The measurement of expected credit losses is based on the present value of cash shortfalls, and takes into account both the amount and timing of contractual payments. Therefore a credit loss will arise in instances where there is a delay in the payment of contractually required amount, even if all contractual cash payments are ultimately expected to be received in full.
For financial assets, a cash shortfall is the difference between:
- The present value of the principal and interest cash flows due to an entity under the contract; and
- The present value of the cash flows that the entity expects to receive.
In estimating expected credit losses, entities are required to consider more than one outcome and consider the likelihood of a number of potential outcomes occurring in practice. An expected loss estimate should reflect:
- An unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes, and
- The time value of money.
This means that entities need to consider:
- All reasonable and supportable information that is relevant in making the forward-looking estimate,
- A range of possible outcomes and the likelihood and reasonableness of those outcomes (that is, not merely an estimate of the ‘most likely outcome’).
IFRS 9 does not require entities to identify every possible scenario, but at least two outcomes need to be considered:
- The probability that a credit loss occurs, and
- The probability that no credit loss occurs.
This approach is required even if the most likely outcome is no loss or that the probability of credit losses occurring is very low.
The calculation of a probability weighted amount does not need to be a complex analysis. In some cases, relatively simple modelling may be sufficient, without the need for a large number of detailed simulations of scenarios. For example, the average credit losses of a large group of financial instruments with shared risk characteristics may be a reasonable estimate of the probability-weighted amount. Entities need to ensure that the observed historical credit loss rates are applied consistently to groups of financial assets with similar risk characteristics.
Various sources of data can be used to estimate expected credit losses. Entities should consider both borrower specific factors, macroeconomic conditions, and internal and external information such as internal historical credit loss experience, internal ratings, and external reports and statistics. Entities should also take into account both the current and future forecast direction of conditions at the reporting date.
An entity is not required to incorporate forecasts of future conditions over the entire remaining life of a financial instrument. For long dated instruments, the standard does not require a detailed estimate for periods that are far in the future – for such periods, an entity may extrapolate projections from available, detailed information.
Entities can use historical data as a starting point and adjust for current conditions and forecasts of future conditions. Entities need to ensure that the adjustments to historical data are directly consistent with other observable data (e.g. changes in unemployment rates, property prices, commodity prices and payment status), and are of similar magnitude. In some cases, if conditions and forecast future conditions are not expected to change, then the unadjusted historical information may be sufficient.
IFRS 9 requires entities regularly to review their methodology and assumptions to reduce any differences between estimated and actual credit loss experience.
IFRS 9 clarifies that the intention is not always to require a complex statistical analysis, but that entities should consider information that is reasonably available without undue cost and effort. However, it is likely that different entities may have different thresholds on what would be considered reasonably available information.
For collateralised financial instruments, the estimate of expected cash flows considers the probability of a foreclosure and the cash flows that would result from obtaining and selling the collateral. Any collateral obtained as a result of foreclosure is not recognised as an asset that is separate from the collateralised financial instrument unless it meets the recognition criteria for an asset in other IFRSs.
The maximum period over which to consider expected credit losses is the contractual period of the financial instrument that the entity is exposed to, and no longer (even if business practice suggests that a longer exposure period may apply). For example, a loan where the lender can contractually demand repayment within a short period will be assessed for expected losses over that short period, even if the lender expects to maintain the loan for a longer period. Similarly, a loan commitment that can contractually be withdrawn within a short period will be assessed for expected losses over that short period, and not for the longer period during which the potential lender expects to continue to make the facility available. However, there is an exception for revolving credit facilities such as credit cards and overdraft facilities (see Loan commitments and financial guarantees).
At initial recognition (except for (i) undrawn loan commitments and financial guarantee contracts, and (ii) purchased or originated credit-impaired financial assets) an entity is required to discount the expected credit losses using the financial instrument’s initial effective interest rate.
The credit adjusted effective interest rate is used to discount cash flows for purchased or originated credit impaired financial assets (see Purchased and originated credit-impaired financial assets).