IAS 39 Impairment principles applied in less-developed markets/economies: case of Macedonia

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Jemimah Higgins
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1 IAS 39 Impairment principles applied in less-developed markets/economies: case of Macedonia Marija Efremova Advisor to the Governor for IFRS National Bank of the Republic of Macedonia Vienna, 6-7 September 2010

2 Content: IAS 39 Impairment principles Regulation for credit risk management for banks operating in R.Macedonia Case study work on an example Discussion This session will talk about impairment on: loan receivables individually significant items

3 IAS 39 Impairment principles (1/4) existence of objective evidence of impairment impairment triggering events measure/assess the amount of impairment loss recognise impairment loss in the books

4 IAS 39 Impairment principles (2/4) Impairment triggering events: significant financial difficulty of the issuer or obligor; a breach of contract (such as a default or delinquency in interest or principal payments); granting to the borrower a concession that the lender would not otherwise consider, due to the borrower s financial difficulties; becoming probable that the borrower will enter bankruptcy or other financial reorganisation; the disappearance of an active market for that financial asset because of financial difficulties; if impairment triggers have not been identified on an individual basis, the asset must be assessed for impairment on a group basis.

5 IAS 39 Impairment principles (3/4) If, and only if, one or more impairment triggering events ( loss event ) has happened after the initial recognition of the asset and that loss event has impact on estimated future cash flows of the asset Impairment incurred Measure the amount of impairment loss

6 IAS 39 Impairment principles (4/4) Impairment loss asset s carrying amount PV of estimated future cash flows, discounted at the asset s original effective interest rate Recognise Impairment loss in the Statement of Comprehensive Income Carrying amount of the loan receivable (including the recognised impairment loss) is regularly reassessed

7 Content: IAS 39 Impairment principles Regulation for credit risk management for banks operating in R.Macedonia Case study work on an example Discussion

8 Regulation for credit risk management for banks operating in R.Macedonia (1/20) Decision for managing credit risk - applicable for banks operating in Macedonia, prescribed in February 2008 with effective implementation as of 1 January 2009 Prescribes: criteria for classification of credit exposures; methodology for determination of the level of impairment losses and provisions; policies and procedures for managing the credit risk.

9 Regulation for credit risk management for banks operating in R.Macedonia (2/20) step 1: classification of the loan receivable into the prescribed risk categories (A, B, C, D, E); step 2: determining the present value of the estimated future cash flows of the receivable; step 3: assessment of the amount of the impairment loss, as a difference between the carrying amount of the loan and the present value of the estimated future cash flows (as determined in step 2)

10 Regulation for credit risk management for banks operating in R.Macedonia (3/20) Alternative: If the bank does not determine the present value of the estimated future cash flows (step 2 is not applied) step 3 (alternative): Impairment loss carrying amount of the receivable upper level of impairment loss of the risk category in which the receivable has been classified (A, B, C, D, E)

11 Regulation for credit risk management for banks operating in R.Macedonia (4/20) step 1: Classification of credit exposures General principles for classification of credit exposures: creditworthiness of the client; servicing the liabilities to the bank; quality of the collateral. Impairment triggering events, as prescribed by IAS 39 (each developed per separate risk categories)

12 Regulation for credit risk management for banks operating in R.Macedonia (5/20) trigger: step 1: breach Classification of of credit exposures contract Risk category Days overdue A B C D E up to 30 days 31 to 60 days (exceptionally 61 to 90) 61 to 120 days (exceptionally 121 to 180) 121 to 270 days (exceptionally over 270) over 270 days

13 Regulation for credit risk management for banks operating in R.Macedonia (6/20) trigger: significant financial difficulty of the borrower step 1: Classification of credit exposures Risk category A B C D E Financial performance Good; no indications for problems for servicing current and future obligations; no restructuring in the last 2 years Currently small difficulties, but there are indications of recovery in the near future; no restructuring in the last 6 months Inadequately capitalised; inadequate liquidity structure; restructured liabilities Illiquid; becoming probable that the borrower will enter bankruptcy or liquidation procedure; written-off receivables by its debtors The client is under a bankruptcy or liquidation procedure

