SCOPE:
An entity shall recognize ECL on following:
1. FA measured at Amortized Cost
2. FS measured at FVTOCI
3. Lease Receivable
4. Contract Asset or Loan Commitment
5. Financial Guarantee Contract
MEANING YOU SHOULD KNOW:
PROBABILITY OF DEFAULT (PD): It is an estimate of a likelihood of a default over a given time horizon. For Example a 15% PD implies that there is 15% Probability that the loan will default.
LOSS GIVEN DEFAULT (LGD): It is the amount that would be lost in the event of a default. For example, a 60% LGD implies that if a default happens only a 60% balance at the point of default will be lost and remaining 40% may be recovered.
EXPOSURE AT DEFAULT (EAD): It is the expected outstanding balance of the receivable at the point of default.
WHAT IS CREDIT LOSS ALOWANCE:
A credit loss is the PV of difference between
- THERE ARE TWO TYPES OF APPROACH TO RECORD ECL.
1. General Approach
2. Simplified Approach
- GENERAL APPROACH: HOW LOSS ALLOWANCE TO BE PROVIDED:
There are two types of losses which entity needs to provide:
1. 12 Month ECL
2. Life time ECL
- If FA is a Trade Receivable, Lease Receivable and Contract Asset:
1. Measure Life Time ECL.
2. Measure 12 Months ECL if Credit risk has not increased significantly.
- In case of other Financial Assets:
1. Measure Life time ECL if credit risk has increased significantly.
2. Measure 12 Month ECL if credit risk has not increased significantly.
- HOW TO DETERMINE THAT CREDIT RISK HAS INCREASED SIGNIFICANTLY:
IND AS 107 defines credit risk “the risk that one party to Financial Instrument will cause a financial loss for the other party by failing to discharge an obligation”. The following are non-exhaustive list of information:
- Significant change in Financial Instrument External Credit Rating.
- Adverse change in business, Financial or economic conditions that are expected to cause a significant change in the Borrower’s ability to meet its debt obligations.
- Significant change in operating results of the Borrower.
- Significant increase in credit risk on other financial instrument of the same borrower.
- Significant change in value of collateral supporting the obligation or in quality of third party guarantee.
- Significant adverse change in Regulatory, Economic or Technological environment of the Borrower.
REBUTTABLE PRESUMPTION:
- An entity can rebut the presumption that credit risk on a financial asset has increased significantly if the entity has reasonable and supportive information that is available without undue cost or effort, that demonstrate that the credit has not increased significantly since initial recognition even though the contractual payments are more than 30 days past due.
- When entity determines that there have significant increase in credit risk before contractual payments are more than 30 days past due, the rebuttable presumption does not apply.
PRACTICAL EXPEDIENTS WHICH ENTITY CAN USE WHEN MEASURING ECL:
- Example of practical expedients is the calculation of ECL on Trade Receivables using a provision matrix:
- Entity would use its historical credit loss experience for trade receivables to estimate the 12 month ECL or Life time ECL on Financial Asset as relevant.
- A provision matrix might provide for fixed Provisions rates depending on number of days that a trade receivable is past due.
For Example:
- Not past due: 1%
- Up to 30 Days: 3%
- 31-90 Days : 5%
- 91-180 Days : 10%
- 181-365 Days: 15%
- Above 365 Days: 25%
STEPS IN USING PROVISIO MATRIX:
1. Determine the appropriate grouping of receivables into categories of shared credit risk characteristics.
- There is no specific requirement on how to group Trade Receivables. However Groupings could be based on Geographical region, Product Type, Customer Rating and type of Customer such as Wholesale or Retail.
2. Determine the period over which historical loss rates are obtained to develop estimates of expected future loss rates.
- The period should be reasonable. That is it should not be on an unrealistic basis. Neither too short nor too long. In practice the period could span 2-5 Years.
3. Determine Historical Loss Rates
4. Consider forward looking Macro Economic factors and adjust historical loss rates to reflect relevant future economic conditions.
- During the time of pandemic, there is a significant downturn in employment as a result there will be default in the short-term. In this circumstance historical loss rates will not reflect appropriate expected losses and will need to be adjusted.
5. Calculate the Expected Credit Losses.
- It is calculated by multiplying current Gross Receivables by the loss rate. For example: Specific adjusted loss rate should be applied to the balance of each age band for the receivables in each group.
- The standard includes a number of examples of how to perform the assessment of whether there has been a significant increase in credit risk. We have included below one of the examples for illustration purposes.
MEASUREMENT OF ECL:
- An entity shall measure an ECL in a way that reflects:
1. Unbiased and probability weighted amount that is determined by evaluating a range of possible outcomes.
2. Time Value of Money
3. Reasonable and supportive information that is available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions.
- When measuring ECL, an entity need not necessarily identify every possible scenario. However, it shall consider the risk or probability that a credit loss occurs and the possibility that no credit loss occurs, even if the possibility of a credit loss occurring is very low.
Author Bio
These factors Banks take into viewpoint while taking credit decision.
Article is informative and worth reading.