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Extracts from IFRS
Where an entity has model adjustments, either newly created or amendments to existing ones, it needs to disclose the key inputs, assumptions and estimation techniques.
The entity should also explain any changes made to the model adjustment during the reporting period and the reason(s) for them (for example, what is the model input or value that it compensates for or adjusts?).
“An entity shall explain the inputs, assumptions and estimation techniques used to apply the requirements in Section 5.5 of IFRS 9. For this purpose an entity shall disclose:
(a) the basis of inputs and assumptions and the estimation techniques used to:
(i) measure the 12-month and lifetime expected credit losses;
(ii) determine whether the credit risk of financial instruments have increased significantly since initial recognition; and
(iii) determine whether a financial asset is a credit-impaired financial asset.
(b) how forward-looking information has been incorporated into the determination of expected credit losses, including the use of macroeconomic information; and
(c) changes in the estimation techniques or significant assumptions made during the reporting period and the reasons for those changes.” [IFRS 7 para 35G].
Model adjustments, particularly in the context of COVID-19, are often amongst management’s most difficult, subjective judgements. Where individually, or taken together with other elements of the ECL estimate, there is a significant risk of a material change in the next financial year, the model adjustments will require disclosure under IAS 1 as critical estimates.
That disclosure needs to provide an understanding of the judgements made.
Where numerical sensitivity disclosures do not incorporate the effect of model adjustments, because it is not feasible to include them, this should be clearly stated. To do otherwise could be misleading and understate the extent of the estimation uncertainty. Narrative disclosure should nonetheless be provided, so that users can understand the potential effect of such judgements. This will often be most insightful when ‘through the eyes of management’, based on the risks that they are seeing and how they have responded to them.
Where numerical disclosures are provided that incorporate the effect of model adjustments, but there are material limitations to that disclosure (for example, it discloses the entity’s best estimate of the range of reasonably possible outcomes but, due to the economic uncertainty, the actual range might be significantly greater), those limitations should be explained. However, the existence of inherent limitations alone is not a basis for omitting relevant disclosure.
“An entity shall disclose information about the assumptions it makes about the future, and other major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. In respect of those assets and liabilities, the notes shall include details of:
(a) their nature, and
(b) their carrying amount as at the end of the reporting period.” [IAS 1 para 125].
“The assumptions and other sources of estimation uncertainty disclosed in accordance with paragraph 125 relate to the estimates that require management's most difficult, subjective or complex judgements.” [IAS 1 para 127].
“An entity presents the disclosures in paragraph 125 in a manner that helps users of financial statements to understand the judgements that management makes about the future and about other sources of estimation uncertainty. The nature and extent of the information provided vary according to the nature of the assumption and other circumstances. Examples of the types of disclosures an entity makes are:
(a) the nature of the assumption or other estimation uncertainty;
(b) the sensitivity of carrying amounts to the methods, assumptions and estimates underlying their calculation, including the reasons for the sensitivity;
(c) the expected resolution of an uncertainty and the range of reasonably possible outcomes within the next financial year in respect of the carrying amounts of the assets and liabilities affected; and
(d) an explanation of changes made to past assumptions concerning those assets and liabilities, if the uncertainty remains unresolved.” [IAS 1 para 129].
The effects of model adjustments should be appropriately incorporated into relevant ECL disclosures, such as ECL ‘roll-forward’ tables and any other related numerical disclosures such as ‘coverage ratios’ (ECL allowance as a percentage of the gross carrying amount).
Where it has not been possible to allocate the model adjustment to individual loans and incorporate it within these numerical disclosures, this should be explained, along with the relevant amounts, so that, taken together with the ECL ‘roll-forward’ tables etc, the disclosure requirement of explaining all changes in the loss allowance is met. This might be necessary where a model adjustment has had to be calculated on a collective ‘top-down’ basis, rather than on a detailed instrument-by-instrument ‘bottom-up’ basis, and so it cannot be meaningfully incorporated into the ECL ‘roll-forward’ tables.
Omitting such explanation might impair comparability of key metrics such as coverage ratios with peers, who might not use model adjustments to the same extent. It might also lead users to mistakenly believe that an entity’s coverage ratio, or other key metric, is materially different from that of its peers, when actually it is not.
“To explain the changes in the loss allowance and the reasons for those changes, an entity shall provide, by class of financial instrument, a reconciliation from the opening balance to the closing balance of the loss allowance, in a table, showing separately the changes during the period for:
(a) the loss allowance measured at an amount equal to 12-month expected credit losses;
(b) the loss allowance measured at an amount equal to lifetime expected credit losses for:
(i) financial instruments for which credit risk has increased significantly since initial recognition but that are not credit-impaired financial assets;
(ii) financial assets that are credit-impaired at the reporting date (but that are not purchased or originated credit-impaired); and
(iii) trade receivables, contract assets or lease receivables for which the loss allowances are measured in accordance with paragraph 5.5.15 of IFRS 9.
(c) financial assets that are purchased or originated credit-impaired. In addition to the reconciliation, an entity shall disclose the total amount of undiscounted expected credit losses at initial recognition on financial assets initially recognised during the reporting period.” [IFRS 7 para 35H].
Entities should apply a ‘stand back’ test to see whether further disclosure is required – IFRS disclosures are principles-based, not a prescriptive ‘tick list’.
In addition, whilst not a requirement, setting out disclosures so that they ‘tell the story’ of the issues faced, and how they have been taken account of within the ECL estimate, will help to maximise the value and insight provided by the disclosures.
“To meet the objectives in paragraph 35B, an entity shall (except as otherwise specified) consider how much detail to disclose, how much emphasis to place on different aspects of the disclosure requirements, the appropriate level of aggregation or disaggregation, and whether users of financial statements need additional explanations to evaluate the quantitative information disclosed.” [IFRS 7 para 35D].
“If the disclosures provided in accordance with paragraphs 35F–35N are insufficient to meet the objectives in paragraph 35B, an entity shall disclose additional information that is necessary to meet those objectives.” [IFRS 7 para 35E].
There should be no material omissions from the disclosures presented.
As a ‘sense check’, consider what a user’s reaction would be if, in six months’ time, there was a material change to a model adjustment. If that would come as a shock to them, does that indicate insufficient current period disclosure and that the disclosure should be enhanced?
“Material Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor.” [IAS 1 para 7].
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