Financial services: loans and interest income

Lakeshore Community Finance lends to small businesses. Its revenue is interest; its biggest judgement is how much of that lending won't come back. IFRS 9 shapes both.

1. Amortised cost. Lakeshore holds its loans to collect contractual payments of principal and interest, so they are measured at amortised cost (IFRS 9.4.1.2). The loan is first recognised at fair value plus directly attributable transaction costs (IFRS 9.5.1.1). Fees Lakeshore charges to arrange the loan are not income on day one: they are an integral part of the loan's yield, so they reduce its initial carrying amount and are earned through the effective interest rate over its life (IFRS 9 B5.4.1–B5.4.3). Directly attributable origination costs — say, a broker's fee — increase the carrying amount.

2. Effective interest. The effective interest rate (EIR) is the rate that exactly discounts the loan's expected cash flows to its initial carrying amount. Interest income each period is EIR × the opening gross carrying amount; the difference between that and the cash coupon accretes the carrying amount towards face value.

3. Expected credit losses (ECL). IFRS 9 requires a loss allowance from day one, based on expectations, not on losses that have already happened (IFRS 9.5.5). A simple estimate is probability of default (PD) × loss given default (LGD) × exposure at default (EAD), weighted for several economic scenarios. The horizon depends on the loan's stage:

• Stage 1 — no significant increase in credit risk since origination: allowance = 12-month ECL (IFRS 9.5.5.5).
• Stage 2 — credit risk has increased significantly (more than 30 days past due is a rebuttable presumption, IFRS 9.5.5.11): allowance = lifetime ECL (IFRS 9.5.5.3). Interest is still on the gross carrying amount.
• Stage 3 — credit-impaired (e.g. 90 days past due, serious financial difficulty): lifetime ECL, and interest income is calculated on the net carrying amount (gross less allowance) (IFRS 9.5.4.1(b)).

The allowance is a contra-asset; movements go to profit or loss. Our chart uses Allowance for credit losses and Credit loss expense for loans as well as receivables.