The global spread of Covid-19 (Coronavirus) will undoubtedly have long-lasting effects on economic activity. Although it’s impossible to assess the full economic ramifications today, there are many areas for which the implications are more immediate—including in accounting and the new IFRS9 impairment models for expected credit losses.
The IFRS9 impairment models that entities have developed to provision for expected credit losses (ECL) will undergo their first tests when the reports for 31 December 2019 are submitted. While a number of different interpretations and public statements have been made regarding ECL implications in 2020, there is a lack of clarity around financial statements that have not yet been authorized, namely for the year ended 2019.
Year-end considerations: adjusting vs. non-adjusting events
Let’s take a closer look at how Covid-19 affects the financial reporting of ECL for the periods that ended on 31 December 2019.
Back in December, when firms were provisioning for expected credit losses for 2019, the situation was very different. The macro-economic forecasts used to provision were skewed towards a less favorable scenario, but not as pessimistic as the present one. The virus did not pose a serious threat to the global economy, and consequently would not have been considered in the provisioning as of this date. At the applicable cut-off date of 31 December 2019, only a very limited number of Coronavirus infections had been reported, the fatality rate was low, and the outbreak was regional. There was no indication that it should be considered.
The accounting term we use in this case is “non-adjusting event”: it refers to events that occur due to conditions that arose after the reporting date. We can look to IFRS9 to find out whether such events need to be included in the ECL as at 31 December 2019.
What does the IFRS standard say…?
IFRS9 states that “estimates of ECLs are required to reflect reasonable and supportable information that is available without undue cost or effort – including information about past events and current conditions, and forecasts of future economic conditions.” [IFRS 188.8.131.52, B5.5.49].
As already outlined above, on 31 December 2019, the economic forecasts did not foresee an economic downturn on the scale that we’re talking about today. Very little was known about the virus, so our projections regarding the impact of the outbreak were far more optimistic at that time than they are with hindsight. One of the fundamental criteria for recognizing an ECL is that conditions should have been known at the reporting date. Therefore, it is not necessary to include Covid-19 impacts in your ECL calculations, per se.
How should we treat a borrower’s bankruptcy?
According to IAS 10.9, “the bankruptcy of a customer that occurs after the reporting period usually confirms that the customer was credit-impaired at the end of the reporting period”. This pandemic is a very unusual situation and has led to sudden changes in business conditions as a result of either government restrictions or changing consumer behavior. However, generally speaking, a bankruptcy is the culmination of a series of events that lead to a severe deterioration in the entity’s economic substance, resulting in insolvency. As such, more in-depth analysis is required to detect the cause of the bankruptcy on a case-by-case basis: we cannot automatically assume that all bankruptcies post- 31 December 2019 are a result of the virus outbreak and thus constitute a non-adjusting event.
A word about disclosures
Although Covid-19 may not have had a significant impact on the ECL to be reported for 31 December, IAS 10 states that “for material non-adjusting events, an entity discloses the nature of the event and an estimate of its financial effect or a statement that an estimate cannot be made. A non-adjusting event is considered to be material if it is of such importance that non-disclosure would affect the ability of users of the financial statements to make proper evaluations and decisions” [IAS 10.21]. These requirements result in an obligation to disclose any additional quantitative and qualitative ECL information that will help reflect the current developments in the calculations, and thus assess the quantitative impact, if an estimation can be made. Further considerations on the IAS 10 implications in the light of current developments can be found here.
The events that can cause material changes in the ECL are as follows:
- Write-offs due to the bankruptcy of the borrower;
- Modifications of financial instruments (whether resulting in derecognition or not) and forbearance measures;
- Material changes in FX rates and interest rates;
- Transfers resulting in derecognition of financial instruments; and
- Significant increase in credit risk.
It’s also worth noting that any IFRS 7 disclosures “relating to the nature and extent of risks arising from financial instruments to which the instrument is exposed at the reporting date” shall be adjusted accordingly.
For example, in the current circumstance information about concentration risk and exposures to liquidity risk might be especially relevant for the users of financial statements.
Entities should verify whether their risk disclosures provide enough information to enable users of financial statements to evaluate the risks to which the entity was exposed at 31 December 2019. Changes implemented after the year end, related to objectives, policies and processes for managing risk, or the methods to measure even if undertaken after the year-end, are also relevant for the end users of the financial statements.
You can find part one of this series here.
You can find part two of this series here.
You can find part three of this series here.
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