3.2 Impairment Models and Expected Credit Losses
4 min read•august 7, 2024
The Expected Credit Loss (ECL) model is a game-changer in financial reporting. It requires companies to recognize potential losses on financial assets before they happen. This forward-looking approach aims to give investors a clearer picture of a company's financial health.
introduced the ECL model to improve how we measure and report credit risk. It applies to various financial instruments and considers different types of expected losses. Understanding this model is crucial for grasping modern financial reporting practices.
Expected Credit Loss (ECL) Model
Overview of the ECL Model
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- Expected credit loss (ECL) model introduced by IFRS 9 to recognize and measure impairment losses on financial assets
- Requires entities to recognize ECLs and update the amount of ECLs recognized at each reporting date to reflect changes in credit risk
- Applies to financial assets measured at amortized cost, debt instruments measured at fair value through other comprehensive income (FVOCI), and certain loan commitments and financial guarantee contracts
- Aims to provide users of financial statements with more useful information about an entity's expected credit losses on financial instruments
Types of Expected Credit Losses
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- Portion of lifetime ECLs that represent the ECLs resulting from default events on a financial instrument that are possible within 12 months after the reporting date
- Recognized for financial instruments that have not had a since initial recognition or that have low credit risk at the reporting date (investment-grade credit rating)
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- ECLs that result from all possible default events over the expected life of a financial instrument
- Recognized for financial instruments that have had a significant increase in credit risk since initial recognition (unless they have low credit risk at the reporting date) and for purchased or originated
- Significant increase in credit risk
- Determined by comparing the risk of default occurring on the financial instrument as at the reporting date with the risk of default occurring on the financial instrument as at the date of initial recognition
- Factors to consider include changes in credit ratings, changes in external market indicators of credit risk, actual or expected significant changes in the operating results or financial position of the borrower, and significant increases in credit risk on other financial instruments of the same borrower
- Credit-impaired financial assets
- Financial asset is credit-impaired when one or more events that have a detrimental impact on its estimated future cash flows have occurred (evidence of credit impairment includes significant financial difficulty of the borrower, a breach of contract such as a default or past due event, or the lender granting a concession to the borrower for economic or contractual reasons relating to the borrower's financial difficulty)
- Interest revenue is calculated by applying the effective interest rate to the amortized cost of the financial asset (gross carrying amount less )
Measuring Expected Credit Losses
Calculation of Loss Allowance
- Loss allowance recognized for ECLs on financial assets measured at amortized cost and debt instruments measured at FVOCI
- For financial assets, loss allowance reduces the carrying amount of the asset in the statement of financial position
- For debt instruments measured at FVOCI, loss allowance recognized in other comprehensive income and does not reduce the carrying amount of the financial asset in the statement of financial position
- ECLs measured as the difference between the contractual cash flows due to the entity and the cash flows the entity expects to receive, discounted at the original effective interest rate (or credit-adjusted effective interest rate for purchased or originated credit-impaired financial assets)
Key Components of ECL Measurement
- (PD)
- Estimate of the likelihood of default over a given time horizon
- Determined based on historical default rates, adjusted for and current conditions
- Example: A corporate bond with a credit rating of BB may have a 1-year PD of 2%, indicating a 2% probability that the issuer will default within the next year
- (LGD)
- Percentage of the exposure that is expected to be lost if a default occurs
- Takes into account factors such as collateral, seniority of the claim, and the entity's recovery processes
- Example: A secured loan with a 30% LGD implies that, in the event of default, the lender expects to recover 70% of the outstanding loan amount through the sale of collateral or other recovery methods
- (EAD)
- Estimate of the exposure at a future default date, taking into account expected changes in the exposure after the reporting date, including repayments of principal and interest and expected drawdowns on committed facilities
- Example: For a loan with an outstanding balance of 50,000, the EAD may be estimated at $120,000, assuming a portion of the undrawn facility is expected to be drawn down prior to default
- Forward-looking information
- ECL estimates should incorporate reasonable and supportable information about past events, current conditions, and forecasts of future economic conditions
- Macroeconomic factors (GDP growth, unemployment rates, and property prices) and their expected impact on PD, LGD, and EAD should be considered
- Multiple economic scenarios (base case, upside, and downside) may be used to capture non-linear relationships between economic factors and credit losses
Key Terms to Review (11)
12-month expected credit losses: 12-month expected credit losses refer to the estimated losses on financial assets that an entity expects to incur over the next 12 months, considering the probability of default and the loss given default. This approach is part of a broader framework aimed at recognizing credit risk earlier, allowing institutions to anticipate potential losses and take proactive measures. By focusing on a shorter time frame, it provides a more immediate reflection of the asset's risk profile in financial statements, making it crucial for accurate impairment assessments.
