Impairment of financial assets – ECL approach

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 approach was used to determine impairment of financial assets. Under the incurred loss approach, impairment is recorded after the event of default has happened. However, the new accounting standard “IFRS 9 – Financial Instruments” has introduced a more prudent approach known as Expected Credit Loss (ECL) approach. In this chapter, we’ll explain the ECL approach to calculate the impairment of  financial assets.

Expected Credit Loss (ECL)

Expected Credit Loss (ECL) approach requires that an entity should 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 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

Following formula can be used to calculate the expected credit loss:

Expected credit loss = PD x LGD x EAD*

* If the effect of discounting is material, present value of EAD should be used in the above formula. Discount rate should be the financial asset’s original effective interest rate.

Where:

  • PD is probability of default
  • LGD is loss given default
  • EAD is exposure at default

Let’s see the definitions of the above-mentioned terms and some other definitions which are important for understanding the process of calculating and recording ECLs.

Probability of default (PD)

It is an estimate of the probability or likelihood of a default over a particular period of time. For example, if we say that a loan has 30% PD, it means that there are 30% chances that the loan will default.

Loss given default (LGD)

It is the amount of loss that will be suffered by an entity in the event of default. It is not necessary that 100% amount will be lost in case of default. For example, a person is not able to repay the full amount of loan but has promised to pay at least 60% of the outstanding amount. In this case, a default has occurred, but loss is expected to be only 40%, so we can say that LGD for this example is 40%. Similarly, some financial assets are secured by way of collaterals or similar arrangements. Amounts recoverable from securities should be considered while calculating loss given default (LGD).

Exposure at default (EAD)

It is the amount that is expected to be outstanding at the time of default.

The product of exposure at default (EAD) and loss given default (LGD) gives us the amount that is expected to be lost in the event of default. It is then multiplied by the probability of default (PD) to arrive at the expected credit loss figure.

Lifetime expected credit loss

It is an estimate of total expected credit losses arising from all possible default events occurring over the expected life of a financial asset.

12 months expected credit loss

It is an estimated portion of the lifetime expected credit losses of a financial asset arising from default events that are possible within the next 12 months from the initial recognition of a financial asset, or from the reporting date.

ECL impairment model

IFRS 9 has introduced a three-stage impairment model. At the time of initial recognition of a financial asset, an entity is required to calculate and recognize 12 months expected credit loss. Subsequently at each reporting date, the entity will evaluate the changes in the financial asset’s credit risk. Based on this evaluation, financial asset is placed in one of the three stages of the impairment model. These stages determine the amount of impairment to be recognized. Calculation of future interest income is also affected by these stages. Let’s see how the three-stage impairment model works.

STAGE 1: Credit risk has not increased significantly since initial recognition of financial asset

  • 12 months expected credit loss should be recognized
  • Interest income should be recorded on gross basis

STAGE 2: Credit risk has increased significantly since initial recognition of financial asset

  • Lifetime expected credit loss should be recognized
  • Interest income should be recorded on gross basis

STAGE 3: Credit risk has increased so much that the financial asset is credit impaired

  • Lifetime expected credit loss should be recognized
  • Interest income should be recorded on net basis (interest income will be based on gross carrying amount less ECL allowance)