CapitalQuarter – Summer 2024
Which IFRS 9 impairment considerations apply to related company loans? How do you apply expected credit losses? And how should you present related company loans in your financial reports?
IFRS 9 Financial Instruments presents users with a comprehensive guide for accounting for classes of financial instruments. A critical aspect of this accounting standard is the impairment and subsequent recoverability of financial assets, including those pertaining to related company loans made to subsidiaries or between fellow subsidiaries.
Applying IFRS 9 to related company loans can present a number of challenges upon application, given these loans are often extended on favourable terms, informally documented, or even entirely undocumented. Common issues arising in the application of impairment requirements to related company loans include:
- The erroneous application of impairment considerations defined under IAS 36 Impairment of Assets
- Where the entity’s business activities relate to those within the exploration and natural resources sector, there’s an over-reliance on the impairment considerations performed in accordance with IFRS 6 Exploration for and Evaluation of Mineral Resources related to intangible assets (held by the subsidiaries to which loans have been extended), without separate reference to IFRS 9
- Lack of clarity on whether the loan is in scope of IFRS 9 or, alternatively, IAS 27 Separate Financial Statements (ie treated as part of the lender’s ‘net investment in subsidiary’)
- Where the related company loan is repayable on demand, companies often fail to consider the requirements of IFRS 9 related to Expected Credit Losses (ECLs).
Classification and measurement of related company loans
Entities must first decide if the related company loan is in scope of IFRS 9 before doing the impairment assessment, or whether in fact it’s in the scope of different standard.
All related company loans and other financial assets that are classified as debt instruments and subsequently recognised and measured at amortised cost or FVOCI are within the scope of IFRS 9’s ECL requirements and subject to the ‘general approach’. Most related company loan receivables will meet the criteria to be classified and be measured at amortised cost after applying the ‘hold to collect’ business model and ‘Sole Payments of Principal and Interest’ (SPPI) test.
Entities should not assume that this applies to all related company loans and should always refer to the classification criteria in IFRS 9.
In scenarios where subsidiaries or related companies are primarily financed through a related company loan, such loans will be more akin to a capital contribution within the borrower’s financial statements (ie an equity instrument) and would form part of the ‘net investment’ for the lender. Interests in subsidiaries, associates and joint ventures are scoped out by IFRS 9 and instead are accounted for under IAS 27 or IAS 28 Investments in Associates and Joint Ventures.
Application of ECL model to related company loans
Previously assessments for impairment indicators, and subsequent recovery of related company loans, were carried out under the retrospective methodology of IAS 39’s incurred loss model. Now IFRS 9 uses a forward-looking approach that considers future expected events and qualitative factors. This means ECLs are recognised earlier, rather than pending evidence of an incurred loss event.
Under IFRS 9, ECLs are defined as being a probability-weighted estimate of credit losses. This is the difference between the discounted cash flows at the effective interest rate that the entity thinks will be recoverable and the cash flows due per the terms of the related company loan. The timing of payments is considered within the ECL model, and credit losses can arise even where an entity expects to fully recover the contractual amount(s) due.
Three different approaches
Three different approaches are available to users when applying the ECL model: ‘general approach’; ‘simplified approach’; and ‘Purchased or Originated Credit Impaired (POCI)’. Related company loans usually fall under the category of the ‘general approach’ where they are classified at amortised cost or FVOCI. These kind of loans can never adopt the ‘simplified’ approach irrespective of their maturity, so must consider provision based on 12-month ECLs (the ‘simplified approach’ is only permitted within the standard for trade receivables and contract assets under IFRS 15 Revenue from Contracts With Customers or lease receivables under IFRS 16 Leases).
The IFRS 9 ‘general approach’ outlines a three-stage model for impairment based on changes in credit quality since initial recognition:
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| Stage 1 No significant increase in risk | Stage 2 Significant increase in risk | Stage 3 Credit impaired | |
| Recognition of ECL | 12-month expected credit loss | Lifetime expected credit loss | Lifetime expected credit loss |
| Recognition of interest | Effective interest on gross carrying amount | Effective interest on gross carrying amount | Effective interest on amortised cost carrying amount (net of credit allowance) |
Significant increase in credit risk
Under the ‘general approach’ above, an entity must assess the credit risk of each related company loan at each reporting date to determine whether there has been a significant increase in credit risk (SICR) since initial recognition. The assessment of SICR is crucial as it establishes whether the loan is subsequently recognised in stage 1, 2 or 3.
The stage of loan governs both the amount of ECL and the amount of interest to be recognised in the profit or loss statement in future accounting periods.
IFRS 9 provides a list of requirements for the SICR assessment:
- Entities should compare the credit risk at the reporting date to the credit risk at initial recognition
- Entities should focus on changes in the risk of default over the life of the loan, rather than the risk of loss
- Reasonable and supportable (including forward-looking) information should be used.
