Financial assets can lose value, and accounting rules help track these losses. This section covers how to spot and measure impairment using the model. It's a key part of managing financial instruments and their risks.
The rules differ based on how assets are classified and measured. For some, you'll use a three-stage model, while others need simpler approaches. Understanding these methods is crucial for accurate financial reporting and risk assessment.
Impairment Models for Financial Assets
Expected Credit Loss (ECL) Model Overview
introduced ECL model replaced incurred loss model from IAS 39
ECL model requires entities to recognize expected credit losses at all times
Entities must update expected credit loss amounts at each reporting date
Three main approaches for measuring expected credit losses
General approach
Simplified approach
Credit-adjusted effective interest rate approach
General Approach: Three-Stage Model
Based on changes in credit quality since initial recognition
Stage 1: 12-month ECL for financial instruments without significant increase in credit risk
Stage 2: Lifetime ECL for financial instruments with significant increase in credit risk
Stage 3: Lifetime ECL for credit-impaired financial assets
Movement between stages based on relative credit risk changes
Simplified and Credit-Adjusted Approaches
Simplified approach used for trade , contract assets, and lease receivables
Always recognize lifetime ECL
Typically utilizes provision matrix based on historical loss rates
Credit-adjusted effective interest rate approach applied to purchased or originated credit-impaired assets
Incorporates lifetime ECL into effective interest rate calculation
Used for assets already credit-impaired at initial recognition (distressed debt)
Indicators of Impairment
Financial Distress and Market Indicators
Significant financial difficulty of issuer or borrower indicates potential impairment
Observable data indicating measurable decrease in estimated future cash flows
Changes in economic conditions correlating with defaults (rising unemployment, industry downturns)
Negative changes in borrower's credit rating
For equity instruments, significant or prolonged decline in fair value below cost
Market price consistently below purchase price for extended period (6-12 months)
Substantial price drop (20-30% below cost)
Impairment Methodology for Financial Assets
Amortized Cost and Fair Value Through Other Comprehensive Income (FVOCI)
Financial assets measured at amortized cost subject to general or simplified approach for ECL calculation
, held-to-maturity investments
Debt instruments measured at FVOCI follow general approach for ECL calculation
Impairment gains or losses recognized in profit or loss
Carrying amount not reduced in statement of financial position
Equity instruments measured at FVOCI not subject to impairment accounting
All fair value changes recognized in other comprehensive income
Fair Value Through Profit or Loss (FVTPL) and Off-Balance Sheet Items
Financial assets measured at FVTPL do not require separate impairment assessment
Fair value changes inherently reflect credit risk (trading securities, derivatives)
Loan commitments and financial guarantee contracts not measured at FVTPL subject to ECL model
Consider exposure period for ECL calculation
May require recognition of provision liability
Impairment methodology must align with asset classification and characteristics
Ensures appropriate risk assessment and loss recognition
Impairment Loss Recognition
Calculation Methods
For amortized cost assets, calculated as difference between:
Asset's carrying amount
Present value of estimated future cash flows discounted at original effective interest rate
General approach: Calculate 12-month ECL (Stage 1) or lifetime ECL (Stages 2 and 3)
Consider multiple economic scenarios and probability-weighted outcomes
Simplified approach: Calculate lifetime ECL using provision matrix
Based on historical credit loss experience
Adjusted for forward-looking factors (economic forecasts, industry trends)
Recognition and Presentation
Recognize impairment losses through loss allowance account
Presented as reduction of gross carrying amount in statement of financial position
For FVOCI debt instruments, recognize impairment loss in profit or loss
Corresponding adjustment to other comprehensive income
No reduction in carrying amount on statement of financial position
Subsequent changes in expected credit losses recognized as impairment gain or loss in profit or loss
For credit-impaired assets, calculate interest revenue using effective interest rate on amortized cost
No longer use gross carrying amount for interest calculation
Key Terms to Review (18)
Banking: Banking is the process of managing financial transactions and services provided by institutions that accept deposits, offer loans, and facilitate the transfer of funds. It plays a crucial role in the economy by providing liquidity, promoting savings, and enabling credit creation, which is essential for investment and growth.
Debt to equity ratio: The debt to equity ratio is a financial metric that compares a company's total liabilities to its shareholders' equity, indicating the relative proportion of debt and equity used to finance the company's assets. This ratio helps assess financial leverage, showing how much debt is being used in relation to the equity provided by shareholders. A higher ratio indicates greater financial risk, as it suggests that a company relies more on borrowed funds than on its own equity.
Discounted cash flow: Discounted cash flow (DCF) is a financial valuation method used to estimate the attractiveness of an investment opportunity by evaluating the present value of expected future cash flows. This technique considers the time value of money, which states that a dollar today is worth more than a dollar in the future due to its potential earning capacity. In assessing financial assets, DCF is particularly useful for determining impairment, as it helps identify whether the carrying amount of an asset exceeds its recoverable amount based on projected cash flows.
