Expected Credit Losses
Expected credit losses represent a probability-weighted provision for impairment losses which a company recognizes on its financial assets carried at amortized cost or at fair value through other comprehensive income (FVOCI) under IFRS 9.
The expected credit losses (ECL) model adopts a forward-looking approach to estimation of impairment losses. It differs from the incurred loss model under the previous accounting standard, IAS 39. On each balance sheet date, companies are required to estimate the present value of the probability-weighted losses arising from default it expects to occur in the future.
12-month ECLs vs lifetime ECLs
IFRS 9 requires companies to initially recognize expected credit losses arising from potential default over the next 12 months. These are often referred to as 12-month ECLs. However, if there is a significant increase in credit risk of the counter-party, it requires recognition of expected credit losses arising from default at any time in the life of the asset. These are called lifetime ECLs.
The ECL model of IFRS 9 is similar to the current expected credit losses (CECL) model under US GAAP. However, while the IFRS 9 ECL model requires companies to initially recognize 12-month credit losses, CECL model requires recognition of lifetime credit losses.
Calculation methodology
While IFRS 9 does not stipulate any specific calculation methodology, the most popular approach used in estimation of expected credit losses (ECL) is the probability of default approach. This approach is popular because the three main inputs used in the model, namely exposure at default, probability of default and loss given default, are already calculated by most financial institutions for internal risk management
Exposure at default
Exposure at default equals the value of the financial asset which is exposed to credit risk. It equals the amount at risk at the time when default would occur minus the value of any collateral which can be used by the company in the event of default.
EAD does not necessarily equal the carrying amount of the financial asset. For example, in case of a lease receivable, EAD would equal the net investment in lease at the future date on which default would occur.
Probability of default
Probability of default (PD) is the likelihood of a the counter-party to a financial asset defaulting over a given time period. This input varies with the time period involved. For example, the probability of default of an entity over a 12-month period would be higher than the probability of default over a 6-month period.
Loss given default
Loss given default is the percentage of the amount at risk that would be lost if default is certain. It equals 1 minus the recovery rate.
Recovery rate is the percentage of total asset value which a company would recover even if default occurs.
Please refer to the GPPC guidelines for a detailed discussion of the probability of default approach.
Following are the main steps involved in ECL calculation:
- Identify different forward-looking scenarios and work out the three inputs discussed above for each scenario.
- Determine the total losses that would occur under each scenario. This would equal the product of exposure at default (EAD) and loss given default (LGD).
- Calculate the weighted-average expected losses. It equals the sum of products of total loss under each scenario and relevant probabilities of default.
- Discount the expected credit losses at the effective interest rate of the relevant financial asset.
The above approach can be expressed mathematically as follows:
$$ \text{ECL}=\frac{\text{EAD}\ \times\ ({\text{LGD}} _ \text{1}\times\ {\text{PD}} _ \text{1}+\ {\text{LGD}} _ \text{2}\times\ {\text{PD}} _ \text{2}+\text{...}+\ {\text{LGD}} _ \text{n}\times\ {\text{PD}} _ \text{n})}{{(\text{1}+\text{r})}^\text{n}} $$
Example
Company P operates a wind power complex whose total capacity is sold to the local government for lease rentals of $10 million per annum. The arrangement contains a 20-year lease (with a rate of interest implicit in the lease of 10%) in accordance with IFRS 16 Leases and the company has recognized a lease receivable as at 1 January 20X1 of $85,135,637.
The company has chosen to recognize 12-month expected credit losses related to the asset. A major credit rating agency has assigned a rating of B- to the company’s counterparty which corresponds to a probability of default (within the next 12 months) of 2.7%. The company assesses that in the event of default, the company will be able to recover 80% of lease receivable.
We first need to determine the exposure at default (EAD). It is a forward-looking figure and not just the carrying amount as at 1 Jan 20X1. Ideally, EAD should be calculated at the end of each period, say a month. But in this example, we assume default occurs at the end of 20X1 when EAD would be $83,649,201.
$$ \text{EAD}\\ =\ \text{\$85,135,637}\ +\ \text{\$85,135,637}\ \times\ \text{10%}\ -\ \text{\$10,000,000}\ \\=\ \text{\$83,649,201} $$
Based on the available information, the potential probability-weighted loss during the first year (assumed to be at the end of the year) would be as follows:
$$ \text{Shortfall}\\ =\text{\$83,649,201}\ \times\ ((\text{1}-\text{80%})\ \times\ \text{2.7%} + \text{0%}\ \times\ (\text{1}\ -\ \text{2.7%}))\\=\text{\$451,706} $$
The equation above shows that since there is a 2.7% probability of the company losing 20% of its total receivable, its cash shortfall would be $451,706. This when discounted at the effective rate of interest (10% in this case) equals $410,642.
$$ \text{Expected credit losses}=\frac{\text{\$451,706}}{\text{1}\ +\ \text{10%}}=\text{\$410,642} $$
This is the provision that the company should deduct from its lease receivables and recognize as an expense in the profit and loss.
by Obaidullah Jan, ACA, CFA and last modified on