IFRS 9 does not specify an approach for assessing a significant increase in credit risk since initial recognition, nor does it quantify what would constitute ‘significant’. This means the assessment is very subjective and requires significant judgement from management. However, the appendix does identify a non-exhaustive list of factors which may be relevant to entities when assessing SICR:
- Changes in internal price indicators of credit risk as a result of change since inception
- Changes in external market indicators of credit risk, ie the credit spread
- Actual or expected changes in the financial instrument’s external credit rating
- Changes in the borrower’s ability to meet debt obligations due to adverse changes in financial or economic conditions, ie a recession, increased interest rates or higher unemployment rates
- Changes in the borrower’s ability to meet debt obligations due to adverse changes in the regulatory or technological environment of the borrower
- Declining operating results of the borrower, ie falling revenue margins or working capital deficiencies
- Changes in the loan documentation, ie breach of covenants or interest waivers
Relevance of these factors will depend on the facts and circumstances specific to the related company loan under assessment.
Application to undocumented loans
Where an entity provides funding without any contractual terms (ie an interest rate or repayment schedule), such arrangements typically give rise to debt instruments and therefore fall under the scope of IFRS 9. Funding without contractual terms is usually treated legally as being repayable on demand and not a capital contribution. Under such circumstances, the lender has the legal substantive right to demand repayment (see loans repayable on demand below).
In limited jurisdictions, applicable laws and regulations may mean that an undocumented loan is treated as a capital contribution and therefore part of the equity investment (see reference to IAS 27 and IAS 28 above). This is not common, but lenders should ensure that undocumented funding arrangements are closely analysed.
Application to loans repayable on demand
Expected credit losses are based on the assumption that the repayment of the loan is demanded at the reporting date. In accordance with IFRS 9, the maximum contractual period for measuring ECL would be typically 1 day, as the lender will have the substantive contractual right to demand repayment and cash would need to be transferred immediately.
For related company loans repayable on demand, two situations normally arise; the borrower can pay on the reporting date if demanded or it cannot. If the borrower has sufficient accessible highly liquid assets (eg cash and cash equivalents) to repay the related company loan, the ECL would likely be immaterial as the probability of default would be zero (see ‘PD’ under ‘Measuring ECLs’ below).
Where a borrower is unable to repay the loan if demanded, the lender would need to consider within their assessment of ECLs the likely manner of recovery and corresponding period of the related company loan. An example here could include granting additional time for the borrower to make repayments rather than proceeding with the liquidation or sale of the borrower’s assets at the reporting date, ie a fire sale.
Application to long-term loans
For long-term loans (either with an interest rate or interest-free) the fair value of any loan is the present value of future cash receipts, discounted using an appropriate market rate or a rate defined within the loan agreement. Differences between the initial fair value and the cash advanced (eg, where the loan carries no interest) are generally treated under IAS 27 as an additional investment in subsidiary in the accounts of the lender, and capital contribution in the accounts of the borrower. The initial amount would accrete back to the principal cash advanced via the Effective Interest Rate method (EIR).
Applying the general approach under IFRS 9, at the reporting date consideration would need to be taken as to changes in credit risk since the inception of the related company loan. The conclusion here would dictate the stage of the loan and the type of ECL to be recognised.
Measuring ECLs
Once an entity has determined the stage of the loan, it must measure either lifetime ECLs or a 12-month ECL. Lifetime ECLs are those that result from all possible default events over the maximum contractual period of the related company loan over which the entity is exposed to credit risk. 12-month ECLs are those that arise on default events that are within 12 months of the reporting date, and therefore represent a portion of the lifetime ECL.
As with the SICR assessment, IFRS 9 does not specify a method for measuring ECLs. The banking sector often uses the PD x LGD x EAD model for regulatory and capital purposes, as follows:
- The Probability of Default (PD), ie the risk of default occurring (over 12 months or the expected life)
- The Loss Given Default (LGD), ie the percentage loss that arises if a default occurs
- The exposure at default (EAD), ie amounts owed under the loan at the point of default.
An alternative, simpler way of calculating ECLs is:
- Estimate possible credit losses that could arise upon a default
- Weight this amount in accordance with the estimated risk of a default occurring over 12 months or the expected life, as appropriate.
The ECL must be measured over the remaining life of the related company loan in a way that reflects IFRS 9:
- An unbiased and probability-weighted amount that is determined by evaluating a range of opportunities
- The time value of money
- Reasonable and supportable information about past events and current conditions, and reasonable and supportable forecasts of future events and economic conditions at the reporting date.
There should be consideration of what information is reasonably available when estimating ECLs. In other words, the judgement required will depend on how much or how little detailed information there is. Sources for measuring ECLs may be both internal and external, for example historic credit losses, internal ratings, credit loss experience of other entities, and external market reports and ratings. Given the nature of the assumptions and inputs when estimating ECLs, it’s important to disclose the technique used by the entity under IFRS 7.
For further information or guidance, please contact Imogen Massey.
