Credit-adjusted effective interest rate

Last update 14/12/2019

Credit-adjusted effective interest rate – The rate that exactly discounts the estimated future cash payments or receipts through the expected life of the financial asset to the amortised cost of a financial asset that is a purchased or originated credit-impaired financial asset.

When calculating the credit-adjusted effective interest rate, an entity shall estimate the expected cash flows by considering all contractual terms of the financial asset (for example, prepayment, extension, call and similar options) and expected credit losses. Credit-adjusted effective interest rate

The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate, transaction costs, and all other premiums or discounts. There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be estimated reliably.

However, in those rare cases when it is not possible to reliably estimate the cash flows or the remaining life of a financial instrument (or group of financial instruments), the entity shall use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments).

Example Credit-adjusted effective interest rate

The Case Credit-adjusted effective interest rate

Entity A provides a term loan to Entity B on January 1, 2018. Credit-adjusted effective interest rate
The loan’s principal amount is $ 1,000,000 with 3% interest per year payable at the end of each month.
The principal is due on December 31, 2021. Credit-adjusted effective interest rate
The loan is secured by a portion of Entity B’s fixed assets. Credit-adjusted effective interest rate

On December 32, 2019 Entity A determined the credit risk of the loan had increased significantly and provided lifetime ECLs of $ 50,000 on the loan (These are the ECLs that result from all possible default events over the expected life of the instrument). 2019 interest revenue = $ 30,000 (3% × $ 1,000,000) which is based on the effective interest rate applied to the gross carrying amount (which is the amortised cost before adjusting for any loss allowance).

On December 31, 2020, Entity A determines the loan to be a credit impaired financial asset, as evidenced by:

Entity B experienced significant financial difficulty and has been placed into receivership.
The monthly interest payments were not made during the year.
Significant reduction in the value of the collateral.

The estimated present value of the collateral that Entity A expects to recover minus associated costs is $ 800,000. The gross carrying amount of the loan (which excludes the impairment allowance) is $ 1,030,000 comprising of the loan amount and the unpaid interest for the year.

Lifetime ECLs = $ 230,000 ($ 1,030,000 – $ 800,000)

The change in the cumulative impairment allowance of $180,000 is recognised in profit or loss.
2020 interest revenue = $ 30,000 (3% × $ 1,000,000) interest revenue in 2020.
2021 interest revenue = $ 24,000 (3% × $ 800,000) which is based on the effective interest rate applied to the amortised cost (gross carrying amount minus loss allowance) of the instrument from the date it became credit-impaired.

Background

The general impairment model does not apply to purchased or originated credit impaired assets. A financial asset is considered credit-impaired on purchase or origination if there is evidence of impairment (as defined in IFRS 9 Appendix A) at the point of initial recognition (for instance, if it is acquired at a deep discount).

For such assets, impairment is determined based on full lifetime ECL on initial recognition. However, lifetime ECL are included in the estimated cash flows when calculating the effective interest rate on initial recognition. The effective interest rate for interest recognition throughout the life of the asset is a credit-adjusted effective interest rate. As a result, no loss allowance is recognised on initial recognition.

Any subsequent changes in lifetime ECL, both positive and negative, will be recognised immediately in profit or loss.