COVID-19 has caused a daily avalanche of data for businesses. And before we can even process and interpret what the data means, it changes. For businesses that have implemented IFRS 9, monitoring and unpacking data that moves in unpredictable ways is especially difficult.
Remember Why We Have IFRS 9
Now is probably a good time to remember that IFRS 9 was developed to cater for the type of uncertainty we are currently facing. Before the 2008 financial crisis, businesses tended to overstate their assets under IAS 39 and account only for impairments when there was objective evidence of default or when a default actually happened, ie too little, too late. IFRS 9 was developed to force businesses to take into account the impact of current and future events, as well as economic factors that ultimately could impact the overall credit risk exposure of a business. The objective of IFRS 9 was to shift management’s mindset from a reactive (or incurred) credit loss model to an expected credit loss model so that businesses would recognise and inform relevant stakeholders of potential impairments ahead of time. As you revise your impairment predictions, remember that no one has been unaffected by COVID-19, including your shareholders, lenders and regulators.
To help navigate these murky waters, we have summarised some key points to help businesses determine the impact of COVID-19 on their expected credit losses (ECLs). All businesses must re-evaluate the core assumptions behind their existing impairment models and find a way to incorporate data into the IFRS 9 models in a way that is rational, reliable, reasonable and can be refreshed as needed.
Impact Of Covid-19 On IFRS 9 Models
In building an IFRS 9 model, businesses would have had to set up parameters that govern how the IFRS 9 model operates. Part of this process would have involved defining terms such as "significant increase in credit risk" (SICR) and "default". These definitions would generally be determined with reference to an internal credit rating methodology to be able to track the credit risk grading of financial assets and how they move between the different stages outlined in IFRS 9. A good starting point would be for all businesses to revisit the definitions that have already been built into the IFRS 9 model and assess if the current definitions still hold true. For example, if customers were offered a payment holiday as part of a relief program during this global pandemic, would this be seen as a significant increase in credit risk?
2. Judgements and assumptions
When assessing the probability of default (PD) and the loss in the event of default (LGD), it’s near impossible at this point to predict how certain variables will behave in the near future. Management needs to stop, pause, have a think and come up with an approach to update the judgements and assumptions built into IFRS 9 models that strike a balance between oversimplifying and overengineering any adjustments. Most important is to document your considerations clearly and stress-test the numbers to ensure they’re within a reasonable range.
For companies with years ending between 31 December 2019 and 31 March 2020, there is insufficient data to make any adjustments to the IFRS 9 model that would be reasonable and supportable. For these entities, we believe additional disclosure is the best way to reflect what management has done to unpack the potential impact of COVID-19. This disclosure would include information about the assumptions about the future, and any major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year.
For companies that will be required to report results within the next 6 – 12 months, consider the following factors in your revised IFRS 9 model when calculating your ECLs:
- Unemployment rates – COVID-19 has caused a lot of operational instability, which may lead to the closure of certain businesses and facilities.
- Interest rates – The SARB recently lowered interest rates to help boost disposable income and encourage economic activity. Keep in mind what’s happening in the global economy too. For example, the US Federal Reserve recently cut interest rates to 0%, which should have encouraged spending, but paradoxically drove the Dow right down, perhaps because of the lockdown effect of many businesses closing down during this time. Also keep in mind that South Africa is lagging behind the rest of the world by three to five weeks in the spread and effect of the virus.
- Concentrations of risk – Be aware of where your credit risks are highest. For example, if a counterparty operates in an area hit particularly severely by COVID-19 then geographical location is a risk concentration to factor in. Consider other risk factors in your particular industry, service line or risk type as applicable.
- Liquidity risk - As a result of national lockdowns and curfews being implemented, many corporates and households will experience a loss of income. You will need to assess the impact of this loss on the cash inflows and outflows expected over the next few months and possibly years and update for any increase in liquidity risk.
- Foreign exchange fluctuations – The loss of economic value overall in different jurisdictions and the restrictions on global movement is likely to cause volatility in foreign currency exchange rates.
- Market volatility – Some global markets are hitting 30-year lows at the moment, which have caused many market authorities to intervene and prevent short-selling. Keep an eye on trading conditions and what protections are being put in place to prevent further collapse.
- Regulators – The responses from industry bodies like the JSE, FSCA and IASB are being rolled-out into accounting practices in real time. It’s crucial to keep pace with these changes. For example, the IASB announced it would defer the rollout of the new insurance standard, IFRS 17 by one more year.
- Insurance – COVID-19 will almost certainly mean an increase in insurance claims now and in the future. Take note of this if any of the products offered has an insurance or credit life element.
- Fair value of collateral – Any fair values of collateral that affect your ECL model will need to be revised as the market and fair value prices adjust. These changes may impact your debt protections and recovery options in the event of a default
- Rescue packages and measures – On the positive side, also consider all rescue packages and other measures being offered by especially governments and banks to support their citizens and customers during this turbulent time.
3. Loan modifications
Where borrowers are experiencing cash flow challenges as a result of COVID-19, financial institutions are open to renegotiating payment terms and finding ways to provide support and relief to customers. Any changes made to the original terms of a loan would constitute a "loan modification" and must be assessed carefully to determine the potential impact. Such an assessment would include a comparison of the cash flows before and after the modification, discounted at the original effective interest rate (EIR). If the difference between these discounted cash flows is more than 10%, the instrument is derecognised and a new instrument would be recognised.
4. Short term instruments
In general, businesses will have assumed that instruments with shorter lifecycles have a lower credit risk because the amounts are recoverable over a short period of time. Credit risk determined upfront on these instruments, will generally be high but not subject to drastic changes over a short period of time. These are often calculated on an aggregated basis per portfolio rather than on an individual account level. It is likely that any pre-COVID 19 assumptions that were made regarding portfolios of short-term instruments, may have changed now and will need to be reconsidered.
On transition to IFRS 9, financial instruments would have been grouped based on shared credit risk characteristics. COVID-19 may mean that instruments that exhibited similar credit risk characteristics start to behave differently. The way instruments were initially grouped may need to be reassessed and aggregated/disaggregated differently as new information becomes available. For example, portfolios may now be determined with reference to the concentrations of risk referred to above.
As many businesses go into hibernation, or even close down, because of COVID-19, we advise our clients to increase savings and be prudent with distribution policies, for example dividends and employee incentive schemes. Identify any existing covenants on borrowings that may be impacted by increased ECLs and engage proactively in discussions with your funders on how facilities could be restructured if necessary. It is crucial to update disclosures for all of the issues outlined above as well as any related tax consequences in the upcoming financial reporting period.
We recommend you use this opportunity to slow down, relook at your strategies and determine the most efficient, effective and economically viable steps to stay the course during COVID-19 and emerge more resilient.
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