Trade receivables Impairment under NZ IFRS 9

1 January 2018, the effective date of NZ IFRS 9 Financial Instruments is fast approaching. All Tier 1 and Tier 2 for-profit entities should already be contemplating their transition plans, especially those with a December year end, as these entities will be “first off the mark” (see our accompanying article Countdown to adopting NZ IFRS 9, 15 and 16 – Time is running out.) 

One area where NZ IFRS 9 will impact most entities is the change in impairment model for trade receivables.

Currently under NZ IAS 39 Financial Instruments: Recognition and Measurement, impairment is calculated based on an incurred loss model – i.e. an impairment allowance is only raised when a receivable has had a credit event such as becoming “past due”.

Under NZ IFRS 9, impairment is required to be calculated based on a complex 3-stage expected loss model. The 3-stage model results in different methodologies being used to calculate impairment based on whether there has been a significant increase in the credit risk of a financial asset since its initial recognition.

These three stages then determine the amount of impairment to be recognised as expected credit losses (ECL) (as well as the amount of interest revenue to be recorded) at each reporting date:

• Stage 1: Credit risk has not increased significantly since initial recognition – recognise 12 months ECL, and recognise interest on a gross basis
• Stage 2: Credit risk has increased significantly since initial recognition – recognise lifetime ECL, and recognise interest on a gross basis
• Stage 3: Financial asset is credit impaired (using the criteria currently included in NZ IAS 39 Financial Instruments: Recognition and Measurement) – recognise lifetime ECL, and present interest on a net basis (i.e. on the gross carrying amount less credit allowance).

In applying this new impairment model, it is anticipated that the amount of impairment will increase for most entities, and the complexities of applying the model are expected to be challenging.

However, as a practical expedient, entities are allowed to apply a simplified impairment model to trade receivables with maturities of less than 12 months.

Instead of applying the 3 stage model above, entities can instead choose to recognise the ‘lifetime expected credit losses’ on these trade receivables. Because the maturities will typically be 12 months or less, the credit loss for 12-month and lifetime expected credit losses would be the same.

The simplified impairment model allows entities to calculate expected credit losses on trade receivables using a provision matrix.

In practice, many entities already estimate credit losses under NZ IAS 39 requirements using a provision matrix where trade receivables are usually grouped based on past-due status.

The provision matrix analysis required by NZ IFRS 9 is more complex as it is required to be based on different customer attributes and different historical loss patterns (e.g. past-due status, geographical region, product type, customer rating, collateral or trade credit insurance, or type of customer).

Under the new model, entities will need to update their historical provision rates with current and forward looking estimates.

There are thus two key differences between the NZ IAS 39 impairment model and the new model for impairment of trade receivables:

• Entities will not wait until the receivable is past due before recognising impairment, and
• The amount of credit losses recognised is based on forward looking estimates that reflect current and forecast credit conditions.

Example 1 – Applying the new impairment model to trade receivables

Company M provides security services to a customer base which consists of a large number of small clients. At 31 December 2018, Company M has $30 million of trade receivables. Credit terms are 30 days and interest free, and Company M has concluded that these trade receivables have no significant financing component in accordance with NZ IFRS 15

Clients are mainly from the construction and dairy sectors, and are located in Christchurch and Wellington.

Company M has observed the following historical defaults rates based on number of days past due:

	Historical  average default rate	Carrying amount ($)
Current	0.73%	16,550,000
1-30 days past due	1.83%	8,700,000
31-60 days past due	3.52%	3,010,000
>61 days past due	6.26%	1,740,000
Total		30,000,000

Impairment under NZ IAS 39 requirements

The amount of impairment Company M would have calculated under NZ IAS 39 requirements is as follows, based on number of days past due:

	Historical average default rate	Carrying amount ($)	Impairment loss allowance ($)
Current	0.73%	16,550,000	N/A*
1-30 days past due	1.83%	8,700,000	159,210
31-60 days past due	3.52%	3,010,000	105,952
>61 days past due	6.26%	1,740,000	108,924
Total		30,000,000	374,086

* For receivables that are current, there is no credit event and thus there is no impairment allowance calculated under NZ IAS 39

Impairment under NZ IFRS 9 requirements

Company M’s clients are from different industries (construction and dairy) and locations (Christchurch and Wellington).

