Chapter 5: Financial Instruments and Expected Credit Losses

5.1 IFRS 9 Classification & Measurement

Under IFRS 9 Financial Instruments, financial assets are classified based on:

• Business model test: holds assets to collect contractual cash flows vs trading or other.
• Cash flow characteristics test: contractual cash flows represent solely payments of principal and interest (SPPI).

These criteria determine measurement at:

• Amortised cost (if business model = hold to collect and SPPI = yes).
• Fair value through other comprehensive income (FVOCI) (hold to collect and sell & SPPI = yes).
• Fair value through profit or loss (FVTPL) (otherwise).

5.2 Stages of Credit Risk & the ECL Model

IFRS 9 introduces an expected credit loss (ECL) model with three stages:

1. Stage 1: 12-month ECL recognised for assets with no significant increase in credit risk since initial recognition.
2. Stage 2: Lifetime ECL for assets with a significant increase in credit risk.
3. Stage 3: Lifetime ECL for credit-impaired assets; interest revenue calculated on the net carrying amount.

ECL is measured as the discounted probability-weighted estimate of credit losses over the relevant period.

5.3 Group-Level vs Specific Provisions

Entities may use:

• Individual assessment: estimate ECL for significant or individually assessed exposures.
• Collective (group-level) assessment: apply historical loss rates or forward-looking adjustments to a pool of similar assets.

In practice, groups of trade receivables without individual indications of impairment are often assessed collectively.

5.4 Journal Entries & Sample Calculations

Worked Example: A company has trade receivables of \$1,000,000 at 31 Dec. Based on historical data and forward-looking information, it estimates a 2% 12-month ECL.

1. Compute ECL: \$1,000,000 × 2% = \$20,000.
2. Year-end journal entry:

Dr Credit loss expense         20,000  
  Cr Allowance for ECL             20,000  

On subsequent write-offs of irrecoverable receivables:

Dr Allowance for ECL          XX,XXX  
  Cr Trade receivables            XX,XXX  

5.5 Practice Problems

1. An entity holds \$500,000 of debt securities at amortised cost. It estimates a 12-month ECL of 1.5%. Calculate the provision and journal entry.
2. Trade receivables of \$2,500,000 have a grouping: low risk (90% of receivables, 0.5% ECL) and higher risk (10%, 5% ECL). Compute total ECL.

5.5 Strategic Approach: Financial Instruments & Expected Credit Losses

Apply this step-by-step framework to classify financial assets and measure expected credit losses under IFRS 9:

1. Identify Financial Assets
   List all loans, receivables, debt securities and other financial assets held by the entity.
2. Business Model Test
   Determine the purpose of holding each asset:
   • Hold to collect contractual cash flows
   • Hold to collect & sell
   • Other (trading / managed on fair-value basis)
3. SPPI Test (Cash-flow Characteristics)
   For each asset, assess whether contractual cash flows are solely payments of principal and interest:
   • If yes → eligible for amortised cost or FVOCI (subject to business model)
   • If no → measured at FVTPL
4. Classify & Measure Initial Recognition
   
   • Amortised cost: fair value + transaction costs.
   • FVOCI: fair value + transaction costs; subsequent FV changes to OCI.
   • FVTPL: fair value; transaction costs expensed.
5. Assess Credit Risk & Stage Assignment
   Compare credit risk at reporting date to risk at initial recognition:
   • Stage 1: No significant increase → recognise 12-month ECL.
   • Stage 2: Significant increase → recognise lifetime ECL.
   • Stage 3: Credit-impaired → lifetime ECL; interest on net carrying amount.
6. Measure Expected Credit Loss (ECL)
   Use a probability-weighted calculation: ECL = PD × LGD × EAD
   • PD: probability of default.
   • LGD: loss given default.
   • EAD: exposure at default.
7. Incorporate Forward-Looking Information
   Adjust PD, LGD and EAD for reasonable and supportable forecasts (macroeconomic factors, sector outlook).
8. recognise Allowance & Journal Entries
   At each reporting date: Dr Credit loss expense [ECL amount] Cr Allowance for ECL [ECL amount]
9. Write-offs & Recoveries
   On write-off: Dr Allowance for ECL [write-off amount] Cr Financial asset [write-off amount] On recovery: Dr Cash [recovered amount] Cr Credit loss expense [recovered amount]
10. Disclose ECL Methodology
    In notes, explain:
    • Classification & measurement policy.
    • Criteria for significant increase in credit risk.
    • Key inputs & assumptions (PD, LGD, EAD, forward-looking factors).
    • Reconciliation of opening and closing allowance balances.