ECL model vs incurred loss model

Impairment is a term that refers to some damage or loss to an entity’s asset. If the expected benefits from an asset are lesser than the asset’s value in the books of account, it is considered to be impaired. Previously, incurred loss model was used to determine impairment of financial assets as per “IAS 39 – Financial Instruments: Recognition and Measurement”. However, the new accounting standard “IFRS 9 – Financial Instruments” has introduced a more prudent approach known as Expected Credit Loss (ECL) model. Let’s briefly discuss both these impairment models.

Incurred loss model

Incurred loss model assumes that all contractual cash flows of a financial asset will be received as per contractual terms unless evidence to the contrary is observed. If any event happens that suggests that a default is likely to occur, only then the impairment of financial asset is recorded. Unlike ECL model, no loss allowance is required to be determined at the time of initial recognition of financial asset or at each reporting date. This model is criticized for being less prudent, as it does not estimate the future expected credit losses. As a result, loss allowances are not recorded timely and businesses cannot carefully plan to deal with significant credit losses.

This criticism is supported by the Global Financial Crisis of 2008. You can search on the internet about the Global Financial Crisis which was a worldwide financial crisis. To avoid similar situations in future, Expected Credit Loss (ECL) model has been introduced.

Expected Credit Loss (ECL) model

Expected Credit Loss (ECL) model requires that an entity should try to predict the future and recognize an allowance for the estimated credit losses, instead of waiting for the default to happen. Credit loss is the difference between the present value of contractual cash flows and the present value of expected cash flows associated with a financial asset. Cash flows are discounted by using the original effective interest rate of the financial instrument. While predicting the future expected cash flows, there can be a range of possible outcomes depending on varying credit risk assumptions. Therefore, expected credit loss is calculated as a probability-weighted amount after evaluating various possible outcomes. Formula and further details of ECL model are explained in our chapter “impairment of financial assets”.

Advantages of ECL model

Shifting from incurred loss model to ECL model has resulted in entities being more prudent. ECL model is a three-stage model which requires the entities to understand and monitor the changes in credit risks right from the beginning i.e. from the date of initial recognition of the financial asset.

Following are some of the advantages of ECL model:

  • It is a more prudent approach compared to the incurred loss model
  • It results in timely recognition of expected credit losses, as it requires the entities to make an estimate of ECLs at the time of initial recognition and at each reporting date.
  • Credit risks are monitored by entities in an efficient manner
  • Disclosures about the financial instruments will be more detailed and useful, containing information about significant increases in credit risks of financial instruments