14 Regulation for credit risk management for banks operating in R.Macedonia (7/20) trigger: granting a concession, Risk due to the borrower s category financial difficulties step 1: Classification of credit exposures A Financial performance No restructuring in the last 2 years B C No restructuring in the last 6 months Restructured liabilities D E

15 Regulation for credit risk management for banks operating in R.Macedonia (8/20) trigger: the borrower will enter bankruptcy or other fin. reorganisation step 1: Classification of credit exposures Risk category Financial performance A - B - C - D E Becoming probable that the borrower will enter bankruptcy or liquidation procedure; written-off receivables by its debtors The client is under a bankruptcy or liquidation procedure

16 Regulation for credit risk management for banks operating in R.Macedonia (9/20) step 2: Determining the present value of the estimated future cash flows of the receivable: Determine the recoverable amount of the receivable by calculating the present value of the estimated future cash flows of the receivable, discounted with the original effective interest rate. Composition of the estimated future cash flows is a key determinant of the amount of impairment losses.

17 Regulation for credit risk management for banks operating in R.Macedonia (10/20) step 2: Determining the present value of the estimated future cash flows of the receivable: Estimated future cash flows of the receivable can be comprised of: for regularly performing loans ex.: contractual repayment amounts (principal and interest) for loans for which there is any uncertainty about the timing and amount There are of the certain cash conditions flows; or in for respect which there is a risk that payments of the inclusion will not be of the made value when of collateral due expected ex.: reduced and/or in the estimated delayed contractual future cash repayment flows of amounts; expected value of the collateral the receivable. upon the loan, to be collected (when regular repayment is no more expected).

18 Regulation for credit risk management for banks operating in R.Macedonia (11/20) In Macedonia: liquid market exists for some equity shares (companies operating in Macedonia) and for treasury and government bills and bonds (maturity ranges from 1 month to 3 years); there is an How active to market measure for residential the fair and commercial value of property, assets but it is not easily observable; transactions for purchase and sale of industrial property are occurring irregularly (predominantly liquid markets? for privatisation purposes). In addition: when there are no observable active and the time needed to overtake a collateral-property is between 6 months and 2 years. the time needed to sold the foreclosed collateral-property is usually more than 18 months.

19 Regulation for credit risk management for banks operating in R.Macedonia (12/20) Active market: quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agencies. prices represent actual and regularly occurring market transactions on an arm s length basis. Inactive market: low volume and level of activity; the available prices vary significantly over time or among market participants; the prices are not current; the changes in prices are predominantly driven by speculative information, and less by the performance or future In plans these of circumstances, the market participants the valuation of collateral taken for the loans extended is based primarily on management s judgment about future cash flows.

20 Regulation for credit risk management for banks operating in R.Macedonia (13/20) Regulator s perspective: How to measure the fair value of assets when there are no observable active and liquid markets? Regulator s action: Prescribe the minimum characteristics of the market to be fulfilled, in order the value of the asset - collateral to be taken into account when calculating impairment losses.

21 Regulation for credit risk management for banks operating in R.Macedonia (14/20) step 2: Determining the present value of the estimated future cash flows of the receivable The value of the collateral is taken into consideration only if: first-class collateral risk category A unconditional irrevocable guarantee issued by non-banking financial or non-financial institution with a good credit standing ( A- Standard&Poor s; A3 Moody s) the asset taken as collateral presents an appropriate asset for collection of the receivable

22 Regulation for credit risk management for banks operating in R.Macedonia (15/20) step 2: Determining the present value of the estimated future cash flows of the receivable if these criteria are The asset taken as collateral presents an appropriate met, the value asset of for collection of the receivable, if: the collateral can there is a functional market for the asset or similar assets; there is information available for the realised estimated transactions future with the same or similar assets in the last 3 months; cash flows of the the information about the realised prices is publicly receivable, available; up to proceeds from eventual sale of the collateral are expected to be collected in a period less then 12 months from outstanding the date of receivable. foreclosure of the collateral....some administrative/documentary criteria... be included in the the amount of the

23 Regulation for credit risk management for banks operating in R.Macedonia (16/20) step 3: Assess the amount of Impairment loss Impairment loss asset s carrying amount PV of estimated future cash flows, discounted at the asset s original effective interest rate (as determined in step 2) Subject to (prudential) limitations

