The operation of businesses in changing market conditions is inevitably accompanied by the risks of uncertainty and the eventual occurrence or non-occurrence of certain events. Let's talk more about credit risk assessment and management tools.
Essence of risk
Credit risk implies the likelihood of a financial loss occurring in one entity (conditionally Party 1 of a financial instrument contract) due to the fact that another entity (Party 2) is unable to fulfill its obligations for some reason. In fact, a credit loss in terms of value is the difference between the cash flows foreseen in the contract and the cash actually received. Note that credit risk is different from the risk of late payments to the bank.
The source of credit risk is financial assets (bank funds, securities, accounts receivable of counterparties, loans to other entities, etc.).
In the context of credit risk analysis, we should mention IFRS 9 concept of expected credit losses that should reflect the potential loss from owning a financial asset. For such losses the enterprise should form a reserve.
It should be noted that the most relevant reserve for expected credit losses is for accounts receivable under settlements with counterparties. In general, an entity should recognize the provision for the following accounting objects:
- financial assets measured at amortized cost;
- financial assets measured at fair value through other comprehensive income (those measured at profit/loss do not require a provision);
- lease receivables;
- accounts receivable on a contractual asset;
- credit obligations;
- financial guarantee agreements.
Method of evaluation
The expected credit losses under IFRS 9 will always be greater than zero. And this is justified because it is impossible to make a reliable assumption that the debt will be fully recovered in all possible conditions. When choosing evaluation method of expected credit losses, an entity should consider:
- an amount that is objective and weighted by probability (determined by evaluating a certain range of possible outcomes);
- cost of money in time;
- information on past events, current conditions and forecasts for future economic conditions. Such information shall be verified and substantiated as necessary. At the same time, it is a prerequisite to receive information in accordance with the principle of cost - benefit (without excessive cost or effort).
It is worth noting that when analyzing the expected level of credit losses, it is important to take into account any flows from the collateral after the expiration of the contract.
Please note that the entity estimates the expected credit losses for the period during which it is vulnerable to credit risk, and the expected credit losses cannot be reduced by taking credit risk management measures.
As at each reporting date, an entity should assess whether credit risk has increased significantly since initial recognition. In the event of late payment of contractual payments for more than 30 days, it is assumed that credit risk on a financial asset has undergone significant growth.
Default situation
In practice, a default situation is possible, the risk of which is also important to assess. This is done by using an entity designed to internally manage the credit risk of defining a default for a financial instrument and, if appropriate, qualitative indicators (such as financial conditions) are considered. However, the simplified assumption is applied that a default occurs no later than 90 days if the entity does not have reasonable necessary and verifiable information that proves that the criterion with a longer delay is appropriate.
The most common credit risk management tools are listed in the Table.
Table. Credit risk management tools
|
Instrument |
Content |
|
Discounts |
Flexible pricing can be an effective incentive to pay with customers and an indicator of financial management quality |
|
Factoring |
A factoring company issues a guarantee for debtors up to 9% of the amount of sales for the period of deferred payment and, if the debtor can not make timely payment, pays for it. In factoring transactions, it is important for businesses to evaluate whether virtually all risks and rewards of ownership of a financial asset are being transferred. Accordingly, an assessment is made of whether control over accounts receivable is maintained. Factoring that results in a derecognition of a financial asset is accounted for by the Company to determine the business model in accordance with IFRS 9. |
|
Insurance |
The object of insurance is the property interests of the policyholder in default (improper performance) of contractual obligations by the debtor of the policyholder |
A much broader list of instruments is traditionally used by banks. In their practice, there is a widespread distribution of credit risk to counterparty risk (deterioration of a client's creditworthiness or default) and country risk (inability to fulfill a client's obligations for political and economic reasons).
Content of notes
With regard to the content of notes, an entity shall disclose the following credit risk information for each class of financial asset:
- the amount of the maximum level of credit risk at the end of the reporting period (without taking into account credit enhancements);
- a description of the credit enhancements (including collateral) held as security for the loan, disclosing their financial impact, nature and carrying value, as well as policies for the potential sale of illiquid assets;
- analysis of credit quality of financial assets (except overdue and impaired);
- analysis of financial assets by maturity, which are past due;
- analysis of financial assets that are impaired (with indicated reasons for impairment).
