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What are credit impairment and loss allowance?

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Credit impaired financial assets are reported on the balance sheet as a loss allowance that reduces the carrying amount of financial assets measured at amortized cost, contract assets and lease receivables to reflect cumulative impairment losses to reflect cumulative impairment losses.

At the initial recognition of a financial asset, an entity recognizes a loss allowance equal to the expected credit losses from the entity’s reporting date, unless it is a purchased or originated credit-impaired financial assets. Subsequent changes in lifetime ECL of the asset are recognized in earnings and increase or reduce the loss allowance previously recognized where treated as unrealized gains/losses and included in OCI.

Assets carried at amortized cost are measured as the difference between the asset’s carrying amount and the present value of its estimated cash flows discounted at its original effective interest rate (EIR). The EIR is the discount rate that equals the present value of the contractual or expected cash flows of an asset.

PV of Impaired Asset at Amortized Cost (Example)
Par value: €5,000,000
Effective interest rate: 5%
Expected redemption value: €4,400,000
Expected Interest payments: 4% (0.20m)
Market rate on 31 December 16: 6%
Date ECF ($m) 5% DF PVECF ($m)
31 Dec 16 0.20 0.9524 0.1905
31 Dec 17 0.20 0.9070 0.1814
31 Dec 18 0.20 0.8638 0.1727
31 Dec 19 0.20+ 4.4 0.8227 3.7844

A purchased credit-impaired (PCI) asset is a financial asset that at acquisition or since its origination has experienced a more-than-insignificant deterioration in credit quality – one or more credit events have occurred that have a detrimental effect on the estimated future cash flows of the asset. Any impairment recovery is recognized as an impairment gain.  An asset is credit-impaired when one or more credit events have occurred that have a significant impact on its expected future cash flows.

A credit-adjusted EIR is the rate used to calculated the effective interest rate (EIR) for initial recognition of purchase credit-impaired assets equal to changes in lifetime ECL from initial recognition, where interest income recognition is through a credit-adjusted EIR multiplied by the amortized cost. A loss allowance is recognized for ECL with a corresponding adjustment to the amortized cost basis of the asset, with the resulting loss allowance estimated at the time of the initial recognition of the asset not included in earnings.

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