Last update 04/12/2019
The credit adjusted approach applies only rarely when an entity acquires or originates a loan or receivable that is “credit impaired” at the date of its initial recognition (e.g., when a loan is acquired at a deep discount due to credit concerns via a business combination).
This is part of the impairment of financial instruments in IFRS 9 Impairment of Financial Instruments.
An asset is credit impaired when one or more events that have a detrimental effect on the estimated future cash flows of the asset have occurred. The credit adjusted approach is one of three IFRS 9 approaches for measuring and recognising expected credit losses, the other two are the general approach and the simplified approach.
The IASB retained the credit adjusted approach for loans and receivables that are credit impaired at the date of initial recognition (e.g., loans acquired at a deep discount due to credit quality) because neither the general nor the simplified approach can appropriately portray the economics of these arrangements.
Examples in IFRS 9 of evidence that an asset is credit-impaired The credit adjusted approach
- Significant financial difficulty of the issuer or borrower The credit adjusted approach
- A breach of contract, such as a default or past due event (i.e., a borrower has failed to make a payment when contractually due) The credit adjusted approach
- The lender, for economic or contractual reasons relating to the borrower’s financial difficulty, has granted a concession that the lender would not otherwise consider The credit adjusted approach
- It is becoming probable that the borrower will enter bankruptcy or other financial reorganization
- The disappearance of an active market for that financial asset because of financial difficulties
- The purchase or origination of a financial asset at a deep discount that reflects incurred credit losses
When a financial asset is credit-impaired, IFRS 9 5.4.1(b) requires an entity to calculate (a lower) interest revenue by applying the effective interest rate to the amortised cost of the financial asset, i.e. the (original) gross amount less expected credit losses. This results in a difference between:
- the interest that would be calculated by applying the effective interest rate to the gross carrying amount of the credit-impaired financial asset, and
- the interest revenue recognised for that asset. The credit adjusted approach
If a financial asset ‘cures’, so that it is transferred back to stage 2 or stage 1, interest revenue would once again be recognised based on the gross carrying amount.
As a result, an entity recognises the adjustment required to bring the loss allowance to the amount required to be recognised in accordance with IFRS 9 as a reversal of expected credit losses ECLs in profit or loss [IFRS 9 5.5.8]. The credit adjusted approach
Example of application of the credit adjusted approach from HSBC
Credit-impaired (stage 3)
HSBC determines that a financial instrument is credit-impaired and in stage 3 by considering relevant objective evidence, primarily whether:
- contractual payments of either principal or interest are past due for more than 90 days; The credit adjusted approach
- there are other indications that the borrower is unlikely to pay such as that a concession has been granted to the borrower for economic or legal reasons relating to the borrower’s financial condition; and The credit adjusted approach
- the loan is otherwise considered to be in default. The credit adjusted approach
If such unlikeliness to pay is not identified at an earlier stage, it is deemed to occur when an exposure is 90 days past due, even where regulatory rules permit default to be defined based on 180 days past due. Therefore the definitions of credit-impaired and default are aligned as far as possible so that stage 3 represents all loans which are considered defaulted or otherwise credit-impaired. The credit adjusted approach
Interest income is recognised by applying the effective interest rate to the amortised cost amount, i.e. gross carrying amount less ECL allowance.
See also: The IFRS Foundation