The three stages Expected Credit Losses are the way of forward looking loss provision accounting for certain financial assets under IFRS 9 Financial Instruments.
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.
Twelve-month versus lifetime expected credit losses
ECLs reflect management’s expectations of shortfalls in the collection of contractual cash flows. Three stages Expected Credit Losses
Twelve-month ECL is the portion of lifetime ECLs associated with the possibility of a loan defaulting in the next 12 months. It is not the expected cash shortfalls over the next 12 months but the effect of the entire credit loss on a loan over its lifetime, weighted by the probability that this loss will occur in the next 12 months. It is also not the credit losses on loans that are forecast to actually default in the next 12 months. If an entity can identify such loans or a portfolio of such loans that are expected to have increased significantly in credit risk since initial recognition, lifetime ECLs are recognised. Three stages Expected Credit Losses
Lifetime ECLs are an expected present value measure of losses that arise if a borrower defaults on its obligation throughout the life of the loan. They are the weighted average credit losses with the probability of default as the weight. Because ECLs also factor in the timing of payments, a credit loss (or cash shortfall) arises even if the bank expects to be paid in full but later than when contractually due. Three stages Expected Credit Losses
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 Three stages Expected Credit Losses
- reasonable and supportable information about past events, current conditions and reasonable and supportable forecasts of future events and economic conditions at the reporting date. Three stages Expected Credit Losses
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. Three stages Expected Credit Losses
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.
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Three stages Expected Credit Losses
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