Company M may experience significantly different loss patterns for different customer segments and will thus need to consider whether historical defaults rates vary significantly based on:

• Past due status
• Industry, and
• Location of the customer

As part of Company M’s transition plan to implementing NZ IFRS 9, it has been observing historical defaults rates of customers from the various geographical locations over the last two years and has observed the following:

Historical default rates for Christchurch

	Dairy	Construction
Current	0.50%	1.30%
1-30 days past due	1.90%	2.80%
31-60 days past due	3.10%	5.25%
>60 days past due	7.50%	8.45%

 

Historical default rates for Wellington

	Dairy	Construction
Current	0.10%	1.20%
1-30 days past due	1.50%	2.70%
31-60 days past due	2.60%	5.20%
>60 days past due	5.60%	8.50%

Company M has observed that:

• Historical default rates vary based on past due status
• Historical default rates vary across the two regions for customers in the dairy sector
• The economic factors impacting default rates in Christchurch and Wellington have been similar for the construction sectors and are expected to continue to be similar going forward.

Company M concludes that the construction sectors in Christchurch and Wellington can be combined as one sub portfolio.

Based on the above, Company M thus segregates its receivables into 12 sub portfolios for impairment testing:

• 4 sub-portfolios for Christchurch – dairy sector
• 4 sub-portfolios for Wellington – dairy sector
• 4 sub-portfolios for Christchurch and Wellington for construction combined

Company M now needs to consider forward-looking estimates, including general economic forecasts that are relevant for each portfolio and adjust the historical default rates for each sub-portfolio accordingly before the impairment calculation under NZ IFRS 9 can be carried out.

Company M forecasts that economic conditions will deteriorate significantly over the next year in Christchurch and Wellington. It is forecast that the deterioration will have the greatest impact in the construction sector.

It also forecasts that the dairy sector in Wellington is likely to be least impacted by the deterioration in economic conditions as the customers in that portfolio are more diversified than those in Christchurch. 

Company M therefore forecasts the following expected default rates at 31/12/18

	Construction in Christchurch and Wellington	Dairy in Christchurch	Dairy in Wellington
Current	2.8%	0.9%	0.3%
1-30 days past due	5.8%	3.2%	2.0%
31-60 days past due	8.9%	5.0%	3.1%
>60 days past due	13.1%	9.1%	6.0%

 

The gross carrying amounts of trade receivables at 31/12/18 is as follows:

	Construction in Christchurch and Wellington ($)	Dairy in Christchurch ($)	Dairy in Wellington  ($)	Total($)
Current	13,500,000	1,550,000	1,500,000	16,550,000
1-30 days past due	6,800,000	1,150,000	750,000	8,700,000
31-60 days past due	1,900,000	450,000	660,000	3,010,000
>60 days past due	890,000	450,000	400,000	1,740,000
				30,000,000

Lifetime expected credit losses calculation – NZ IFRS 9

	Construction in Christchurch and Wellington ($)	Dairy in Christchurch  ($)	Dairy in Wellington  ($)	Total ($)
Current	378,000	13,950	4,500	396,450
1-30 days past due	394,400	36,800	15,000	446,200
31-60 days past due	169,100	22,500	20,460	212,060
>60 days past due	116,590	40,950	24,000	181,540
Lifetime expected credit loss allowance				1,236,250

 

As can be seen from the above calculations, Company M’s impairment allowance under NZ IFRS 9 requirements ($1,226,350) is significantly more than the amount it would have provided for under NZ IAS 39 requirements ($374,086).

The main factors impacting on the increase in the impairment allowance are:

• Under NZ  IFRS 9 expected credit losses are also provided for the current portion of the trade receivables
• NZ IFRS 9 requires the use of forward looking estimates, and in this scenario Christchurch and Wellington are expected to experience significant deterioration in general economic conditions
• NZ IFRS 9 requires more granular segregation of trade receivable portfolios in the provision matrix.

A word of warning!

This practical expedient simplified model is only available for trade receivables and contract assets that do not contain a significant financing component in accordance with NZ IFRS 15 Revenue from Contracts with Customers and, by accounting policy election, may also be applied to other long term trade receivables and lease receivables.

The simplified model CANNOT be applied to loan receivables from related parties, key management personnel and intercompany entities. For those loan receivables, the more complex 3 stage model must be applied.

The way forward

For those entities that have not yet implemented a transition plan for NZ IFRS 9, it is highly recommended that you do so as soon as possible. Entities will need to put policies and procedures in place to track information required by NZ IFRS 9 and in some instances significant changes may be required to accounting systems.

Transition to NZ IFRS 9 is not straight forward and decisions on what transition model to follow need to be made as soon as possible.

Please refer to our publications Need to Know: IFRS 9 Financial Instruments – Impairment of Financial Assets and IFRS in Practice 2016: IFRS 9 Financial Instruments, for more on the impairment and transition requirements of NZ IFRS 9.

 

For more on the above, please contact your local BDO representative.