12-Month Expected Credit Losses – FAQ | IFRS

12-Month Expected Credit Losses

12-month expected credit loss is the portion of the lifetime expected credit losses that represent the expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date. To get background on the impairment model introduced in IFRS 9 see ‘Impairment of financial assets‘.

Initial recognition 12-Month Expected Credit Losses

At initial recognition of a financial asset, an entity recognises, as a standard approach, a loss allowance equal to 12-month expected credit losses. The actual loss does not need to take place within the 12 month period; it is the occurrence of the default event that ultimately results in that loss. An exception is purchased or originated credit impaired financial assets, this is a financial asset purchased at a significant discount (against nominal value). Purchased credit-impaired financial assets are recorded on initial recognition at the transaction price without presentation of an allowance for expected contractual cash shortfalls that are implicit in the purchase price. Originated credit impaired financial assets are recorded on initial recognition at the below nominal value price offered at issuance without presentation of an allowance for expected contractual cash shortfalls that are implicit in the below nominal value price offered at issuance.

Calculation of 12-Month Expected Credit Losses

The 12-month expected credit loss calculation (ECL) model should result in an unbiased and probability weighted loss allowance to be recorded at initial recognition. Management can adopt one of several methods in computing ECL. In many cases an entity already has in place an internal risk management model (although informal or maybe in a basic form and/or not sufficiently documented) to start with. A very acceptable and convenient model to use in such cases would be the Probability of Default approach:

12-Month ECL = EAD x LGD x PD

EAD = Exposure at default is the best estimate of the extent to which the reporting entity is exposed to a counterparty in the event of a default and at the time of the counterparty’s default (i.e. the exposure to credit risk or credit exposure).

LGD = Loss given default is the best estimate of the loss from a transaction given that a default occurs. It is independent from any deterioration of asset quality/risk assessment and is based on recovery cash flows based on:

    • internal historical data (of date of default, exposure at default, post default classification (liquidation, restructured/refinanced or cured), collateral (if any) indicator, collateral valuation, collateral allocation, unsecured recovery collection and recovery costs),
    • market data from comparable historical events: 12-Month Expected Credit Losses
      • assets sales (specific sales – property, equities, fixed assets, gold, commodities or non-specific sales),
      • contractual obligations (external refinance, guarantee, insurance, hedge (CDS contracts, restructure) or
      • facility transformation (debt for equity, sale of equity)
    • Asset pricing model/implied LGD – use credit spreads on non-defaulted risky bonds currently traded in an active (comparable) market. This assumes that when a corporate entity defaults its bonds are a potential investment contract. The (increased) discount rate implied in the trading price must reflect the opportunity costs of such an investment. The spread above risk free bonds is a reflection of the expected loss percentage which can be segregated into the LGD amount once the PD values are known.
    • External ratings – in case of no default history for certain portfolios like investments, banks and sovereign market-based estimates of LGD from external rating agencies could be used. Another way is to adjust such external ratings to better fit the specific financial assets under review.

PD = Probability of default is the best estimate of the probability whether borrowers will default on their obligations in the future. For assets in stage 1 a 12-month PD is required, for stage 2 and 3 assets a lifetime PD is required for which a PD term structure has to be determined. Historical PD data derived from industry reference data bases or internal historical data has to be calibrated with forward-looking macro-economic trends are used to determine the PD term structure. This forward looking PD estimate has to reflect the entity’s current view of the future and has to be an unbiased estimate as it should not include any conservatism or optimism.

Example – Case Financial guarantee contract12-Month Expected Credit Losses

Assumptions:

  • On 1 January 20X8, Company A guarantees a CU1,000 loan of Subsidiary B which Bank XYZ has provided to Subsidiary B for three years at 7%. The capital amount advanced will be repaid at the end of the three year term; 12-Month Expected Credit Losses
  • If Company A had not issued a guarantee Bank XYZ would have charged Subsidiary B an interest rate of 10%;
  • On January 20X8 and 31 December 20X8 and 20X9, the lifetime probabilities that Subsidiary B will default on the loan are 3.5%, 3% and 3% respectively On 31 December 20X8 and 20X9, the probabilities that the Subsidiary B will default on the loan in the next 12 months are 2% and 3% respectively.

Accounting for the financial guarantee at initial recognition

  1. The financial guarantee contract is initially measured at fair value. The fair value of the guarantee is CU75, being the present value of the difference between:
    – The net contractual cash flows that would have been required without the guarantee – (CU100/1.1^1+CU100/1.1^2+CU1,100/1.1^3) = CU1,000; and
    – The net contractual cash flows required under the loan with the guarantee – (CU70/1.1+CU70/1.12+CU1,070/1.13) = CU 925The entry is Investment in subsidiary DT CU75, / Liability CR CU75 12-Month Expected Credit Losses 
  2. The 12 month expected credit loss has to be provided at the same moment
    There is a 2% probability that Subsidiary B will default on the loan in the next 12 months. If Subsidiary B does default, Company A does not expect to recover any amount from Subsidiary B. As a result EAD is 1, LGD is CU1,000 and PD is 2%. The 12-month expected credit losses are therefore CU20 (1 * CU1,000 * 2%).12-Month Expected Credit Losses. The entry is Profit or loss – Impairment of financial guarantee DT CU20 /Investment in subsidiary CR 20

See also: The IFRS Foundation

12-Month Expected Credit Losses 12-Month Expected Credit Losses 12-Month Expected Credit Losses

12-Month Expected Credit Losses 12-Month Expected Credit Losses 12-Month Expected Credit Losses

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