MFRS 9 Financial Instruments introduces significant changes to the way entities measure the impairment loss (credit loss) for financial instruments. Under the previous MFRS 139 Financial Instruments: Recognition and Measurement, the impairment loss is measured based on the ‘incurred loss model’. Under this model, financial instruments such as loans, debt securities, and trade receivables are assumed to be repaid until there is evidence/event that indicates otherwise (the event is known as loss or trigger event). As such, impairment loss is only recognised and measured for financial instruments with loss/trigger event(s). MFRS 139 prohibits an entity to take into account or consider the future expectation of credit loss of financial instruments in the impairment loss measurement. The failure to consider the future expectation of credit loss is often quoted by stakeholders as the main weakness of this model. Often, the impairment loss is recognised and measured when customers and borrowers are already in deep trouble.
What is the expected credit loss model?
As compared to MFRS 139, credit loss for financial instruments under MFRS 9 is measured using the new model – the ‘expected credit loss model’ where financial instruments are assumed to have the probability of default on initial recognition, even for customers with good credit rating/standing. The expected credit loss model accelerates the recognition of potential credit loss, way before the triggering event/loss event takes place. The expected loss model requires an entity to exercise significant judgments and estimates as it pushes for an entity to consider historical information (past track record), current condition as well as reasonable and supportable forward looking information, which includes a forecast of future macro-economic factors or variables to measure the expected credit loss. Because the expected credit loss model takes into consideration future economic conditions, the amount of credit loss allowance may fluctuate significantly, especially for banks depending on the economic conditions. This can be a tricky consideration to many companies following the COVID-19 pandemic as there is higher uncertainty in the forward economic recovery.
What is Forward looking information?
The term forward looking information is a new technical jargon under MFRS 9. Many MFRS users find it a struggle to understand and determine what kind of forward looking macro-economic factors that they need to consider and incorporate in the expected credit loss model. This is particularly important as there is various economic uncertainty in the future and past data on its own is insufficient to measure the impairment loss. The ‘forward looking information’ term is not defined in MFRS 9. Some of the questions that users commonly in relation to forward looking information are:
- What are the common macro-economic factors that an entity shall incorporate in its expected credit loss model?
- How many macro-economic factors should be considered? Are there any minimum and maximum factors that must be considered and incorporated in the expected credit loss model?
There are three key inputs in measuring the expected credit loss which are (i) the probability of default, (ii) loss given default, and (iii) exposure at default. Forward looking information is generally considered within the three key inputs to derive to the measurement of credit loss. Besides, forward looking information is also considered to determine whether there is a significant increase in credit risk for financial instruments under the general approach. An entity shall incorporate relevant and supportable forward looking macro-economic variables that reflect the industry, type of customers, and financial instruments that they hold. There are no explicit requirements in MFRS 9 on the minimum and maximum numbers of forward looking information that should be incorporated in the expected credit loss model, so long that the forward looking information is relevant and supportable. Forward looking information estimates are required to be updated and analysed at each reporting date to ensure they are appropriate and reasonable in the measurement of the expected credit loss.
The common forward looking information considered by companies in Malaysia
Below is a quick summary of the common forward looking information considered by listed companies in Malaysia based on their latest available audited financial statements. Please take note that this observation is not exhaustive as some companies did not disclose in their financial statements the forward looking macro-economic factors that they have considered in full.
| Industry | Common forward looking information used |
|---|---|
| Commercial banks | – Overnight policy rate (OPR) – Housing price index – Unemployment rate – Kuala Lumpur Interbank Offered Rate (KLIBOR) – Gross Domestic Product (GDP) of Malaysia/GDP growth rate – Private consumption expenditure – Base lending/financing rate |
| Energy | – Oil price – Geographical area of customers or country rating – Market interest rate or growth rates – Gross Domestic Product (GDP) or GDP growth rate |
| Property | – Gross Domestic Product (GDP) or GDP growth rate – Unemployment rate – Inflation rate |
| Health care | – Market interest rate or growth rate – Gross Domestic Product |
In addition to the above, it has also been observed that some companies had disclosed in their financial statements that the amount of expected credit loss is insensitive to the changes in the forecast economic conditions and hence, forward looking information does not have a significant impact to the credit risk based on the industry where the companies operate.
Impairment disclosure requirements have been expanded significantly which shall include disclosure of inputs, assumptions, and estimation used in the expected credit loss model. Where significant judgements and estimates are involved in this area, entities shall ensure necessary disclosures are made in the financial statements.