Intercompany Loan impairment

Is the intercompany financing in the scope of IFRS 9 or IAS 27?

Intercompany financings that, in substance, form part of an entity’s ‘investment in a subsidiary’ are not in IFRS 9’s scope. Rather, IAS 27 applies to such investments.

• An intercompany loan is outside IFRS 9’s scope (and within IAS 27’s scope) only if it meets the definition of an equity instrument for the subsidiary (for example, it is a capital contribution).

• All loans to subsidiaries that are accounted for by the subsidiary as liability is within IFRS 9’s scope.

• If the terms of intercompany financing are clarified or changed on the adoption of IFRS 9, the careful analysis might be required.

Is the loan repayable on demand?

· For loans that are repayable on demand, expected credit losses are based on the assumption that repayment of the loan is demanded at the reporting date.

· If the borrower has sufficient accessible highly liquid assets to repay the loan if demanded at the reporting date, the expected credit loss is likely to be immaterial.

· If the borrower could not repay the loan if demanded at the reporting date, the lender should consider the expected manner of recovery to measure expected credit losses. This might be a ‘repay over time’ strategy (that allows the borrower time to pay), or a fire sale of less liquid assets.

· If the recovery strategies indicate that the lender would fully recover the outstanding balance of the loan, the expected credit loss will be limited to the effect of discounting the amount due on the loan (at the loan’s effective interest rate, which might be 0% if the loan is interest-free) over the period until cash is realized. If the time to realize cash is short or the effective interest rate is low, the effect of discounting might be immaterial. If the effective interest rate is 0%, and all strategies indicate that the lender would fully recover the outstanding balance of the loan, there is no impairment loss to recognize.

Some intercompany loans between entities within a group are repayable on demand. Such loans might or might not be interest-free. How should a lender calculate expected credit losses for an intercompany loan that is repayable on demand?

IFRS 9 notes that the maximum period over which expected impairment losses should be measured is the longest contractual period where an entity is exposed to credit risk. In the case of loans repayable on demand, the contractual period is the very short period needed to transfer the cash once demanded (that is typically one day or less). Therefore, the impairment provision would be based on the assumption that the loan is demanded at the reporting date, and it would reflect the losses (if any) that would result from this. Considering the 3-stage general impairment model explained , if the lender uses a PD*LGD*EAD methodology 1, then the lender of an intercompany loan that is repayable on demand needs to understand:

· the PD (‘probability of default’) – that is, the likelihood that the borrower would not be able to repay in the very short payment period;

· the LGD (‘loss given default’) – that is, the loss that occurs if the borrower is unable to repay in that very short payment period; and

· the EAD (‘exposure at the default’) – that is, the outstanding balance at the reporting date.

IFRS 9 requires the lender to measure the expected credit loss at a probability-weighted amount that reflects the possibility that a credit loss occurs, and the possibility that no credit loss occurs, even if the possibility of a credit loss occurring is low. For an intercompany loan repayable on demand, there are likely to be two mutually exclusive scenarios: either the borrower can pay today if demanded (that is, it has sufficient highly liquid resources); or it cannot. If the borrower cannot pay today if demanded, the assessment should consider the expected manner of recovery and recovery period of the intercompany loan (the lender’s ‘recovery scenarios’).

For example, if, at the reporting date, the borrower would be unable to immediately repay the loan if demanded by the lender, the lender might expect that it would maximize recovery of the loan by allowing the borrower time to pay (that is, to continue trading or to sell its assets over some time), instead of forcing the borrower to liquidate or sell some or all of its assets to repay the loan immediately.

Similarly, a borrower might, in the past, have paid any excess cash to its parent by way of dividend, which could prevent it from having sufficient available liquid assets to repay its intercompany loan if repayment was demanded. In this case, management of the group might determine that it would maximize recovery of the loan by the borrower ceasing to make such dividend payments in reporting periods where it would not otherwise have sufficient available liquid assets to repay its intercompany loan. However, it should not be assumed that management will support a subsidiary that is otherwise unable to repay an intercompany loan in the absence of a contractual obligation to do so or other supporting evidence (such as a guarantee or letter of comfort, discussed further in Section E). In addition, management should take a holistic view of the group, in particular, since a strategy to support one group entity might give rise to funding issues or potential impairments elsewhere in the group. If the borrower has sufficient highly liquid assets to repay the intercompany loan if it is demanded today, does that mean that the expected credit loss could be close to zero?

Yes. If the borrower has sufficient available liquid assets (that is, cash and cash equivalents which can be accessed immediately) to repay the outstanding loan if the loan was demanded today, the PD would be close to 0%. It is important to consider whether the borrower has any more senior external or internal loans which would need to be repaid before the intercompany loan is assessed since these would reduce the liquid assets available to repay that intercompany loan. In such a scenario, assuming that the entity has no restrictions on its liquid assets and could meet a demand to repay the loan at the reporting date, any impairment on the intercompany position would likely be immaterial.

