Impairment (the provision for doubtful debts) aims to ensure the carrying amount of loans/other financial assets aren't overstated.
The current model under AASB 139 Financial Instruments: Recognition and Measurement is based on recognising an ‘incurred loss’ when something happens after the initial loan or investment is made.
The new model being introduced by AASB 9 Financial Instruments is an expected credit loss model that recognises potential losses based on forward-looking information. The consequence of the new model is similar to the general provision for doubtful debts and a day one loss that occurred pre-International Financial Reporting Standards (IFRS).
The new model is applicable to all financial assets that apply the amortised cost approach (discussed above), and those recognised at fair value through other comprehensive income (OCI) with recycling.
While the new model is similar to how banks and financial institutions manage their loans, the same model needs to be applied by non-financial institutions. Affected financial assets include:
- trade receivables
- investments in debt securities, such as government and corporate bonds
- loans to related parties (including controlled entities)
- other loans and advances
- financial guarantee contracts, for example a parent guaranteeing the debts of a subsidiary
- contract assets under AASB 15 (for example some work in progress).
The application to loans within the state total government sector is discussed below.
General approach—the three buckets
When banks lend money to borrowers, the bank aims to limit losses, though they expect that there will be some bad debts. Rather than recognise estimates of these bad debts over the life of each loan, the new model is based on recognising some estimated losses up-front, and then more losses when there is a significant increase in credit risk.
The model uses what has been referred to as a ‘three bucket’ or ‘three stage’ approach (colloquially known as the good, the bad and the ugly).
- Stage one: initial recognition—recognise 12 month expected credit losses.
- Stage two: significant increase in credit risk—recognise lifetime expected credit losses.
- Stage three: credit impaired—recognise lifetime expected credit losses and recognise interest revenue based on the written down amount.
A critical issue is determining when a loan (or advance or investment, and so on) has a significant increase in credit risk. This means moving from Stage one to Stage two, and the ‘cliff effect’ of recognising additional expected losses, from 12 months to lifetime expected losses. The aim is to recognise the additional losses before there is a default. One indicator of an increase in credit risk is if payments are more than 30 days overdue. The standard provides further guidance.
Expected credit losses
A common approach for determining expected credit losses by non-financial institutions is the following formula:
PD (probability of default)
LGD (loss given default)
EAD (exposure at default)
Using illustrative amounts for a low credit risk for 12 month expected losses is:
0.5% x 60% x $10,000,000
Application to loans to Queensland Government entities
Most people would expect that the Queensland Government’s probability of default in the next 12 months is very low. Consequently, the 12 month expected credit losses might not be material. Queensland Audit Office is currently in discussion with Treasury’s Financial Management Division on how these provisions should be applied in practice, with different types of entities and differing loan securities.
Trade receivables and other simplifications
The standard includes simplifications, as applying the general approach to many—possibly thousands of—debtors would be onerous. The simplification is to recognise lifetime expected losses on initial recognition. As trade receivables are usually due within 12 months, this would result in much the same answer.
The simplifications also apply to contract assets under AASB 15 that do not have a significant financing component. Entities have an accounting policy to apply the simplified approach to:
- trade receivables and contract assets (under AASB 15) that have a significant financing component
- lease receivables.
However, entities do not have the option of applying the simplified approach to other loans, such as loans to related parties.
If you are subject to Treasury’s Financial Reporting Requirements, you will need to follow any applicable mandated policies.
Many entities determine the provision for doubtful debts for trade debtors based on their aging, (for example into current, 30 days overdue, 60 days overdue, or more than 90 days overdue) and then apply a historical default rate. This approach can be applied under the new standard with reference to a provision matrix. The difference to current practice is adjustments to historical discount rates for forward-looking information and to applying a probability of default to current debtors (that is, those not currently overdue).
In practice, this may not result in a materially different amount. However, you will need to assess the effect to determine if the difference is material or not.