Expected Credit Losses IFRS 13 definition: The weighted average of credit losses with the respective risks of a default occurring as the weights.
Under the “expected credit loss” model, an entity calculates the allowance for credit losses by considering on a discounted basis the cash shortfalls it would incur in various default scenarios for prescribed future periods and multiplying the shortfalls by the probability of each scenario occurring. The allowance is the sum of these probability weighted outcomes. Because every loan and receivable carries with it some risk of default, every such asset has an expected loss attached to it—from the moment of its origination or acquisition.
IFRS 9 establishes not one, but three separate approaches for measuring and recognising expected credit losses:
- A general approach that applies to all loans and receivables not eligible for the other approaches;
- A simplified approach that is required for certain trade receivables and so-called “IFRS 15 contract assets” and otherwise optional for these assets and lease receivables.
- A “credit adjusted approach” that applies to loans that are credit impaired at initial recognition (e.g., loans acquired at a deep discount due to their credit risk).
Measurement of Expected Credit Losses: what information to consider
IFRS 13 establishes that management should measure expected credit losses over the remaining life of a financial instrument in a way that reflects:
- an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes;
- the time value of money; and
- reasonable and supportable information about past events, current conditions and reasonable and supportable forecasts of future events and economic conditions at the reporting date.
When estimating ECL, management should consider information that is reasonably available, including information about past events, current conditions and reasonable and supportable forecasts of future events and economic conditions. The degree of judgement that is required for the estimates depends on the availability of detailed information.
IFRS 13 is not specific on how to extrapolate projections from available information.
Different ways of extrapolation can be used. For example, management could apply the average ECL over the remaining period or use a steady rate of expected credit losses based on the last available forecast. These are only examples, and other methods might apply. Management should choose an approach and apply it consistently.
This is a highly judgemental area which could have a large impact on the allowance for impairment.
The three stages of impairment
After initial recognition, the three stages of impairment loss calculation and interest revenue recognition are applied each reporting date as follows:
- Stage 1: Credit risk has not increased significantly since initial recognition – continue recognising the (updated) 12-month expected credit losses
- Stage 2: Credit risk has increased significantly since initial recognition – recognise lifetime expected losses, with interest revenue being calculated based on the gross amount of the asset
- Stage 3: There is objective evidence of impairment as at the reporting date – recognise lifetime expected losses, with interest revenue being based on the net amount of the asset (that is, based on the impaired amount of the asset).
Because the model is forward looking, expected credit losses are recognised from the point at which the financial assets are originated or purchased. This means that a Day 1 loss will be recognised for 12-month expected credit losses at initial recognition. Although this might appear counter intuitive from an individual asset perspective, from a portfolio perspective this is intended to approximate a more sophisticated approach which identifies the amount of the interest charge that relates to expected credit losses (the ‘credit spread’ – for example, 2% out of an interest charge of 8%) and accounts for interest revenue at 6% and credits the 2% credit spread to an expected loss impairment account.
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