24 Regulation for credit risk management for banks operating in R.Macedonia (17/20) step 1: Classification of credit exposures (A, B, C, D, E) versus step 3: Assess the amount of Impairment loss

25 Regulation for credit risk management for banks operating in R.Macedonia (18/20) step 1 vs step 3: Risk category Rang of % of impairment loss A 0% - 10% B 10.1% - 25% C 25.1% - 50% D 50.1% - 75% E 75.1% - 100%

26 Regulation for credit risk management for banks operating in R.Macedonia (19/20) step 1 vs step 3: the amount of Impairment loss can not be lower than the impairment loss determined by application of the lowest % of impairment loss for the risk category in which the receivable has been classified (determined in step 1) Better risk category if the bank has determined Impairment loss higher than the one calculated by applying the highest % of impairment loss for the risk category in which the receivable has been classified (determined in step 1), the bank must reclassify the receivable in the appropriate risk category Worsen risk category

27 Regulation for credit risk management for banks operating in R.Macedonia (20/20) Effects / Differences in the recognised Impairment losses due to: (Non-)Inclusion of the value of collateral in the calculation of the recoverable amount Impairment loss can not be lower than the one calculated when applying the lowest % of impairment loss for the respective risk category Firstly, step 1: Classification; then calculation of Impairment loss, subject to prudential limitations

28 Content: IAS 39 Impairment principles Regulation for credit risk management for banks operating in R.Macedonia Case study work on an example Discussion

29 Case- study 1 (1/8) At the bank approved a short-term loan to company X for working capital needs, in the amount of EUR 1 million. The loan should be repaid on a 1 year period, with a full repayment at the end of the period. The loan bears an interest of 6.75% p.a., payable monthly. This loan is approved under the terms of the frame credit agreement between the bank and company X. This loan is collateralised with the collateral taken by the bank under the frame credit agreement between the bank and company X.

30 Case- study 1 (2/8) General information about the borrower: The company X, founded in 1975, is a family business and operates in Macedonia; The main activity of the company is production and wholesale of metal goods, pipes, devices and equipment for central heating and production of mesh reinforcement and profile beams for construction works; The company operates a hotel (170 beds, restaurant of 300 seats, congress room of 200 seats, sports recreation and trade centre) and 4 petrol stations, including restaurant services; The company employs 75 employees (95 employees in 2008);

31 Case- study 1 (3/8) The company has a frame loan agreement for utilizing different credit facilities from the Bank, within maximum credit exposure of EUR 8.4 million. Collateral: In millions of Euro Value of the collateral Date of valuation Petrol station Petrol station Collateral Petrol station Hotel Pledge on raw materials Pledge on production equipment Total: 9.2

32 Case- study 1 (4/8) Credit facilities used by the borrower: Credit exposure Number of credit facilities used In millions of Euro Principal Interest Off-Balance Sheet exposure Total credit exposure: Short-term Long-term 3 3 3

33 Case- study 1 (5/8) Financial performance: In millions of Euro Sales revenue metal production 2.5 (62%) 7.5 (67%) n.a. - petrol stations 1.3 (31%) 3.1 (28%) n.a. - hotel 0.3 (7%) 0.5 (5%) n.a. Net income/(loss) (0.5) (0.2) 0.2 Finished products and raw materials Long-term liabilities Short-term liabilities Financing expense

34 Case- study 1 (6/8) Financial performance: Current ratio Quick ratio Stock turnover ratio Debt/equity ratio ROE (in %) (130.94) (52.13) Net profit margin (in %) (12.36) (2.00) 2.31 Inventory turnover (days) Receivables collection period (days) Payables payment period (days)

35 Case- study 1 (7/8) Due to the global crisis, that impacted the metal industry as well, the company faces financial difficulties: realised loss in 2008 and 2009; deteriorated operating profit; deteriorated liquidity position in the second half of 2009; increase of inventory of both finished goods and raw materials; canceled purchase agreements from the company s customers from Greece, Serbia, Croatia, Slovenia. The external auditor issued qualified Audit opinion for the FS 2008, for the value of inventories (overstated for EUR 0.6 million)

