Step 7 Measure expected credit losses

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Last update 18/09/2019

Although the focus for IFRS 9 Financial Instruments is on financial institutions such as banks and insurance companies, ‘normal’ operating entities are also affected by IFRS 9. Maybe their investment and loan portfolios are less complex but in operating a business and as part of the internal credit risk management practice policy making it is still important to implement the impairment model under IFRS 9 Financial Instruments. This is step 7 which started with an introduction in Impairment of investments and loans.

The measurement of Expected Credit Losses is inherently difficult, subjective and judgmental, in particular if the receivable is not rated or no market observable information is available. The measurement of Expected credit losses has to be carefully documented in the (period) financial close, which includes working sheets on each step in this process. The content may look as follows:

  1. Introduction
    1. Measurement date and purpose (Annual Financial Statements financial close, Interim period financial close, Consolidation return financial close or ….)
    2. Industry characteristics, Step 7 Measure expected credit losses
    3. Relevant historical data (updated each year),
  2. The measurement of expected credit losses Step 7 Measure expected credit losses
    1. Definition of default, substantiated with industry and/or company data,
    2. Decision on using the general or simplified approach (or both) including data analysis of the recent history to-date and outlook for the near future,
      1. The simplified approach – Provision matrix calculation including two or three years/periods of comparable calculations,
      2. The general approach – Definition of significant increase in credit risks including data analysis of the recent history to-date, outlook for the near future, and previous definitions (or if the same definition but only updated data, state the latest revision date),
      3. Definition of low risk receivables/financial assets including data analysis of the recent history to-date, outlook for the near future, and previous definitions (or if the same definition but only updated data, state the latest revision date),
      4. Allocation of low and higher risk receivables, data build up with comparison of latest revision (including latest revision date),
      5. Measurement of expected credit losses for the higher than low risk receivables/financial assets including data analysis of the recent history to-date and outlook for the near future,
  3. Review and conclude Step 7 Measure expected credit losses
    1. on the correctness of the documentation in the previous chapters and
    2. on the reflection on the below considerations.
  4. Sign offs and date of completion Step 7 Measure expected credit losses

The measurement model should reflect the following considerations:

Key considerations

Possible actions

An unbiased and probability-weighted amount

 Estimate should reflect at least two scenarios:

  • The probability that a credit loss occurs, even if this probability is very low, and
  • The probability that no credit loss occurs.

Consider using average historical credit losses for a large group of similar financial assets or historical default rates implied by credit default spreads, bond spreads of the counterpart or a comparative peer group exposure as a reasonable estimate of the probability-weighted amounts.

The time value of money

 Apply an appropriate discount rate:

  • Financial assets other than credit impaired financial assets and lease receivables: Apply the effective interest rate (EIR) determined on initial recognition or an approximation thereof,
  • Lease receivables: Apply discount rate used inm measuring lease receivables in accordance with IFRS 16,
  • Financial guarantee contracts: Apply the discount rate that reflects the current market assessment of the time value of money and the risk that are specific to the cash flows, but only if, and to the extent that, risks are taken into account by adjusting the discount rate instead of adjusting the cash flows that are being discounted.

Consider estimating an average rate that would approximate the EIR to discount the expected losses.

Reasonable and supportable information that is available without undue costs or effort
  • The estimates of ECL are required to reflect reasonable and supportable information that is available without undue costs or effort – including information about past events and current conditions and forecasts of future economic conditions,
  • Information that is available for financial reporting purposes is typically considered to be available without undue costs or effort.
  • Consider if the information on historical loss experience, current conditions, and forecasts of future economic conditions is reasonable and supportable information and is available without undue cost or effort,
  • Consider data sources such as:
    • internal historical credit loss experience,
    • internal and external ratings,
    • the credit loss experience of other companies, and
    • external reports and statistics,
  • If no information or insufficient sources of entity-specific data is available, then use experience from similar financial instruments,
  • For periods far in the future, consider availability of detailed information by for example extrapolating the information that is available from earlier periods,
  • Adjust historical information based on current observable data to reflect conditions and forecast of future conditions by considering that the (group of) financial instruments, using:
    • unemployment rates,
    • GDP
    • property prices,
    • commodity prices,
    • payment status, or
    • other factors that are indicative of credit losses.

Jump to:

Step 1 Define Default, Step 2 Decide to use the general or simplified approach, Step 3 Define significant increase in credit risk, Step 4 Define low credit risk, Step 5 Allocate receivables to high and low credit risk, Step 6 Apply the provision matrix

Related posts:

  1. Step 4 Define low credit risk
  2. Step 5 Allocate receivables to high and low credit risk
  3. Step 3 Define significant increase in credit risk
  4. When and how to recognise Expected Credit Losses