The Accounting Standards Board (the Board) received an enquiry, wherein, guidance was sought that whether the historic and expected delay in settlement of circular debt balances in the energy sector of Pakistan (as per enquirer an amount ultimately due from the Government of Pakistan) results in an objective evidence of impairment under IAS 39.
The fact pattern is summarized below:
(a) The Securities & Exchange Commission of Pakistan (SECP), vide S.R.O 985(I)/2019 (dated September 2, 2019), granted temporary exemption from application of ‘Expected Credit Loss (ECL) Method’ of IFRS 9, Financial Instruments, to companies holding financial assets due directly or ultimately from the GoP. SECP granted this exemption till June 30, 2021. However, companies availing such exemption were required to follow relevant requirements of IAS 39. (Please note that SECP, subsequently, has extended above-noted exemption till June 2022).
(b) Historically, there have been delays in timing of settlement of circular debts. The abovementioned temporary exemption was granted by SECP in the wake of prevailing circular debt issue in the country and considering the uncertainties/practical limitations in determining the timing of settlement of the circular debt.
(c) Under IAS 39, companies are required to make an assessment on whether there is any objective evidence of impairment. In the context of circular debt, it has been a country wide consensus that historic and expected delay because of circular debt in the energy sector of Pakistan are not an objective evidence of impairment.
In the context of the above fact pattern, enquirer requested for Board’s guidance that whether the historic and expected delay in settlement of circular debt balances in the energy sector of Pakistan results in an objective evidence of impairment under IAS 39.
The Accounting Standards Board comments and conclusion1. The Board noted that in Pakistan IFRS 9 has been adopted under the Companies Act, 2017 and it is applicable to companies. The Board also noted that SECP, however, has deferred the applicability of IFRS 9 ECL (i.e. impairment) requirements till June 30, 2022 on the ‘financial assets due from the Government of Pakistan’. While granting this relaxation SECP has directed the companies to apply relevant requirements of IAS 39.
In view of above, impairment related requirements of IAS 39 are applicable on companies that have availed exemption from IFRS 9 ECL requirements.
2. The Board noted that IAS 39 in paragraphs 58 to 65 and AG84-AG93 sets-out the requirements and principle-based guidance for impairment of financial assets.
In accordance with IAS 39, the assessment of impairment loss on a trade debts/receivable (i.e. circular debt related balances) will include:
(a) assessment of an ‘objective evidence’ of impairment (the objective evidence is provided by one or more events that occurred after the initial recognition of the trade receivable (a loss event). The loss event (or events) impacts the estimated future cash flows of a trade receivable or a group of such receivables (where loss event(s) does not adversely impact the estimated future cash flows under the contractual terms there would be no impairment); and
(b) a reliable estimation of the above impact.
Where above conditions are fulfilled, impairment loss shall be recognised on a trade receivable.
Objective evidence of impairment
3. The Board observed that under paragraph 58 of IAS 39, impairment testing of a trade receivable requires assessment of whether there is any objective evidence of impairment. This assessment shall be based on all available information at the reporting date.
Objective evidence of impairment could be explained as one or more events that have occurred and have an impact on the expected future cash flows of the financial instruments.
Paragraph 58 of IAS 39 is reproduced below (emphasis is ours):
“An entity shall assess at the end of each reporting period whether there is any objective evidence that a financial asset or group of financial assets is impaired. If any such evidence exists, the entity shall apply paragraph 63 (for financial assets carried at amortised cost), paragraph 66 (for financial assets carried at cost) or paragraph 67 (for available-for-sale financial assets) to determine the amount of any impairment loss.”
4. IFRS 9 in paragraph BCE.107, while commenting on impairment model of IAS 39, notes that “the impairment models in IAS 39 require the recognition of credit losses only once there is objective evidence of impairment or when a credit loss is incurred (thus the impairment model includes a ‘recognition threshold’). As a result, the effect of future events, even when expected, cannot be considered. This recognition threshold is perceived to have caused a delay in the recognition of credit losses and was identified during the global financial crisis as a weakness in accounting standards.”
5. The Board noted that IAS 39 in paragraph 59 lists down examples of loss events that could result in such objective evidence (general triggers).
In accordance with paragraph 59, objective evidence that a financial asset is impaired includes observable data that comes to the attention of the holder of the asset about the loss events.
Paragraph 59 is reproduced below (emphasis is ours):
“A financial asset or a group of financial assets is impaired and impairment losses are incurred if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the asset (a ‘loss event’) and that loss event (or events) has an impact on the estimated future cash flows of the financial asset or group of financial assets that can be reliably estimated. It may not be possible to identify a single, discrete event that caused the impairment. Rather the combined effect of several events may have caused the impairment. Losses expected as a result of future events, no matter how likely, are not recognised. Objective evidence that a financial asset or group of assets is impaired includes observable data that comes to the attention of the holder of the asset about the following loss events:”
(b) significant financial difficulty of the issuer or obligor;
(c) a breach of contract, such as a default or delinquency in interest or principal payments;
(d) the lender, for economic or legal reasons relating to the borrower’s financial difficulty, granting to the borrower a concession that the lender would not otherwise consider;
(e) it becoming probable that the borrower will enter bankruptcy or other financial reorganisation;
(f) the disappearance of an active market for that financial asset because of financial difficulties; or
(g) observable data indicating that there is a measurable decrease in the estimated future cash flows from a group of financial assets since the initial recognition of those assets, although the decrease cannot yet be identified with the individual financial assets in the group, including:
i. adverse changes in the payment status of borrowers in the group (e.g. an increased number of delayed payments or an increased number of credit card borrowers who have reached their credit limit and are paying the minimum monthly amount); or
ii. national or local economic conditions that correlate with defaults on the assets in the group (e.g. an increase in the unemployment rate in the geographical area of the borrowers, a decrease in property prices for mortgages in the relevant area, a decrease in oil prices for loan assets to oil producers, or adverse changes in industry conditions that affect the borrowers in the group).
