Collateral and expected credit losses – 1 Simple Easy Example

Collateral and expected credit losses

In IFRS 9 collateral is a relevant factor in the measurement of expected credit losses.

In IFRS 9 the estimate of expected cash shortfalls is reflected by the cash flows expected from collateral and other credit enhancements that are integral to the instrument’s contractual terms. The estimate of expected cash shortfalls on a collateralized financial instrument reflects: Collateral and expected credit losses

• the amount and timing of cash flows that are expected from foreclosure on the collateral or other ways of recoverability of the collateral, Collateral and expected credit losses
• less the costs of obtaining and selling the collateral. Collateral and expected credit losses

This is irrespective of whether or not foreclosure is probable. In other words, the estimate of expected cash flows considers both the probability of a foreclosure and the cash flows that would result from it. Collateral and expected credit losses

A consequence of this is that any cash flows that are expected from the realization of the collateral beyond the contractual maturity of the contract are included in the analysis. This is not to say that the entity is required to assume that recovery will be through foreclosure only however. Collateral and expected credit losses

Instead the entity should calculate the cash flows arising from the various ways in which the asset might be recovered and assign probability-weightings to those outcomes. Collateral and expected credit losses

5 Common Types of Collateral for Business Loans are:

1. Real property, like a home or business property, Collateral and expected credit losses
2. Manufacturing equipment, Collateral and expected credit losses
3. Inventory, Collateral and expected credit losses
4. Cash, Collateral and expected credit losses
5. Trade accounts receivable, Collateral and expected credit losses
6. Blanket lien.  Collateral and expected credit losses

Pledging collateral is critically important when attempting to secure financing for a business. But why is that? And, further, what is collateral in business? Collateral and expected credit losses

On that first point, collateral is just one form of security for lenders. Obviously, lenders are putting a lot at stake when they offer up capital to a small business. And as well-intentioned as a business owner is when they accept a loan, there’s always the risk that things can go south and they’ll be unable to repay what they owe. Collateral and expected credit losses

That’s the function collateral—if a borrower defaults on their loan, the lender has the right to seize whatever assets the borrower pledged to make up for the lost capital. Collateral and expected credit losses

Other than collateral’s very real function, on a symbolic level lenders like to see that a borrower has skin in the game—and that they, too, have a lot to lose if they fall through on their loan payments. Collateral and expected credit losses

Example inclusion collateral in ECL Lease receivables

The estimated expected credit losses in a collaterised financial instrument includes the cash inflows and their timing that are expected from foreclosure less cost for obtaining and selling the collateral (as stated above), irrespective of whether a foreclosure is probable (i.e. under the forward looking IFRS 9 ECL model the estimate of expected credit losses considers the probability of a foreclosure and the cash flows that would result from it, not if there is an increased credit risk trigger going from Stage 1 ECL to Stage 2 ECL).

When measuring a loss allowance for a lease receivable, the cash flows used for the measurement should be consistent with the cash flows used in measuring the lease receivable in accordance with IFRS 16 Leases.

This means when selecting the discount rate to be used for measuring lifetime expected credit losses of lease receivables, the rate the lessor  charges the lessee or the effective interest rate implicit in the lease shall be applied, depending on which rate is used in measuring the lease receivable.

Entity Q generates a loan of €10 million. The loan is repayable by the borrower on equal annual installments of €2.40 million over a five-year term. The effective interest rate that Entity Q charges the borrower is 6.4% per annum compromising a 4% risk-free rate and 2.5% for credit risk. The collateral (lease asset) is expected to generate a cash inflow of €2 million in year 5.

Entity Q estimates that there is a 75% chance that the loan will not default, a 15% chance that the loan defaults and the expected cash flow in each year is €1.80 million, and a 10% chance that the loan defaults and the expected cash flow in each year is €1.20 million.

At initial recognition, Entity Q estimates the following cash shortfalls, including or excluding a the collateral (lease asset):

The lifetime expected credit losses, measured at the net present value are €.21 million in this (rather simplified) calculation model (other calculation models are possible!). The 12-month expected credit losses measured at present value ((€0.21 million/5)/(1.0 + 0.064)) is €0.0395 million. As a result at initial recognition a 12-month expected credit losses allowance is recorded:

to record the loan receivable at gross amount paid to the borrower Collateral and expected credit losses

to recognise the 12-month expected credit losses allowance at initial recognition.

This also shows that the 12-month expected credit losses allowance at initial recognition without collateral would have been 0.1090¹, almost three times as high!

Also read: Collateral

Collateral and expected credit losses

Collateral and expected credit losses