Audit readiness (6): Impairment of Trade receivables

This week the subject of discussion is impairment of trade receivables. Trade receivables are financial assets which fall within the scope of IAS 39 & IFRS 9. However, considering that IFRS 9 is not yet effective and also the position of the Financial Reporting Council of Nigeria (FRC) on early adoption of IFRS 9, we would focus on the recommendations of IAS 39 – Financial instruments: recognition and measurement. Trade receivables constitute a significant item on the Statement of Financial Position of entities in trading, manufacturing and non-financial services sectors. In discussing this topic we would assume that there is a fore knowledge of some aspects of IAS 39 which we have dealt with extensively in our prior editions.  

A financial instrument is defined as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Trade receivables and payables, bank loans and overdrafts, issued debt, ordinary and preference shares, investments in securities (e.g. shares and bonds), and various derivatives are just some examples of financial instruments. In addition, some contracts to buy and sell non-financial items that would not meet the definition of financial instruments are specifically brought within the scope of the financial instruments Standards on the basis that they behave and are used in a similar way to financial instruments.

Trade receivables qualify as financial assets and would be considered impaired if its carrying amounts exceeds its recoverable amount. The principle of impairment is the same for both standards IAS 36 and IAS 39. However, the procedures in assessing the asset for impairment are quite different. IAS 39 requires all financial assets, with the exception of those measured at FVTPL, to be assessed for impairment. IAS 39 adopts different approaches to assessing and calculating impairment for different classification categories but the two most notable characteristics of the IAS 39 impairment model are that:

1. Impairment losses should be recognised when they are incurred, rather than as expected; and
2. An impairment loss should be regarded as incurred if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after initial recognition (a ‘loss event’).

Evidence of impairment

IAS 39 requires an assessment, at the end of each reporting period, as to whether there is any objective evidence that a financial asset or group of financial assets is impaired. An asset is considered impaired, and an impairment loss recognized only if such evidence exists.  All evidence provided to External Auditors to support the assessment must be reasonable and verifiable.  It is pertinent to note here that some External Auditors have more information on their clients’ customers than the information provided by the clients. 

Documentation of impairment assessment process

An entity’s documentation of it process for testing trade receivables for impairment is one of the key areas most auditors would consider during their audit. Customary audit procedures around testing for allowance on account receivables very likely would include among others:

1. Obtaining a roll forward schedule of the allowance for doubtful accounts
2. Understanding, documenting, and evaluating the reasonableness of the methods and assumptions used by management to estimate the allowances for doubtful accounts; and if management’s methods and assumptions are reasonable
3. Test the accuracy and completeness of the data used by management

IAS 39’s insistence on recognising an impairment loss on receivables only when they are incurred infers the use of an “incurred loss” model in assessing the impairment on receivables. The implication is that an entity must on a continuous basis re-assess its ability to collect its receivables and to ascertain if there are objective evidences that a loss event has occurred.   Loss events can be considered to be events that crystalize to form objective evidence of impairment; and examples may include significant financial difficulty of the parties involved; reports of accident on a customer’s major factory, or it becoming probable that the customer will enter bankruptcy.

Group assets

The trade receivables are expected to be assessed on a group basis and the standard gives specific guidance in relation to group assessment of financial assets for impairment.

Individual assessment

It is necessary to consider whether there is objective evidence of an impairment for financial assets that are ‘individually significant’. Assets that are not individually significant may be assessed either individually or collectively. There is no guidance on the appropriate interpretation of the term ‘individually significant’ and it is, undoubtedly, an area of considerable judgment for management.

Once an impairment loss has been identified, its amount is measured as the difference between the asset’s carrying amount and the present value of estimated future cash flows, discounted at the original effective interest rate (for receivables expected to be paid within a period of 12 months the effect of discounting is not expected to be significant). The carrying amount of the asset is reduced, either directly or through use of an allowance account.

Collective assessment

When assessing a group of trade receivables collectively for impairment, asset groups used should include receivables with similar credit risk characteristics.  In doing so, the entity may consider the asset type, debtor’s industry, geographical location, collateral type, past-due status and other relevant factors”. The collective assessment should also include financial assets that have been considered individually, whether or not they are individually significant, for which no impairment has been recognised. Most importantly, collective assessments of impairment reflects the incurred loss model and will not result in the recognition of expected future losses. The aim is to reflect, on a group basis, the effect of loss events that have occurred with respect to individual assets in the group (but have not yet been identified on an individual asset basis).

Consistent with the principle of only recognising incurred but not reported losses, if a formulae-based approach or statistical method is employed, the method must not give rise to an impairment loss on initial recognition. Such methods may be used only if they are consistent with the guidance in IAS 39 and:

• Incorporate the effects of the time value of money;
• Consider the cash flows for the whole of the remaining life of an asset; and
• Consider the age of receivables within the group.

It is not acceptable to set aside additional provisions or reserves in excess of the amount of impairment or bad debt losses that are recognised under IAS 39.