Perfect Good 1 When to recognise Expected Credit Losses

When to recognise Expected Credit Losses,Expected credit losses calculation,deterioration of the credit quality,lifetime expected credit losses,12-month expected credit lossesWhen to recognise Expected Credit Losses

Under IFRS 9 expected credit losses are recognised

from the point at which financial instruments are originated or purchased.

There is no longer a threshold (such as a trigger loss event of default) before expected credit losses would start to be recognised. With limited exceptions, a 12-month expected credit losses must be recognised initially for all assets subject to impairment. For example, an entity recognises a loss allowance at the initial recognition of a purchased debt instrument rather than when an event of default by the issuer occurs.

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).

When to recognise Expected Credit Losses,Expected credit losses calculation,deterioration of the credit quality,lifetime expected credit losses,12-month expected credit losses

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.

When to recognise Expected Credit Losses,Expected credit losses calculation,deterioration of the credit quality,lifetime expected credit losses,12-month expected credit lossesThe requirements in IFRS 9 result in lifetime expected credit losses being recognised only when the credit risk of a financial instrument is worse than that anticipated when the financial instrument was first originated or purchased. If, at the reporting date, the credit risk on a financial instrument has not increased significantly since initial recognition, an entity shall measure the loss allowance for that financial instrument at an amount equal to 12-month expected credit losses [IFRS 9 5.5]. 12-month expected credit losses are defined as the expected credit losses that result from those default events on the financial instrument that are possible within the 12 months after the reporting date.

A portion of lifetime expected credit losses is recognised when financial instruments are first originated or purchased. This is a way to reflect that the yield on the instrument includes a return to cover those credit losses expected from when a financial instrument is first recognised. If this amount was not recognised the full yield would be recognised as interest income with no adjustment for credit losses that were always expected.

Expected credit losses calculation – Example at recognition and at year-end 1

Entity B, as a lender, contracts a five-year term loan of CU1,000,000 at the beginning of Year 1. If there were no possibility of credit losses, the coupon rate that Entity B would charge the borrower is 5% per annum. When to recognise Expected Credit Losses

However, because of the borrower’s credit rating, Entity B estimates that there is a possibility the borrower might default on the payments and the expected credit losses are estimated at CU10,000 per year over the five-year term. When to recognise Expected Credit Losses

Accordingly, Entity B charges the borrower a 6% coupon rate to reflect the yield on the instrument to include a return to cover those credit losses expected when the loan is first recognised. The present value of the lifetime expected credit losses of CU10,000 per year for five years discounted at 6% is CU42,124. The present value of the 12-month expected credit losses of CU10,000 for the first year discounted at 6% is CU9,434 (10,000/1.06).

Thus, on initial recognition, Entity B records the following journal entries:

Dr Loan receivable                                        CU1,000,000 When to recognise Expected Credit Losses

Cr Cash                                                                                    CU1,000,000When to recognise Expected Credit Losses

to recognise loan asset at gross amount

Dr Impairment loss in profit or loss                  CU9,434 When to recognise Expected Credit Losses

Cr Loss allowance in financial position                                      CU9,434When to recognise Expected Credit Losses

to recognise 12-month expected credit losses When to recognise Expected Credit Losses

If, at the end of Year 1, there is no significant deterioration of the credit quality, there would be no change to the recognition of the 12-month expected credit losses. When to recognise Expected Credit Losses

However, suppose, at the end of year 1, there is a significant deterioration of the credit quality and Entity B re-estimates that the present value of the lifetime expected credit losses is CU34,651 (discount CU10,000 per year for year 2 – 5). Entity B recognises the lifetime expected credit losses (calculated as CU34,651 – CU9,434 = CU25,217), as follows: When to recognise Expected Credit Losses

Dr Impairment loss in profit or loss                 CU25,217  When to recognise Expected Credit Losses

Cr Loss allowance in financial position                                   CU25,217 When to recognise Expected Credit Losses

to recognise lifetime expected credit losses When to recognise Expected Credit Losses

The loss allowance in the statement of financial position would have a balance of CU34,651 and that is equal to the lifetime expected credit losses at the end of Year 1.

See also: IFRS Community – ECL

When to recognise Expected Credit Losses

When to recognise Expected Credit Losses When to recognise Expected Credit Losses When to recognise Expected Credit Losses When to recognise Expected Credit Losses When to recognise Expected Credit Losses When to recognise Expected Credit Losses When to recognise Expected Credit Losses When to recognise Expected Credit Losses When to recognise Expected Credit Losses When to recognise Expected Credit Losses

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