tip:**
> ACCA questions often ask for the closing allowance or the charge to profit or loss. Read the wording carefully. If an allowance already exists, the profit or loss charge is the movement needed to reach the required closing allowance.

IFRS 9 requires expected credit losses to reflect:

- an unbiased and probability-weighted amount;
- the time value of money;
- reasonable and supportable information available without undue cost or effort;
- past events, current conditions and forecasts of future economic conditions.

This means an entity should not rely only on historical default rates if current or forecast conditions have changed. For instance, if unemployment is expected to rise in a region where many customers operate, default rates may need to be increased.

In practice, exam questions usually simplify the calculations. You may be given probabilities, loss rates or an ageing schedule. Your role is to apply the correct percentage to the correct balance and decide whether 12-month or lifetime ECL is required.

### Trade receivables and the simplified lifetime ECL approach

Many trade receivables are short-term and do not contain a significant financing component. For these balances, IFRS 9 requires a simplified approach: recognise lifetime ECL from initial recognition. There is no need to track whether credit risk has increased significantly.

> **Key Term: Provision matrix**
> A method of estimating expected credit losses on receivables by applying loss rates to groups of balances, often based on ageing.

A provision matrix may group receivables as current, 1–30 days overdue, 31–60 days overdue and over 60 days overdue. Older balances usually have higher expected loss rates.

For example, a company has the following receivables:

- current balances: $80,000, loss rate 1%;
- 1–30 days overdue: $30,000, loss rate 4%;
- 31–60 days overdue: $15,000, loss rate 10%;
- over 60 days overdue: $5,000, loss rate 30%.

The expected credit loss allowance is:

$$
(\$80,000 \times 1\%) + (\$30,000 \times 4\%) + (\$15,000 \times 10\%) + (\$5,000 \times 30\%) = \$5,000
$$

This allowance is recognised even if no individual customer has yet defaulted. The calculation uses expected losses across the portfolio.

> **Exam Warning:**
> Do not apply only specific bad debts when a question gives expected loss percentages for receivables. IFRS 9 requires expected credit losses, so an allowance may be needed for balances that are not yet overdue.

If a receivable is written off because there is no reasonable expectation of recovery, the receivable is removed from the statement of financial position. If an allowance already exists for that receivable, the write-off is usually recorded against the allowance rather than creating a new expense.

For example, if a $2,000 receivable is written off and an allowance already covers it:

- Dr loss allowance $2,000
- Cr trade receivables $2,000

If there is no allowance, the write-off is charged to profit or loss.

### IFRS 7 disclosures about ECL and credit risk

IFRS 7 Financial Instruments: Disclosures requires entities to provide information that helps users understand the significance of financial instruments and the nature and extent of risks arising from them. For expected credit losses, the focus is mainly on credit risk.

The disclosures should explain both the numbers and the judgements behind them. Users need to understand how management has assessed credit risk, how the loss allowance has been measured, and how credit risk has changed during the period.

Typical IFRS 7 credit risk and ECL disclosures include:

- how the entity determines whether credit risk has increased significantly;
- the definition of default used by the entity;
- how assets are grouped when ECL is measured collectively;
- key assumptions and estimation methods used in measuring ECL;
- how forward-looking information has been included;
- reconciliation of opening and closing loss allowances;
- changes caused by new financial assets, repayments, write-offs and changes in risk;
- gross carrying amounts by credit risk grade or ageing category;
- information about collateral and other credit enhancements;
- write-off policies.

For trade receivables, entities often disclose an ageing analysis and the related ECL allowance. This helps users see how much of the receivables balance is overdue and how much allowance has been recognised.

Disclosures are not only narrative. They should connect to the figures in the financial statements. For example, if the loss allowance has increased sharply, the notes should help explain whether this was caused by higher sales, a weaker customer base, worse economic forecasts or specific customer defaults.

In ACCA FR, a question might ask which disclosure is required, or it might test your understanding through a scenario. For instance, if a company says that credit risk has not changed but a large proportion of balances is now over 90 days overdue, that judgement may be questionable.

> **Test Tip:**
> When answering written parts, link IFRS 7 disclosures to users’ needs: they need to understand exposure to credit risk, how ECL was measured, and why the allowance changed.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- IFRS 9 uses an expected credit loss model for many debt financial assets.
- Expected credit losses are recognised before actual default occurs.
- Financial assets measured at amortised cost are subject to ECL impairment.
- Debt instruments measured at FVOCI are also subject to ECL impairment.
- Financial assets at FVTPL and equity investments are not subject to the IFRS 9 ECL model.
- Stage 1 assets use 12-month ECL unless credit risk has increased significantly.
- Stage 2 assets use lifetime ECL because credit risk has increased significantly.
- Stage 3 assets are credit-impaired and use lifetime ECL, with interest calculated on the net carrying amount.
- A 12-month ECL is not the same as losses expected to arise only in the next 12 months.
- Trade receivables without a significant financing component use the simplified lifetime ECL approach.
- Provision matrices are common for calculating ECL on receivables.
- IFRS 7 requires disclosures about credit risk, ECL methods, assumptions, movements in allowances and credit exposure.

## Key Terms and Concepts

- Expected credit loss
- 12-month ECL
- Lifetime ECL
- Significant increase in credit risk
- Credit-impaired financial asset
- Probability of default
- Loss given default
- Exposure at default
- Provision matrix


Impairment and disclosures - Expected credit loss models (12-month vs lifetime)