Credit-impaired financial assets: Credit-impaired financial assets refer to loans or other financial instruments that have experienced a significant deterioration in credit quality, indicating a higher risk of default. These assets are recognized when there is objective evidence that a borrower is unlikely to meet their contractual obligations, prompting institutions to assess and measure expected credit losses more accurately in their financial reporting.
Expected Credit Loss Model: The expected credit loss model is a financial reporting approach that estimates potential credit losses over the life of a financial asset, rather than waiting for a loss event to occur. This proactive method requires institutions to account for expected losses based on historical data, current conditions, and forecasts, promoting more timely recognition of risk and enhancing the overall financial transparency of institutions. It significantly shifts how credit risk is assessed, moving from an 'incurred loss' approach to one that incorporates future expectations.
Exposure at Default: Exposure at Default (EAD) refers to the total value that a financial institution is exposed to at the time of a borrower's default. This term is crucial for calculating credit risk and assessing potential losses in lending situations. Understanding EAD helps institutions determine how much capital to hold against potential losses, which is essential for maintaining financial stability and complying with regulatory requirements.
Forward-looking information: Forward-looking information refers to estimates and projections about future events, conditions, or performance that are based on current data and assumptions. This type of information plays a crucial role in assessing risk and making informed decisions, especially in financial contexts where anticipating future credit losses or impairments is essential for effective risk management.
IFRS 9: IFRS 9 is an international financial reporting standard that provides guidelines for the classification, measurement, impairment, and hedge accounting of financial instruments. It was developed to enhance the transparency and consistency of financial reporting, addressing issues present in previous standards by introducing more forward-looking approaches to credit losses and clearer rules for financial asset classification.
Lifetime expected credit losses: Lifetime expected credit losses refer to the anticipated losses on a financial asset over its entire life, factoring in historical data, current conditions, and forecasts of future economic performance. This concept is crucial for lenders as it helps them estimate potential losses from defaults more accurately and ensures that they maintain appropriate reserves to cover these potential losses. By assessing credit risk over the lifetime of an asset, financial institutions can adopt a proactive approach to risk management.
Loss Allowance: Loss allowance is an accounting estimate used to account for the expected losses on financial assets, particularly in the context of loans and receivables. It reflects the amount that an entity expects to lose due to defaults or impairment of those assets, providing a more accurate picture of financial health. This concept is crucial in the calculation of expected credit losses and plays a significant role in impairment models that aim to anticipate future losses rather than waiting for actual defaults to occur.
Loss Given Default: Loss Given Default (LGD) is a financial metric that estimates the potential loss a lender would incur if a borrower defaults on a loan, expressed as a percentage of the total exposure at default. This concept is essential in assessing credit risk, as it helps financial institutions determine the likelihood and extent of potential losses in the event of borrower default. LGD plays a critical role in impairment models and expected credit losses, influencing how banks set aside capital reserves and report their credit risk exposure.
Probability of Default: The probability of default is a financial term that quantifies the likelihood that a borrower will fail to meet their debt obligations within a specified time frame. This metric is critical in assessing credit risk, as it influences the estimation of expected credit losses and impairment models used by financial institutions. Understanding the probability of default helps institutions to set appropriate provisions for potential losses and adhere to regulatory disclosure requirements regarding credit risk.
Significant increase in credit risk: A significant increase in credit risk occurs when there is a marked deterioration in the creditworthiness of a borrower, indicating that the likelihood of default has risen substantially compared to the initial assessment at the time the financial instrument was recognized. This concept is crucial for determining the appropriate stage of credit loss recognition, which impacts how financial institutions measure expected credit losses and allocate provisions. Understanding when a significant increase in credit risk has occurred helps ensure accurate reporting and compliance with regulatory frameworks, enhancing financial stability.