How is the expected credit loss measured
ECL measurement criteria
An entity shall measure expected credit losses of a financial instrument in a way that reflects:
- an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes;
- the time value of money; and
- reasonable and supportable information that is available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions.
The expected credit losses are calculated based on the present value of all cash shortfalls over the expected life of financial instruments. A cash shortfall is determined as the difference between the cash flows that are due to an entity as per the contract and the revised cash flows that the entity expects to receive based on the probability-weighted estimate of credit losses. A credit loss can arise even if the entity expects to receive the amount due in full but with the delayed timings of such cash flows than what were contractual dues. This is because the expected credit losses consider both the amount as well as the timing of such payments.
To summarise this in a nutshell, for a financial asset, a credit loss is the present value of the difference between:
- the contractual cash flows that are due to an entity under the contract; and
- the cash flows that the entity expects to receive.
For undrawn loan commitments, a credit loss is the present value of the difference between:
- the contractual cash flows that are due to the entity if the holder of the loan commitment draws down the loan; and
- the cash flows that the entity expects to receive if the loan is drawn down.
The purpose of estimating expected credit losses is neither to estimate a worst-case scenario nor to estimate the best-case scenario. Instead, an estimate of expected credit losses shall always reflect the possibility that a credit loss occurs and the possibility that no credit loss occurs even if the most likely outcome is no credit loss.
The average credit loss of a large group of financial instruments which have common risk characteristics may be a reasonable estimate of the probability-weighted amount of credit loss. The expected credit loss should be discounted to the reporting date and not to the expected default date or some other date. The discount factor to be used for this purpose should be based on the effective interest rate determined at initial recognition of the financial instrument concerned. If a financial instrument has a variable interest rate, the expected credit loss should be discounted using the current effective interest rate.
The estimate of expected credit losses should reflect an unbiased probability weighted amount that was determined by evaluating a range of possible outcomes. The expected credit losses shall reflect at least two outcomes namely:
- Probability that a credit loss occurs; and
- Probability that no credit loss occurs, even if possibility of credit loss occurring is very low.
The maximum period considered while measuring expected credit loss is the maximum contractual period which includes extension options if applicable, over which the entity is exposed to credit risk. The maximum period is not more than the period mentioned above, even if that long period is consistent with business practice. For some financial instruments which may include both a loan component and a non-drawn commitment component, the maximum period to consider for measuring expected credit losses would not be mitigated by credit risk management actions, even if that period extends beyond the maximum contractual period.
In some cases relatively simple modelling may be sufficient without a need for a large number of detailed simulations scenarios, eg, the average credit loss of a large group of financial instruments with shared risk characteristics may be a reasonable estimate of the probability weighted amount.
Reasonable and supportable information
Reasonable and supportable information is that which is reasonably available at the reporting date without undue cost or effort, including information about past events, current conditions and forecasts of future economic conditions. Information that is available for financial reporting purposes is considered to be available without undue cost or effort.
An entity is not required to undertake an exhaustive search for information but it is enough if it considers all reasonable and supportable information that is available without undue cost or effort which is relevant to estimate the expected credit losses. The following information is normally considered for this purpose.
- Factors that are specific to the borrower.
- General economic conditions.
- An assessment of both the current as well as the forecast directions of such conditions at the reporting date.
- Various sources of data which are both internal namely entry specific and/or external.
- Initial historical credit loss experience
- Internal ratings
- Credit loss experience of other entities
- External ratings reports and statistics
The entities that have insufficient sources of entity specific data may use peer group experience for the compatible financial instrument or groups of financial instruments for this purpose.
Debt instrument measured at FVOCI
For financial assets that are debt instruments measured at FVOCI, both the amortised cost and the fair value of the instrument are relevant. The reason for this is the objective of categorising a debt instrument as FVOCI is that both the contractual cash flows characteristic and the fair value of the instrument are relevant as the asset is held to receive contractual cash flows as well as to buy or sell such assets. For the contractual cash flow characteristic, amortised cost is relevant as the interest revenue would be based on the effective rate calculated at the time of inception of the debt instruments. The fair value of such instruments is also relevant because the entity would want to profit from the sale of such instrument whenever the opportunity for the same exists. As a result of this, the debt instrument should always be shown at the fair value in the balance sheet and for the purpose of recognising interest revenue, the effective interest rate method should be applied to such assets based on the amortised cost. The disclosure requirements for debt instruments measured at FVOCI, specifically requires that the impairment allowance should not be reduced from the fair value nor should it be shown as a deduction from the fair value of the instrument but, instead, should be shown as accumulated loss allowance (OCI) as part of equity. So, in a nutshell, the expected credit losses are not reduced from the carrying amount in the balance sheet and the carrying value remains at fair value only.
- Interest revenue is calculated based on EIR at the opening amortised cost.
- Foreign exchange gains and losses on such instruments are recognised in the profit and loss account
- Impairment gains and losses are recognised in the profit and loss account.
- The corresponding impairment gain or loss, as the case may be, is shown as part of the accumulated impairment account.
- When the financial asset is de-recognised, the cumulative gains and losses previously recognised as other comprehensive income is reclassified or recycled from equity to profit or loss as reclassification adjustment including the balance in the accumulated impairment account, if any.
Stage 1 Expected credit loss
The expected credit loss is computed at three stages. The following shows a diagrammatic representation of the same.
An entity is required to recognise a loss allowance for the expected credit losses on a financial asset, lease receivable, a contract asset or a loan commitment and a financial guarantee contract. The loss allowance for the financial instrument shall be measured at an amount equally to 12 months expected credit losses.
Stage 2 Expected credit loss
The entity is required to measure the loss allowance for a financial instrument on an amount equal to the lifetime expected credit loss if the credit risk on that financial instrument has increased significantly since initial recognition.
The objective of the impairment requirements is to recognise lifetime expected credit losses for all financial instruments for which there have been significant increases in credit risk since initial recognition — whether assessed on an individual or collective basis — considering all reasonable and supportable information, including that which is forward looking.
Lifetime expected credit losses
The lifetime expected credit losses are defined as the expected credit losses that result from all possible default events over the expected life of the financial instrument. The term default is not defined anywhere in Ind AS 109. It may be presumed that the definition should be consistent with that used for the purpose of the internal credit risk management purposes. The factors that may have to be considered include breaches covenant where it is appropriate. There is also a rebuttable presumption that the default does not occur later than ninety days past due unless an entity has reasonable and supportable information to corroborate a longer period for the purpose of calculating the default. The entities can also use their own definitions of default including the regulatory definition wherever it is applicable, eg, when Banks and NBFCs start to implement Ind AS, they can use the definition of default as per their regulatory body namely, the Reserve Bank of India. The definitions, of course, need to be consistent.
Stage 3 Expected credit loss
Credit impaired financial assets
The definition as per the Standard is reproduced below:
A financial asset is credit-impaired when one or more events that have a detrimental impact on the estimated future cash flows of that financial asset have occurred. Evidence that a financial asset is credit-impaired includes observable data about the following events:
- Significant financial difficulty of the issuer or the borrower;
- A breach of contract, such as a default or past due event;
- The lender(s) of the borrower, for economic or contractual reasons relating to the borrower’s financial difficulty, having granted to the borrower a concession(s) that the lender(s) would not otherwise consider;
- It is becoming probable that the borrower will enter bankruptcy or other financial reorganisation;
- The disappearance of an active market for that financial asset because of financial difficulties; or
- The purchase or origination of a financial asset at a deep discount that reflects the incurred credit losses.
It may not be possible to identify a single discrete event instead, the combined effect of several events may have caused financial assets to become credit-impaired.