With the deferment in applicability of IND AS to 1stApr 2019 in respect of Scheduled Commercial Bank, the current rule based provisioning norms namely “Income Recognition, Asset Classification & Provisioning (IRACP)” as prescribed by the RBI are scheduled to be transitioned to “Expected Credit Loss Model (ECL Model)” based on contents of “Ind AS 109 Financial Instruments”.IND AS 109 replaces the existing “Incurred Loss Model” with a forward-looking “ECL Model”. With this transition, entities can no longer afford to wait till occurrence of loss event and thereafter resort to provisioning, instead, entities are expected to be forward looking and should exercise credit modelling leading to, making of needed provisions based on changes in quality of credit.
Past experiences of financial crisis has revealed, the need of being proactive in reckoning the potential deterioration in the credit quality of the financial assets. Further adequate disclosures of increase in credit risk will facilitate prudent decision making and initiate needed corrective measures.
Para 5.5.1 of IND AS 109, specifies the applicability of “ECL Model” to :
1. A financial asset which is measured at amortised cost and which meets below conditions:
a. It is held within a business model whose objective is to hold financial assets in order to collect contractual cash flows,and
b. The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding
2. A financial asset shall be measured at fair value through other comprehensive income and which meets below conditions:
a. The financial asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets and,
b. The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.
3. A lease receivable,
4. A contract asset or a loan commitment and,
5. A financial guarantee contract to which the impairment requirements apply.
Note that almost all the financial statement, will have element of assets having nexus to “Credit Risk”, consequently the model would be applicable to all the entities which have contractual receivables or recoveries from other entities.
Credit losses are nothing but the differences between the contractual cash flow due to the entity and cash flow that entity actually expects to receive.
“Para 5.5 Of IND AS 109” discusses about the “General Approach” for recognition of expected credit losses.
Under the general approach, an entity must determine whether the financial asset is in one of the three stages in order to determine :
At broad level the model works by assessing the credit quality and categorises the financial assets into below referred 3 stages:
1. Asset Quality: Will include those financial instruments for whom there is no material decline in credit risk since initial recognition or those which have low credit risk at the reporting date.
2. Provisioning & Income Recognition: For these assets, 12-month expected credit losses are recognised. 12-month ECL means, the portion of lifetime expected credit losses that represent the expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date. Interest revenue is calculated on the gross carrying amount of the asset (that is, without deduction for credit allowance).
1. Asset Quality: Will include those financial instruments for whom there is significant increase in credit risk since initial recognition(unless they have low credit risk at the reporting date) but which do not have objective evidence of impairment.
2. Provisioning & Income Recognition: For these assets, lifetime ECL are recognised, but interest revenue is still calculated on the gross carrying amountof the asset. Lifetime ECL are the expected credit losses that result from all possible default events over the expected life of the financial instrument. Expected credit losses are the weighted average credit losses with the probability of default (‘PD’) as the weight.
1. Asset Quality: Will include those financial assets for whom there are objective evidence of impairment at the reporting date.
2. Provisioning & Income Recognition: For these assets, lifetime ECL are recognised and interest revenue is calculated on the net carrying amount (that is, net of credit allowance).
1. Relative Assessment:
In a situation where two different entities say A & B have “Receivable” from a common entity say C, yet if credit risk at initial recognition stage is starkly different for A & B respectively, then it would lead to difference in categorisation for A & B respectively, inspite of the fact that rest characteristics of the assets are same.
2. Assessment Is Based On Estimate & Not On Actuals:
Entities will have to develop, examine, test and maintain complex models and thereafter make significant estimates and judgement, to arrive at provisions and interest accruals.
Entities will have to formulate robust “Information Systems” which could timely churn out indicators for changes like :
Increased attrition, would surely pose concern for maintenance, documentation and reconciliation in respect of different cross platform systems and accounting treatments.
The emphatic mandate as posed by IND AS surely would pose further stress on the already beleaguered Banking System, however envisaged in the challenges is the glory of stable, reliable and transparent system. The extension of one year can prudently be utilised by entities to ensure implementation of needed systems and processes which would make Indian reporting at par with international reporting.
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(The Author CA.Rajeev Joshi is a partner with YSP & Co LLP with over 20 years of experience in myriad areas of GST, Direct Tax, System Audits, Controllership and CFO Functions.The author could be reached at firstname.lastname@example.org/8356097618 / 9619912774.)