Learning Outcomes
After reading this article, you will be able to explain the IFRS 9 model for impairment of financial assets and classify assets based on changes in credit risk. You will identify what constitutes a significant increase in credit risk, distinguish between 12-month and lifetime expected credit losses, and evaluate the practical implications for hedge accounting. You will also apply knowledge to SBR scenario questions.
ACCA Strategic Business Reporting (SBR) Syllabus
For ACCA Strategic Business Reporting (SBR), you are required to understand the impairment model for financial assets and the impact of significant credit risk changes, as well as the basics of hedge accounting under IFRS 9. Focus your revision on:
- Explain and apply the general approach to impairment of financial instruments, including estimating expected credit losses
- Discuss the assessment and implications of a significant increase in credit risk
- Describe and apply the requirements for staging: 12-month vs lifetime expected credit losses
- Identify the impact of credit risk changes on measurement, disclosure, and group reporting
- Explain, at a principles level, the interrelationship between impairment and hedge accounting
- Discuss indicators that trigger a move to lifetime loss allowance
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Under IFRS 9, when must a financial asset’s loss allowance be based on lifetime expected credit losses?
- Which of the following is NOT usually an indicator of a significant increase in credit risk?
a) A 40-day payment overdue
b) Deterioration in external credit rating
c) Major adverse change in the economy
d) Consistent payments on time - True or false: The “significant increase in credit risk” assessment should rely only on information at initial recognition.
- Briefly explain how hedge accounting is affected if a hedged item becomes credit-impaired during a hedging relationship.
Introduction
IFRS 9 sets out a forward-looking impairment model for financial assets—including loans, receivables, and some investments. This model uses both past events and current/future economic conditions to drive recognition of credit losses. The standard’s emphasis is on identifying significant increases in credit risk and ensuring financial statements reflect potential future losses as soon as the risk environment worsens.
A core judgment for preparers is determining when credit risk has changed significantly since initial recognition—a decision that directly affects whether 12-month or lifetime expected credit losses must be recognised. This assessment also impacts hedge accounting, as changes in credit risk may affect hedge effectiveness and ongoing eligibility.
Key Term: credit risk
The risk that a counterparty to a financial instrument will fail to meet its contractual obligations, resulting in a financial loss.
IFRS 9 Impairment Model Overview
Under IFRS 9, most financial assets are subject to impairment through a staged “expected credit loss” (ECL) model:
- Stage 1: On initial recognition, or if credit risk has not increased significantly since recognition, entities recognise a loss allowance equal to 12-month expected credit losses.
- Stage 2: If there is a significant increase in credit risk since initial recognition, lifetime expected credit losses must be recognised.
- Stage 3: If the asset becomes credit-impaired, lifetime ECLs continue, and interest is recognised on the net carrying amount (i.e., after deducting the loss allowance).
Key Term: expected credit losses (ECL)
The weighted average of credit losses, with the probability of default as the weighting factor, discounted to the reporting date.
Assessing Significant Increases in Credit Risk
The key trigger for moving a financial asset from Stage 1 to Stage 2 is a “significant increase in credit risk” since initial recognition. Entities must compare the risk of default at the current reporting date to the risk at initial recognition, using reasonable and supportable information—past, current, and forward-looking—without undue cost or effort.
Common indicators for a significant increase in credit risk include:
- Actual or expected significant change in the financial instrument’s performance, e.g., payments more than 30 days overdue
- Negative changes in external or internal credit ratings
- Significant changes in operating results, such as declining sales or margins for a borrower
- Changes in collateral value securing the asset
- Adverse economic or market conditions
If a financial asset is considered “low credit risk” at the reporting date (such as an investment-grade bond), IFRS 9 allows entities to presume credit risk has not increased significantly.
Key Term: significant increase in credit risk
A measurable rise in the probability of default since initial recognition, requiring transition to lifetime expected credit loss recognition.
Worked Example 1.1
A company holds a five-year loan receivable. At initial recognition, the counterparty had a strong credit rating and payments were on time. In year two, economic reports indicate the counterparty's industry is contracting and its credit rating is downgraded by a major rating agency. What should the company do with its loss allowance?
Answer:
The downgrade and negative industry outlook signal a significant increase in credit risk. The company must move the loan to Stage 2 and recognise a loss allowance equal to lifetime expected credit losses, not just those expected within 12 months.
Exam Warning
Establishing the significance of a credit risk increase is always a relative assessment—compare current and initial risk for that specific asset. Do not base your judgment on absolute, static risk levels.
Practical Application: 30-Days-Past-Due Presumption
IFRS 9 includes a rebuttable presumption that credit risk has increased significantly if contractual payments are more than 30 days overdue. Entities may rebut if they have reasonable evidence the presumption is inappropriate for certain asset types (for example, short-term trade receivables in some industries).
Implications for Financial Reporting and Hedge Accounting
Changing the stage of a financial asset (from Stage 1 to Stage 2) has direct implications:
- Increases profit and loss volatility as more substantial loss allowances are recognised
- Requires updated disclosures and explanations in the notes to the accounts
- May impact the effectiveness of hedging relationships if the related financial asset’s credit risk changes materially
A credit-impaired (Stage 3) asset in a hedge relationship can cause discontinuation of hedge accounting if hedge effectiveness thresholds are no longer met.
Key Term: hedge accounting
A method where gains or losses on a hedging instrument and the hedged item are recognised in the same period, reducing mismatches in profit or loss.
Judgement and Disclosure
Entities must exercise significant judgement when assessing if credit risk has increased significantly. IFRS 9 requires:
- Regular, documented reviews considering both quantitative and qualitative factors
- Use of reasonable and supportable information that is available without undue cost
- Clear disclosure of how significant increases in credit risk are assessed, including key assumptions
Worked Example 1.2
An entity issues trade receivables with 90-day payment terms. At year-end, $1m of receivables are 35 days overdue, but management has strong evidence the customers always pay late due to sector norms and have never defaulted. Should the entity recognise lifetime ECLs?
Answer:
There is a rebuttable presumption of significant increase in credit risk after 30 days overdue. However, with supportable evidence that late payment is normal and does not indicate credit risk increase in this sector, the entity may continue to recognise only 12-month ECLs.
Revision Tip
Regularly update your expected credit loss calculations. Always document any decision to rebut the 30-day presumption with robust, auditable evidence.
Summary
The IFRS 9 impairment model requires continuous, relative assessment of credit risk. A significant increase since initial recognition calls for lifetime ECL recognition. This ensures users are alerted to heightened risk exposure, and aligns with objectives of transparency in financial reporting. For preparers, careful, well-documented judgement is required to support assessments, and timely adjustments must be made when indicators point to increased credit risk.
Key Point Checklist
This article has covered the following key knowledge points:
- Define and apply the expected credit loss model under IFRS 9
- Identify when a significant increase in credit risk occurs
- Distinguish between 12-month and lifetime expected credit losses
- Recognise and apply the 30-days-past-due presumption
- Assess the impact of credit risk changes on loss allowance and hedge accounting
- Understand disclosure and documentation requirements for credit risk assessments
Key Terms and Concepts
- credit risk
- expected credit losses (ECL)
- significant increase in credit risk
- hedge accounting