36 Case- study 1 (8/8) The company services its liabilities to the bank regularly (source for repayment: revenues from the other businesses of the company (hotel and petrol stations) and by drawing new facilities from the bank for repayment of the previous facilities) In the 1 st quarter 2010 the company requested a rescheduling of the short-term facilities into one long-term facility on a 7 years period, with regular monthly repayment schedule

37 Case- study 2 (1/8) At the bank approved a long-term loan to company Y for investment purposes (for expansion and modernization of the production process), in the amount of EUR 7.6 million. The loan has a grace period up to The loan is repayable on a monthly basis during 8 years (96 months) period after the grace period (up to ). The loan bears an interest of 6.75% p.a., payable monthly. This loan is collateralised with the collateral taken by the bank under the frame credit agreement between the bank and company Y. The company s participation in the investment is 20%.

38 Case- study 2 (2/8) General information about the borrower: The company Y is the largest producer of steel and slabs in Macedonia and the only producer of hot rolled plates in the region; The major shareholder of the company is an international steel production and wholesale company; One part of the company s business refers to processing activities for the major shareholder and the other part is own production and sale of company Y; The company is listed on the Macedonian Stock Exchange; The company employs more than 1,000 employees;

39 Case- study 2 (3/8) The company has a frame loan agreement for utilizing different credit facilities from the bank, within maximum credit exposure of EUR 39.5 million. Collateral: In millions of Euro Value of the collateral Date of valuation Collateral Production facilities and administrative building Pledge over the production equipment, raw materials and finished products Future pledge on equipment (to be purchased under the investment project) n.a. Total: 102.5

40 Case- study 2 (4/8) Credit facilities used by the borrower: Credit exposure Number of credit facilities used In millions of Euro Principal Interest and other receivable Off-Balance Sheet exposure Total credit exposure: Short-term Long-term

41 Case- study 2 (5/8) Financial performance: In millions of Euro Sales revenue Net income/(loss) (0.2) Finished products and raw materials Long-term liabilities Short-term liabilities Financing expense

42 Case- study 2 (6/8) Financial performance: Current ratio Quick ratio Stock turnover ratio Debt/equity ratio ROE (in %) (0.23) Net profit margin (in %) (0.39) Inventory turnover (days) Receivables collection period (days) Payables payment period (days) n.a. n.a n.a. n.a n.a. n.a

43 Case- study 2 (7/8) Due to the global crisis, that impacted severely the metal industry, the company faces financial difficulties: realising loss in 2010 and significantly decreased profit in 2009; change in the structure of the company s activities own production and sales significantly reduced (previously around 70% of production), while increased processing activities for the major shareholder; fall in sale prices on the international markets for more than 60% and sharp fall in demand since 2008; deteriorated liquidity position in the second half of 2009 and 2010 (part of it due to the investment project). The external auditor draws attention to the going concern of the company, due to its large dependence on the major shareholder.

44 Case- study 2 (8/8) No redundancies, but salaries decreased for 15%. There is an agreement that the major shareholder will cover the company s generated losses on a quarterly basis (in 2009: covered EUR 4.7million). The major shareholder extended a short-term interest-free loan in the amount of EUR 26 million, considered as permanent financing. The company services its liabilities to the bank regularly (source for repayment: by drawing new facilities from the bank for repayment of the previous facilities and by the financial support from the major shareholder). The company s share price on the Macedonian Stock Exchange has decreased for around 32% in 2009 and 2010.

45 Case- study 1 and 2 You are required to: identify the impairment triggers, if any estimate the impairment loss as of classify the loan receivable in risk category, in accordance with the credit risk management regulation in R.Macedonia and estimate the level of impairment losses

46 Content: IAS 39 Impairment principles Regulation for credit risk management for banks operating in R.Macedonia Case study work on an example Discussion

47 Thank you for your attention!

Decision on the classification of exposures into risk categories and the method of determining credit losses. Subject matter Article 1

Decision on the classification of exposures into risk categories and the method of determining credit losses. Subject matter Article 1 Pursuant to Article 101, paragraph (2), item (2) of the Credit Institutions Act (Official Gazette 159/2013, 19/2015 and 102/2015) and Article 43 paragraph (2), item (9) of the Act on the Croatian National