6. The Board also noted that IFRS 9 mentions ‘credit-impaired’ financial assets. In ECL model, a credit-impaired financial asset is at Stage 3, effectively at the point at which there has been an incurred loss event under the IAS 39 model.
The examples in IFRS 9 of when an asset is credit-impaired are identical to the examples that IAS 39 uses to indicate that an impairment loss should be recognized because objective evidence of impairment exists.
Credit-impaired financial asset is defined in IFRS 9, as under:
“A financial asset is credit-impaired when one or more events that have a detrimental impact on the estimated future cash flows of that financial asset have occurred. Evidence that a financial asset is credit-impaired include observable data about the following events:
(a) significant financial difficulty of the issuer or the borrower;
(b) a breach of contract, such as a default or past due event;
(c) the lender(s) of the borrower, for economic or contractual reasons relating to the borrower’s financial difficulty, having granted to the borrower a concession(s) that the lender(s) would not otherwise consider;
(d) it is becoming probable that the borrower will enter bankruptcy or other financial reorganisation;
(e) the disappearance of an active market for that financial asset because of financial difficulties; or
(f) the purchase or origination of a financial asset at a deep discount that reflects the incurred credit losses.
It may not be possible to identify a single discrete event—instead, the combined effect of several events may have caused financial assets to become credit-impaired.”
Measurement of impairment loss
7. The Board observed that when the loss event has an impact on the estimated future cash flows of a trade debt, then entity shall consider this impact on the measurement of the impairment loss.
Under IAS 39 paragraph 63, impairment of trade receivables is measured on the basis of the present value of estimated future cash flows (including the cash flows expected from a collateral and guarantee, under the contractual terms).
Paragraph 63 of IAS 39 is reproduced below (emphasis is ours):
“If there is objective evidence that an impairment loss on loans and receivables or held-to-maturity investments carried at amortised cost has been incurred, the amount of the loss is measured as the difference between the asset’s carrying amount and the present value of estimated future cash flows (excluding future credit losses that have not been incurred) discounted at the financial asset’s original effective interest rate (i.e. the effective interest rate computed at initial recognition). The carrying amount of the asset shall be reduced either directly or through use of an allowance account. The amount of the loss shall be recognised in profit or loss.”
8. The Board noted that an entity has incurred an impairment loss if it is probable that it will not be able to collect all amounts due according to the contractual terms. Contractual cash flows and historical loss experience provide the basis for estimating future cash flows. Based on the principle outlined in IAS 39, in case of delayed settlement of a trade debt:
(a) there would be no impairment, where, an entity under the contractual terms will receive compensation for every delayed payment (including interest on the delayed payment of principal and liquidated damages/surcharge). In such cases, the present value of future cash flows (both principal and interest) discounted at the receivable’s original effective interest rate will equal or more than the carrying amount of the loan/receivable.
(b) there would be an impairment loss, when, an entity under the contractual terms is not compensated for a delayed payment. In such cases, the present value of future cash flows discounted at the receivable’s original effective interest rate will be less than the carrying amount of the loan/receivable.
These scenarios could arise when there is no interest for delayed receipt of principal, or any interest on delayed principal is lower than the market interest-rate, or there is no interest on the delayed payment of original interest.
Conclusion
9. The Board, based on the enquired fact pattern and above discussion, concluded that:
(a) It is management responsibility and decision to recognise (or not recognise) impairment in the financial statements. The assessment of whether an objective evidence of impairment on a financial asset exists, is a matter of management judgement requiring consideration of all the facts and circumstances of each case.
(b) In accordance with the principle-based approach outlined in paragraph 59 of IAS 39, an objective evidence of impairment exists, when:
i. one or more events have occurred after the initial recognition of the asset (a ‘loss event’); and
ii. that loss event (or events) has an impact on the estimated future cash flows of the financial asset or group of financial assets that can be reliably estimated.
(c) Paragraph 59 of IAS 39 also states that objective evidence that a financial asset is impaired includes observable data that comes to the attention of the holder of the asset about the loss events.
Paragraph 59 also lists down examples of loss events that could result in objective evidence of impairment.
(d) IAS 39 provides sufficient guidance for an entity to assess whether there is an objective evidence of impairment with regards to long overdue circular debt balances, which as per management assessment are directly or indirectly due from GoP.
Management of an entity should exercise its judgement considering all the relevant facts and circumstances to determine whether the delay in the settlement of circular debt balances provides (or does not provide) an objective evidence of impairment under IAS 39.
(Issued in October, 2021)