Expected Credit Loss: Expected credit loss is a financial metric used to estimate the potential loss in value of a financial asset due to the default of the borrower. This concept plays a crucial role in assessing the impairment of financial assets, as it requires entities to recognize losses earlier based on expectations of future credit risks, rather than waiting for actual defaults to occur. By calculating expected credit losses, companies can present a more accurate picture of their financial health and make informed decisions about asset valuation and risk management.
FASB Guidance: FASB guidance refers to the standards and regulations set forth by the Financial Accounting Standards Board (FASB) that govern how financial reporting should be conducted in the United States. This guidance is crucial for ensuring consistency, transparency, and accuracy in financial statements, particularly when it comes to complex issues like the impairment of financial assets, where companies must assess and report the value of their assets accurately in light of potential losses.
GAAP: GAAP stands for Generally Accepted Accounting Principles, which are a set of rules and standards that govern the preparation and presentation of financial statements. These principles provide consistency and transparency in financial reporting, ensuring that stakeholders can accurately interpret a company's financial health. GAAP is crucial for ensuring that non-controlling interests and goodwill are reported appropriately, that impairment of financial assets is recognized correctly, and that earnings per share calculations follow standardized methods.
IFRS 9: IFRS 9 is an International Financial Reporting Standard that addresses the recognition, measurement, impairment, and hedge accounting of financial instruments. It represents a significant shift from previous standards, focusing on a more principles-based approach for recognizing financial assets and liabilities. The standard impacts how organizations assess and report their financial instruments, including the classification of assets and the recognition of gains and losses.
Impairment Disclosures: Impairment disclosures refer to the requirements for organizations to report on any impairment losses related to financial assets. These disclosures are essential as they provide stakeholders with insights into the financial health of an organization and help in assessing the risks associated with holding those assets. The information included in these disclosures allows for greater transparency regarding the potential decline in the value of financial assets and the impact it may have on overall financial performance.
Impairment loss: Impairment loss refers to a reduction in the carrying amount of an asset when its recoverable amount falls below its book value. This concept is crucial in understanding how financial instruments are recognized and measured, as well as how financial assets are evaluated for potential losses. Recognizing impairment loss ensures that the financial statements accurately reflect the value of assets, maintaining transparency and reliability for users of the financial statements.
Loans: Loans are financial agreements in which a lender provides a borrower with funds that must be repaid over time, typically with interest. These agreements can vary widely in terms of structure, duration, and purpose, often influencing the financial health of both the lender and borrower. Understanding loans is essential for recognizing potential impairments to financial assets and the significance of related parties in transactions involving borrowed funds.
Market approach: The market approach is a valuation method that estimates the fair value of an asset by comparing it to similar assets that have been sold in the marketplace. This technique focuses on current market conditions and utilizes prices from transactions involving comparable assets to derive an estimated value, making it particularly relevant in situations where market activity is robust.
Real estate: Real estate refers to land and any permanent structures or improvements attached to it, such as buildings and fixtures. It encompasses various forms, including residential, commercial, industrial, and agricultural properties, and plays a crucial role in the economy by influencing investment, financing, and market stability.
Receivables: Receivables are amounts owed to a company by customers or other entities for goods or services provided on credit. They represent a significant asset on the balance sheet, as they indicate future cash inflows. Proper management of receivables is crucial for maintaining cash flow and assessing the credit risk associated with customers.
Recoverable amount: The recoverable amount is the higher value between an asset's fair value less costs to sell and its value in use. This concept is crucial when assessing whether a financial asset has suffered impairment, as it determines the maximum amount that can be recognized in financial statements for an asset that may not be performing as expected.
Return on Assets: Return on assets (ROA) is a financial metric used to assess a company's ability to generate profit from its assets. It is calculated by dividing net income by total assets, indicating how efficiently a firm is using its resources to produce earnings. A higher ROA reflects effective management and operational efficiency, which is critical in evaluating the impact of asset impairment, decisions surrounding sale and leaseback transactions, and in performing ratio analysis for investment decisions.
Risk Disclosures: Risk disclosures are detailed statements provided by companies that outline the various risks that could impact their financial performance and operations. These disclosures are crucial for investors and stakeholders as they offer insights into potential uncertainties, helping them make informed decisions regarding their investments. By transparently communicating risks, companies adhere to regulatory requirements and foster trust with investors.
SEC Regulations: SEC regulations are rules and standards set by the Securities and Exchange Commission to govern the securities industry, ensuring transparency, fairness, and investor protection. These regulations play a crucial role in financial reporting and disclosure practices, impacting how companies assess impairment of financial assets and calculate the weighted average number of shares. By establishing guidelines for accurate reporting, SEC regulations help maintain the integrity of financial markets.
Write-down: A write-down is an accounting action that reduces the book value of an asset due to a decrease in its fair market value. This process is crucial in financial accounting as it ensures that the asset is not overstated on the balance sheet, reflecting its actual worth. Write-downs are often associated with impairments, where a company recognizes that an asset has lost value and must adjust its financial records accordingly to maintain accurate reporting.