Introduction
One of the requirements of IND AS 109 is that an entity shall recognise a loss allowance for expected credit losses on a financial asset that is measured in accordance with amortized cost or fair value through other comprehensive income method.
The financial asset mentioned can be a lease receivable, a contract asset or a loan commitment and a financial guarantee contract to which impairment requirements apply in accordance with the standard.
Page Contents
Recognition of Expected Credit Losses
- As per IND AS 109, a General Approach is followed for the recognition of ECL. The entity shall apply the impairment requirements for the measurement of a loss allowance for financial assets that are measured at fair value through other comprehensive income. However, the loss allowance shall be recognized in other comprehensive income and shall not reduce the carrying amount of the financial asset in the balance sheet.
- At each reporting date, the entity shall measure the loss allowance for a financial instrument at an amount equal to the lifetime expected credit losses if the credit risk on that financial instrument has increased significantly since initial recognition.
- However, on the reporting date, if the credit risk on a financial instrument has not increased significantly since initial recognition, an entity shall measure the loss allowance for that financial instrument at an amount equal to 12-month expected credit losses.
- In case of trade receivables/contract assets and lease receivables the entity shall always measure ECL at an amount equal to lifetime expected credit losses. An entity may select its accounting policy for trade receivables, lease receivables and contract assets independently of each other.
- In case of financial assets measured at ammortized cost, the ECL shall be recognized in the profit & loss account.
Measurement of Expected Credit Losses
An entity shall measure ECL of a financial asset in a way that reflects,
(a) an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes.
(b) the time value of money, and
(c) reasonable & supportable information that is available without undue cost or efforts at the reporting date about past events, current conditions and forecasts of future economic conditions.
As we can see, the standard does not mention about any specific methods for measuring ECL. The following can be some of the practical approaches for measurement of ECL.
The common financial asset for most of the entities is Trade Receivables. Hence, let us see below how ECL relating to trade receivables can be measured.
1. Bad Debts % Approach
Average rate of bad debts on sales for previous years shall be calculated and that rate shall be applied for the sales of the current year. Depending on the size of the business, number of previous years has to be decided.
Example – KGF Limited is a listed company that reports under the IND AS. Its bad debts for previous 5 years, along with the turnover are as follows,
FY 17-18 – Bad Debts-₹ 1,53,827, Turnover-₹ 35,68,69,285
FY 18-19 – Bad Debts-₹ 2,49,820, Turnover-₹ 43,13,10,687
FY 19-20 – Bad Debts-₹ 1,05,888, Turnover-₹ 34,81,86,214
FY 20-21 – Bad Debts-₹ 19.81,235, Turnover-₹ 40,72,89,726
FY 21-22 – Bad Debts-₹ 13,39,948, Turnover-₹ 42,97,40,558
The rate of bad debts over the turnover for each of the 5 previous years are,
0.04%, 0.06%, 0.03%, 0.49%, 0.31%
Average of the above rates is 0.19%.
Therefore, if the turnover for FY 22-23 is ₹ 50,46,23,205 the ECL for FY 22-23 would be 50,46,23,205*0.19% = ₹ 9,38,599.
The journal entry would be – ECL Provision A/C Dr
To Trade Receivables
2. Sales Return Approach/Percentage of Return Approach
Under this method, average sales return % with respect to each customer for the relevant previous years is calculated. That % is applied on the closing balance ( As on the reporting period) of trade receivable of the respective customer in order to arrive at the ECL figure. This approach can be applied when the customer base of the entity is less i.e there are repetitive customers.
Example – Pathaan Corporations have the following customers. Details of sales made and sales rejections incurred are also mentioned respectively,
1. Tiger Zinda Hai Private Limited – Sales ₹10,00,000 Returns – ₹ 1,00,000 (10%) (Receivable Balance – ₹50,000)
2. Zoya Services Limited – Sales ₹ 20,00,000 Returns – ₹1,00,000 (5%) (Receivable Balance – ₹5,00,000)
3. Kabir & Khalid Corporations – Sales ₹ 5,00,000 Returns ₹ 75,000 (15%) (Receivable Balance – ₹1,00,000)
The respective ECL would be as follows
1. 50,000*10% – ₹ 5,000
2. 5,00,000*5% – ₹ 25,000
3. 1,00,000*15% – ₹ 15,000
Total ECL – ₹ 45,000.
The above 2 mentioned methods of computing ECL are some of the common methods adopted practically by an entity. Entities can opt to adopt any other methods which would be relatable to the entity. For example – ECL can be estimated using the warranties estimate.
Conclusion
Under the IND AS Reporting, computation of ECL is prominent for financial assets. Trade Receivables being the common ones.
The 2 methods discussed here are commonly applicable for most of the entities. In case you have any other method for deriving at the ECL amount, please feel free to share the same in the comments below.
Thank you for reading!!
Author Bio
Very well explained, Please Share Examplary Calculation – ECL for NBFC