IFRS 9 has profoundly changed the way companies account for credit risk. Where the former standard, IAS 39, waited for a loss to be incurred before recognising it, IFRS 9 requires anticipation: as soon as a financial asset is recognised on the balance sheet, the entity must estimate the losses it expects to suffer and set aside a provision accordingly. This shift from an incurred-loss logic to an expected-loss logic concerns banks directly, but also any Luxembourg company that reports under IFRS: financing companies, holding companies, consolidated groups or businesses carrying a significant portfolio of trade receivables.
Understanding the IFRS 9 impairment test is therefore essential, both to produce reliable financial statements and to avoid late corrections when the financial statements are reviewed. This article sets out its rationale, its scope and its practical implementation, supported by worked examples.
I. From an incurred loss to an expected loss
Under IAS 39, an impairment could only be recorded once an objective trigger had occurred: a confirmed missed payment, evident financial difficulty, or a counterparty default. This approach, considered too slow in the aftermath of the 2008 financial crisis, delayed the recognition of losses until they were almost certain.
IFRS 9 reverses this reasoning. The entity no longer asks ‘has a loss occurred?’ but ‘what loss can I reasonably anticipate?’. The provision is set up from the outset, then adjusted at each reporting date as the risk evolves. The objective is twofold: to reflect credit risk more prudently and to give the reader of the accounts a truer and more forward-looking picture of the portfolio’s solvency.
II. Which assets are concerned
The expected credit loss model does not apply to the entire balance sheet. It mainly targets:
- financial assets measured at amortised cost (loans, bonds held, deposits);
- financial assets measured at fair value through other comprehensive income (FVOCI);
- trade receivables, contract assets and lease receivables;
- loan commitments given and financial guarantee contracts.
By contrast, instruments measured at fair value through profit or loss (FVTPL) are excluded: their change in value, which already incorporates credit risk, flows directly through profit or loss. Equity instruments are likewise outside the scope of the impairment test.
III. The general three-stage model
For instruments falling under the general model, IFRS 9 scales the provision according to how credit risk has evolved since initial recognition. Three stages follow one another, each entailing a different measurement of the expected loss and a different basis for recognising interest.
| Stage | Risk situation | Provision recognised | Basis for interest |
|---|---|---|---|
| 1 | Risk unchanged or low since origination | 12-month expected losses | Gross carrying amount |
| 2 | Significant increase in credit risk | Lifetime expected losses | Gross carrying amount |
| 3 | Credit-impaired asset (default confirmed) | Lifetime expected losses | Net amount (after the provision) |
The move from Stage 1 to Stage 2 is the most delicate point of the standard. It does not depend on a missed payment, but on a significant increase in credit risk assessed against the risk estimated at origination. In practice, a payment more than thirty days overdue gives rise to a presumption of such deterioration, but other signals also trigger it: a downgrade of the counterparty’s rating, a deterioration in its financial indicators, or a worsening of the sector’s economic environment. This assessment relies heavily on judgement and must be carefully documented.
IV. How an expected loss is measured
An expected credit loss is not a single forecast, but a probability-weighted average of several scenarios, discounted to the reporting date. Three parameters structure the calculation:
- the probability of default (PD), i.e. the risk that the counterparty fails to repay;
- the loss given default (LGD), i.e. the portion of the receivable that would not be recovered;
- the exposure at default (EAD), i.e. the amount actually at risk.
The product of these three parameters gives the expected loss before discounting. A distinctive feature of IFRS 9 is that the estimate must incorporate reasonable and supportable forward-looking information: growth prospects, interest rates, unemployment, sector conditions. The provision therefore does not look only at the past, but takes into account the future conditions anticipated at the reporting date.
V. The simplified approach for trade receivables
Requiring three-stage monitoring for every customer invoice would be disproportionate. IFRS 9 therefore provides for a simplified approach, mandatory for trade receivables and contract assets without a significant financing component, and optional for lease receivables. It consists in provisioning, from the outset, the expected losses over the entire life of the receivable, without having to track the move from one stage to another.
In practice, the company builds a provision matrix: it classifies its receivables by ageing and applies to each band a historical loss rate, adjusted for economic prospects. Consider a company with a trade-receivable balance of EUR 1,000,000 broken down as follows.
| Ageing | Balance | Loss rate | Provision |
|---|---|---|---|
| Not yet due | EUR 600,000 | 0.5% | EUR 3,000 |
| 1 to 30 days | EUR 250,000 | 2% | EUR 5,000 |
| 31 to 60 days | EUR 100,000 | 8% | EUR 8,000 |
| 61 to 90 days | EUR 30,000 | 20% | EUR 6,000 |
| More than 90 days | EUR 20,000 | 50% | EUR 10,000 |
| Total | 1 000 000 € | 32 000 € |
In this example, the company recognises an impairment of EUR 32,000, i.e. 3.2% of its balance. The rate applied increases with ageing, reflecting the decreasing likelihood of recovery, and the rates used must be reviewed at each reporting date to incorporate recent collection experience and economic prospects.
VI. The special case of guarantees and commitments
Financial guarantees and loan commitments given do not appear as assets: they represent a future risk, not an existing receivable. The expected losses attached to them are therefore recognised not as a reduction of an asset, but as a provision on the liabilities side. This point is frequently overlooked by groups that grant intra-group guarantees, even though it can weigh on consolidated equity.
VII. Practical challenges for Luxembourg companies
In Luxembourg, a financial centre where many structures report under IFRS, the impairment test raises recurring difficulties. The first relates to data quality: reconstructing a reliable loss history requires rigorous monitoring of collections, which is often absent in smaller structures. The second relates to judgement: the boundary between Stage 1 and Stage 2, like the choice of forward-looking scenarios, must be capable of being justified to the réviseur d’entreprises. The third relates to documentation: an unsupported provision is a fragile provision, liable to be challenged when the accounts are reviewed.
Conclusion
The IFRS 9 impairment test is not merely a calculation: it is a discipline combining risk modelling, economic anticipation and rigorous documentation. Well mastered, it strengthens the credibility of the financial statements in the eyes of banks, investors and auditors; poorly handled, it exposes the company to costly adjustments and qualifications. At Ease Advisory, we support Luxembourg companies in keeping their accounts to IFRS standards, building their provision matrices and preparing robust financial statements, ready for review. Unsure how to treat your receivables or your commitments? Let’s talk.