How will the new financial instrument standard impact business combinations when determining expected credit losses on financial assets

Most entities will by now be applying the expected credit loss (ECL) requirements in IFRS 9 Financial Instruments when assessing whether financial assets that are at amortised cost, or debt instruments at fair value through other comprehensive income (FVTOCI), are impaired. However, it is important to note that when acquiring a business and applying IFRS 3 Business Combinations, acquirer groups will need to reassess, at acquisition date, the stages assigned by the acquiree when applying the new ECL requirements.

For financial assets acquired in a business combination, initial recognition occurs at the time of the business combination (acquisition date). This effectively means the status of most financial assets to which the new ECL model applies reverts back to Stage 1 on acquisition date in the books of the acquirer group. The exception is for acquired ‘Stage 3’ loans which are ‘purchased or originated credit-impaired financial assets’ at acquisition date where a separate impairment approach is applied.

Which financial assets require impairment testing using the new ECL model?

IFRS 9 requires the following types of financial assets to apply the new ECL requirements, i.e. debt instruments measured at:

Amortised cost, or
Fair value through other comprehensive income (FVTOCI).

How do the ‘staging’ provisions in the ECL model work?

The IFRS 9 ECL model requires the above types of financial assets to be categorised into three ‘buckets’ as follows:

Stage 1: Financial assets that have not had a significant increase in credit risk since initial recognition
Stage 2: Financial assets that have had a significant increase in credit risk since initial recognition, or
Stage 3: Credit-impaired financial assets.

The staging drives the measurement and disclosure requirements in the ECL model.

Since the relative change in credit risk since initial recognition is the mechanism for migration between these stages or ‘buckets’, ‘initial recognition’ must be considered carefully. For an acquirer, ‘initial recognition’ is the date of the business combination.

Example 1

Big Co acquires Small Co on 1 July 2019.

Small Co has three loan receivables in its books on acquisition date (1 July 2019):

Loan A (in stage 1)
Loan B (in stage 2)
Loan C (in stage 3, i.e. credit impaired).

The stages assigned above are based on the relative movement in credit risk experienced by Small Co since they were originated by Small Co prior to 1 July 2019.

From the Big Co Group’s (acquirer) perspective, the date of initial recognition for these loans is 1 July 2019. This means that on initial recognition by the Big Co Group:

Loan A remains in Stage 1
Loan B reverts to Stage 1, and
Loan C will be under the purchased or originated credit impaired approach (POCI) approach.

Loan	In books of Small Co	Big Co Group consolidation
A	Stage 1	Stage 1
B	Stage 2	Stage 1
C	Stage 3	POCI approach

All loans will basically revert to ‘Stage 1’, except for Loan C, the acquired ‘Stage 3’ loan which is considered a ‘purchased or originated credit-impaired’ (POCI) financial asset at acquisition date.

Implications of reassessing ECL stages

The requirement for the acquirer to reassess the ECL stages will result in several significant implications which may be complex to address in financial reporting systems:

Big Co Group’s assessment of the staging of these loans will differ from Small Co’s
In order to address the staging provisions, Big Co Group will need to develop policies and procedures to measure the relative movement in credit risk since the date of the business combination, and
The ongoing ECL required on the instruments may therefore differ as staging may differ (e.g. a 12-month ECL may be required for Big Co Group, but a lifetime ECL may be required for Small Co).
Loan In books of Small Co Big Co Group consolidation
A Stage 1 12-month ECL Stage 1 12-month ECL
B Stage 2 Lifetime ECL (gross interest) Stage 1 12-month ECL
C Stage 3 Lifetime ECL (net interest) POCI approach¹

¹ POCI assets will need to follow the specific guidance in IFRS 9 which requires a credit-adjusted effective interest rate to be used. This rate builds ECL into the effective interest rate of the instrument, which may be complex to calculate and not easily achieved with current accounting systems and processes.

Don’t forget to determine fair value of financial assets at acquisition date

As noted in our article in October 2019 Accounting News, prior to assessing the stages for ECL impairment calculations, the acquirer must also determine the fair value for each financial asset of the acquiree at acquisition date.

Even if both the acquiree and acquirer will each continue to measure a financial asset at amortised cost after the acquisition date, the acquirer will still have to recognise, at acquisition date, such financial asset at fair value. Changing the fair value at acquisition date will also result in the acquirer using a different effective interest rate to the acquiree.

Presentation of Expected Credit Losses

Like most assets acquired in a business combination, financial assets acquired in a business combination that are subject to the ECL requirements of IFRS 9 are initially recorded at their fair value as at the date of the business combination. While ECL is a forward-looking measure with some similarities to fair value measurement, the concepts are not identical. Therefore, the net carrying value of financial assets may differ from their fair value.

Example 2

Same facts as Example 1. Assume Loan B, which was originated by Small Co, at the date of the business combination (1 July 2019), had:

A gross carrying value of $100, and
A corresponding $20 ECL recorded against it, representing the lifetime ECL of the financial asset, as it is classified as a Stage 2 financial asset.

At the time of the business combination, Big Co determines the fair value of Loan B to be $78 (note that the fair value of a financial asset may be more or less than the gross carrying value less ECL depending on a number of factors).

No separate valuation allowance is recorded in the purchase price allocation by Big Co (IFRS 3.B41) because the fair value of the financial asset incorporates uncertainty regarding credit risk. The difference in classification and measurement of the financial asset from the perspective of Small Co and Big Co’s consolidated records as at the time of the business combination can be demonstrated as follows:

Loan B	Big Co ($)	Small Co ($)
Gross carrying value	78	100
ECL balance	Nil	20
Net carrying value	78	80
Stage in ECL methodology	Stage 1 – 12-month ECL	Stage 2 – lifetime ECL

This results in not only the carrying value differing upon the completion of the business combination, but also the measurement of the ECL balance and the staging of the financial asset in the ECL guidance. Addressing these differences from a systems and process standpoint may be complex, especially if Big Co A and Small Co are required to maintain distinct financial records for reasons such as local jurisdictional regulation.