It’s now one year and eight months since the mandatory implementation of International Financial Reporting Standard Nine (IFRS 9). IFRS 9 Financial Instruments standard is effective 1 January 2018. IFRS 9 replaced IAS 39 Financial Instruments: Recognition and Measurement.
It prescribes the rules for recognition, classification, measurement (impairment), derecognition of financial instruments and hedge accounting. IFRS 9 biggest differentiator is the introduction of the expected credit loss model.
What Credit loss anyway?
Have you ever approached a typical money lender to borrow money? On the 23rd of December 2018 at around 6:30 am, I received a call from Hillary, a great friend of mine. He said: “Good morning dear friend.” Good morning Hillary, I replied. Why are you calling me so early like this, I asked? “I need to borrow money from you, he replied.” How much do you need? “I need Ugx5m.” what for? “You know it’s Christmas season, I have to go to the village and spend it with family, he said while smiling” I don’t have such an amount on me now. But I know of a friend of mine who does money lending. He can help you out.
5MINS READ: IFRS9 FINANCIAL INSTRUMENT MADE EASIER
At 8:30 am, we had arrived at the money lender’s office. How much do you need? “I need at least Ugx3m,” Hillary replied in a low tone. What collateral do you have? He has a new ThinkPad, I replied. Ok, how much did he acquire it for? It cost him Ugx7.5m. and he needs Ugx3m! “Divide the Ugx7.5m by 2, then divide the result by 3. That’s how much I can give you, said the moneylender.” The maximum Hillary could get was Ugx1.25m. The difference between what the money owed to Hillary and what the moneylender expects to receive from him gives us the credit loss.
In simple terms, credit loss is the difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flows that the entity expects to receive, discounted at the original EIR or credit-adjusted EIR (IFRS 9. Appendix A).
When estimating cash flows for the determination of ECL, the entity (money lender) takes into account (IFRS 9. Appendix A) of the;
- the expected life of a financial instrument
- All contractual terms of the financial instrument (e.g. prepayment, extension, call, and similar options)
- collaterals held
- other credit enhancements integral to the contractual terms
In the next article, we shall provide an example in excel format on computing the ECL.