All You Need to Know About ECL Calculation Under IFRS 9
Most of the companies face difficulties in developing and updating the ECL (expected credit losses) calculation models, especially at these uncertain economic times where finding reliable information is challenging. Implementation of IFRS 9 mandates the proper calculation, accounting and disclosure of expected credit losses. Here we discuss the implications of ECL calculation under IFRS 9.
What is meant by ECL under IFRS 9 and how is it different from the impairment provision requirements of IAS 39?
Impairment provision under IFRS 9 is referred to as expected credit loss (ECL) because it is determined based on the estimated expectation of an economic loss of asset under consideration. Previously the impairment provisioning requirements of IAS 39 implied a backwards-looking approach based on the already incurred losses over the reporting period. Also, provisions were made only when there was evidence for impairment as of the reporting date as per the previous accounting requirements. IFRS 9 provides a forward-looking approach laying out the requirement for making provision based on the expectation of credit losses even at the initial recognition of assets.
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Main factors involved in the calculation of ECL
The major factors involved in the calculation of ECL are
- Exposure at Default (EAD) – For any asset for which ECL is getting calculated, EAD represents the projected credit risk exposure at any given point of time. For example, if we are assessing ECL for a particular company relating to any of its investments in bonds as of any reporting date, EAD for that investment will be its amortised cost balance as per the books of the company at that date.
- Probability of Default (PD) – This represents the projected possibility of default with respect to any asset.
- Loss Given Default (LGD) – This represents a projected economic loss to the company in case of default happens with respect to any asset. Existence of collateral and their valuation plays an important role in the computation of this factor for any asset.
- ECL formula – The basic ECL formula for any asset is ECL = EAD x PD x LGD. This has to be further refined based on the specific requirements of each company, the approach taken for each asset, factors of sensitivity and discounting factors based on the estimated life of assets as required.
Different approaches for ECL calculation allowed under IFRS 9
IFRS 9 gives two type approaches to calculate ECL model as below:
- General approach – This approach is often referred to as a three-stage approach because of the impact of changes in credit risk over the period of the asset on the ECL calculation. The major feature in this approach is determining the requirement for 12 months ECL or lifetime ECL by analysing whether there is a significant increase in the credit risk of an asset or not.
- Simplified approach – This is intended mainly for short term receivable balances to provide for lifetime ECL on initial recognition of these assets, avoiding complex calculations. This helps in avoiding sophisticated models for simpler asset balances which do not require tracking of movement in credit risks.
How to identify significant increase in credit risk of assets for the calculation of ECL?
In determining whether there is a significant increase in credit risk or not, following details to be analysed relating to the asset/receivable account which is under consideration for ECL:
- Any fluctuations with respect to external market indicators such as cost of debt or equity
- Existence of any adverse changes in operational/economic situations
- Any fluctuations with respect to internal value indicators including negative changes in credit rating
- Fluctuations in the market value of the collateral held or changes in the repayment pattern
- Major decline in the operating results
- Defaults in payments
What are the challenges in updating an ECL calculation model?
Key challenges faced by the companies in updating their ECL calculation models are:
- Availability of the external reliable information such as ratings of the companies, macroeconomic factors, discount rates etc. to be used in the ECL calculation model
- Availability of internal historical data in the required detailed level to formulate the trends and to customise the calculations
- Application of company and sector-specific details into the ECL model
- Documentation of the calculation models and assumptions used, enabling the update of data in the model as and when required
- Incorporating the changes into an existing ECL model for any major change in the business of the company or fluctuations in the economy in which the company is operating
How COVID-19 and its consequences affect the ECL calculation?
ECL calculation involves consideration of macro-economic factors such as GDP growth. Uncertainty that the pandemic has created all across the world has made it very difficult with respect to the forecasts and projections relating to these economic factors used in arriving at the assumptions in the ECL models. For example, most of the regions are facing a negative GDP growth in the year 2020 because of the pandemic compared to a positive growth percentage of the previous year. This change has significantly impacted the ECL results and companies find it extremely challenging in updating the ECL working models to incorporate this economic decline due to its unpredictable nature. Also, another major impact of this declining economic scenario happens to be in the fair valuation of assets held as collateral as part of the calculation of one of the major factor of ECL computation which is “LGD” (Loss Given Default).
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How CDA helps you in implementing and reviewing ECL calculation models for your company?
With the experience of working with several clients and being equipped with a dedicated team specialised in IFRS accounting, CDA provides various consulting and advisory services such as:
- To clarify your queries in and around the ECL calculations and IFRS 9 requirements
- To develop ECL calculation models as applicable to the assets of your company
- To assist in documenting the rationale for approaches taken and various underlying assumptions
- To review the existing ECL models in your company to ensure the completeness and to validate the compliance with IFRS 9 requirements
- To help you implement the ECL models in ERP systems to facilitate automation of calculations at an optimum level
Hope you got a clear idea of the implications of ECL calculation under IFRS 9. Having any queries on ECL calculation under IFRS 9? Feel free to contact us for a one-hour free consultation, which we can share with you the changes and key updates relating to the IFRS requirements and the best industry practices.