Credit risk

It is a risk that the borrower might not pay back. Let’s understand this with an example say a bank gave Mr. X a loan. Now if Mr. X pays repays the loan, well and good. In case Mr. X took the loan and invested it in a business and that business ran into losses. Now, Mr. X cannot repay the loan. This is a credit risk for the bank.

What is expected credit loss (ECL)?

It is the weighted average of credit losses with the respective risks of defaults occurring as the weights.

1. Exposure at default (EAD) is the total amount of the loan outstanding, so it’s how much one company owes to another company at the reporting date;
2. Probability of default – it is the percentage and it is the likelihood that the borrower will not be able to repay its debt within some period;
3. Loss given default – it is also the percentage and it is how much the lender loses if the borrower defaults and is not able to repay its debts.

The ECLmodel states that one has to recognize a provision or an allowance for the expected losses. Say, Mr. A has taken a loan of USD 10,000. Out of which he is only able to repay USD 8,000. In this case, the lender is to create an allowance for the expected loss of USD 2,000.

Many intercompany loans are deemed as repayable on demand. In other words, the lender can just ask the borrower to send the money back.

The question is:

Does the borrower have enough cash to repay the loan immediately?

If yes, then there is no impairment, or the impairment is probably not material and you can forget about it.

If not, then the lender should make some calculations of the potential impairment, for example, the lender should estimate the probable repayment calendar and discount the cash flows to the present value.

If the loan is not repayable on demand, then we need to determine at what stage it is.

If the loan is in stage 1 – that is, a performing or healthy asset, then impairment is calculated at 12-month ECL.

12-months expected losses mean

lifetime losses*probability in the next 12 months

it means that the probability of default is needed to be estimated within the next 12 months.

In most cases, impairment would be close to zero or immaterial because if it’s a healthy asset, then the probability of default is very low.

If the loan is at stage 2 or 3 – so, if the credit risk has significantly increased or the loan has already defaulted, the impairment at lifetime ECL is to be calculated. Here, the probability of default within the whole life of the loan is required to be determined.

Stage 1: credit risk did not increase significantly

IFRS 9 does not clarify what is a significant risk but no matter what type of entity is in question, a significant risk shall exist. At one point or the other, the best of the best people might fail to repay their loans. Some might make default in installment, interest payment, etc., at all points a credit risk does exist but it is said to significantly increase when there are both quantitative and qualitative factors that endanger or create a sense of non-payment for the lender. Let’s get back to Mr. X, he has been seen spending the loan amount recklessly in random businesses and they are running into losses, here the lender knows for a fact that Mr. X shall not be able to repay the loan. Moving further, a company has been given a loan, the quantitative factors could be a decrease in profit ratios, decrease in the annual cash flow, the share price is declining, the contracts with customers are being declined. The qualitative factors could be changes in management, fraud and other investigations, embezzlement of funds, the assets being overstated, etc. Hence, there is no standard definition of a significant increase in credit risk.

12-months expected losses mean lifetime losses*probability in the next 12 months

Stage 2: credit risk had increased significantly

For loans that are in stage 2 or 3, a lifetime expected credit loss is recognized.

· In measuring the expected credit loss, all reasonable and supportable information that is available without undue cost or effort should be considered. This includes both internal and external information, and information about past events, current conditions, and forecasts of future economic conditions.

· The effect of credit enhancements such as collateral, guarantees, and letters of support should also be included. Contractually enforceable guarantees have a greater effect than letters of support that are not.

Is the loan low credit risk?

A loan has low credit risk if the borrower has a strong capacity to meet its contractual cash flow obligations in the near term, and adverse changes in economic and business conditions in the longer term might, but will not necessarily, reduce the ability of the borrower to fulfill its obligations.

· For loans that are low credit risk at the reporting date, IFRS 9 allows a 12- month expected credit loss to be recognized.

· An external rating of ‘investment grade’ is an example of low credit risk. However, an intercompany loan should not be assumed to have the same rating as other instruments issued by the borrower (such as loans to third parties) without further analysis.

· Low credit risk loans might have a very low risk of default (or ‘probability of default’ (PD)).

· A ‘short-cut’ can be used to determine if the expected credit loss on a low credit risk loan is material. This short-cut assumes that the PD for the intercompany loan is that of the lowest investment grade (either BBB- or Baa3, depending on the credit rating agency used) and the maximum possible loss in the event of a default (that is, the loan is fully drawn and no amount is recovered). If this results in an immaterial expected credit loss, no further work is required. If, however, this short-cut results in a material expected credit loss, further work will be required to estimate both the actual PD and the actual loss in the event of a default. 

Troubles with impairment on intercompany loans

• For intercompany loans, apply a general 3-stage model, not a simplified model. It means you have to assess at which stage the loan is first and then perform calculations.
• It is difficult to get inputs to calculations: loss given at default and probability of default because intercompany loans are usually not credit rated. I mean, you can have the credit rating of the external loans with banks and you would derive the probability of default based on that rating, but not with internal loans.

And, you cannot apply an external rating to internal loan without any adjustment, because the internal and external loans are not equal