General approach Expected credit losses

The general approach expected credit losses is what it is the most accepted or normal or preferred way of loss provisioning financial assets to a level at which it is becoming unlikely that they are overstated.

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.

Next to recording loss allowances based on expected credit losses under the ‘general approach’  IFRS 9 has also made it possible to use a simplified approach for trade receivables, contract assets and lease receivablesWhen it comes to the actual measurement of a loss allowance under thegeneral approachan entity should measure expected credit losses of a financial instrument in a way that reflects the principles of measurement set out in IFRS 9. These dictate that the estimate of expected credit losses should reflect:

  • an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes;
  • the time value of money; and General approach Expected credit losses
  • reasonable and supportable information about past events, current conditions and forecasts of future economic conditions that is available without undue cost or effort at the reporting date.

General approach - Expected credit losses

When measuring expected credit losses, an entity need not necessarily identify every possible forward looking scenario. However, it should consider the risk or probability that a credit loss occurs by reflecting the possibility that a credit loss occurs and the possibility that no credit loss occurs, even if the possibility of a credit loss occurring is very low. It is also worth noting that the credit loss outcomes of scenarios are not necessarily linear. In other words, an increase in unemployment of 1% could have a greater negative impact than the positive impact resulting from a reduction of 1% in unemployment. General approach Expected credit losses

Putting the theory into practice, expected credit losses under the ‘general approach’ can best be described using the following formula:

Probability of Default (PD) x Loss given Default (LGD) x Exposure at Default (EAD)Effective

=

Expected Credit Losses.

For each forward looking scenario an entity will effectively develop an expected credit loss using this formula and probability weight the outcomes. General approach Expected credit losses

Probability of Default (PD) is an estimate of the likelihood of a default over a given time horizon. For example, a 20% PD implies that there is a 20% probability that the loan will default. (IFRS 9 makes a distinction between 12-month PD and a lifetime PD as described above).

Something else -   Convertible notes Basic requirements

Loss given Default (LGD) is the amount that would be lost in the event of a default. For example, a 70% LGD implies that if a default happens only 70% of the balance at the point of default will be lost and the remaining 30% may be recovered (be that through recovery of security or cash collection). General approach Expected credit losses

Exposure at Default (EAD) is the expected outstanding balance of the receivable at the point of default.

IFRS 9 establishes not one, but three separate approaches for measuring and recognising expected credit losses:

  • general approach that applies to all loans and receivables not eligible for the other approaches;
  • 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).

General approach Expected credit losses

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General approach Expected credit losses

General approach Expected credit losses General approach Expected credit losses

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