Impairment, credit losses and onerous commitments
The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) issued Financial Accounting Standard (FAS) 30 - Impairment, credit losses and onerous commitments which deals with impairment and provisions on a broad range of asset types. The main purpose of this standard is to bring all the different impairment models (new and existing guidance covered in other standards) under one single standard.
The standard introduces the concept of expected credit losses on financing contracts and other asset classes primarily exposed to credit risk and the provision/ impairment model for investments and other assets (including inventories). FAS 30 supersedes certain sections of FAS 25, Investment in Sukuk, shares and similar instruments which relate to impairment and replaces FAS 11, Provisions and Reserves. However, the standard does not address any classification and initial recognition of assets and exposures. The requirements of classification and initial recognition for a specific Islamic financing contract, which is currently prescribed under respective FASs would continue to apply. This standard shall be effective for the financial periods beginning on or after 1 January 2020, however early adoption is permitted.
FAS 30 introduces a forward looking impairment model for credit losses, prompting timely recognition of expected impairment and credit losses based on significant increase in credit risk, and accelerates the recognition of different types of losses in line with the recent accounting standards issued by various international accounting standard setting bodies.
FAS 30 classifies assets and exposures into three categories based on the nature of risks involved (i.e. credit risk and other risks) and prescribes three approaches for assessing losses for each of these categories of assets 1) Credit Losses approach, 2) Impairment approach and 3) Net Realizable Value approach.
FAS 30 also covers provisioning requirements for onerous conditions in contracts or future commitments.
In case of jointly financed assets, FAS 30 requires allocation of the impairment and credit losses between the equity shareholders and other participatory stakeholders (including unrestricted investment accountholders).
This standard is a significant initiative by AAOIFI to harmonise its loss measurement guidelines with International Financial Reporting Standards (IFRSs). While the exposures subject to each loss approach may differ due to differences in classification and measurement guidelines, we do not expect any significant differences in the application of these guidelines between IFI’s and their conventional counterparts. The different approaches reflect an economic loss measurement and hence each loss approach is expected to reach a similar outcome as compared to application of its equivalent IFRS. The application of this standard will result in a significant change in current policies and practices followed by Islamic financial institutions.
We hope that this publication would help you in gaining a greater understanding of FAS 30 and its implications.
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