IFRS 9: Expected Credit Loss (ECL) Model

IFRS 9 introduces a new model for accounting for financial instruments, replacing IAS 39. A significant change is the move from an 'incurred loss' model to an 'expected credit loss' (ECL) model. This model requires entities to recognize expected credit losses on financial assets measured at amortized cost or fair value through other comprehensive income (FVOCI), lease receivables, and contract assets.

Core Principles of the ECL Model

The ECL model is forward-looking. It requires entities to consider not just past events and current conditions but also reasonable and supportable forecasts of future economic conditions when assessing credit risk. This is a fundamental shift from the previous incurred loss model, which was criticized for being too slow to recognize credit losses.

Stages of the ECL Model

IFRS 9 classifies financial assets into three stages based on the change in credit risk since initial recognition. Each stage has different measurement requirements for expected credit losses:

Stage	Change in Credit Risk	Measurement of ECL	Impairment Allowance
Stage 1	No significant increase in credit risk since initial recognition	12-month expected credit losses	Recognized for all financial assets in Stage 1
Stage 2	Significant increase in credit risk since initial recognition	Lifetime expected credit losses	Recognized for all financial assets in Stage 2
Stage 3	Credit-impaired financial asset	Lifetime expected credit losses	Recognized for all financial assets in Stage 3

Stage 1: 12-Month Expected Credit Losses

For financial assets where there has been no significant increase in credit risk since initial recognition, the entity recognizes a loss allowance equal to the ECLs that result from default events within the next 12 months. This is often referred to as '12-month ECL'.

Stage 2: Lifetime Expected Credit Losses (Significant Increase in Credit Risk)

If there has been a significant increase in credit risk since initial recognition, the entity must measure the loss allowance at an amount equal to the ECLs resulting from all possible default events over the remaining contractual term of the financial instrument. This is known as 'lifetime ECL'.

Stage 3: Lifetime Expected Credit Losses (Credit-Impaired)

If a financial asset is considered credit-impaired, the entity recognizes a loss allowance equal to the lifetime ECLs. 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.

Key Inputs for ECL Measurement

The calculation of ECL involves several key inputs and considerations:

The Expected Credit Loss (ECL) calculation is a probabilistic approach. It involves multiplying three key components: Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD). The ECL is then discounted back to the reporting date. For Stage 1, the PD is for the next 12 months, while for Stages 2 and 3, it's for the remaining life of the instrument. LGD represents the proportion of the exposure that is lost if a default occurs, and EAD is the amount expected to be outstanding at the time of default. The model also incorporates forward-looking information through multiple economic scenarios.

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Probability of Default (PD)

The likelihood of a borrower defaulting on their obligation within a specified period. This is often derived from historical default rates, credit ratings, and forward-looking economic indicators.

Loss Given Default (LGD)

The proportion of the exposure that an entity can expect to lose if a default occurs. This considers factors like collateral, guarantees, and the seniority of the claim.

Exposure at Default (EAD)

The amount that an entity can expect to be owed by the borrower at the time of default. This includes the current outstanding balance and any additional amounts that may be drawn down before default.

Forward-Looking Information and Scenarios

A crucial aspect of IFRS 9 is the requirement to incorporate reasonable and supportable forward-looking information. This typically involves developing multiple economic scenarios (e.g., base case, optimistic, pessimistic) and assigning probabilities to each. The ECL is then a probability-weighted average of the ECLs calculated for each scenario.

The 'reasonable and supportable' nature of forecasts is key. Entities should not simply extrapolate past trends without considering current economic conditions and future expectations.

Practical Considerations and Challenges

Implementing the ECL model can be complex. Key challenges include:

Data availability and quality: Gathering sufficient historical data for PD, LGD, and EAD calculations.
Model development and validation: Creating robust models and ensuring they are regularly validated.
Determining 'significant increase in credit risk': Establishing clear criteria for when credit risk has significantly increased.
Forecasting economic conditions: Developing reliable forecasts for future economic scenarios.
Disclosure requirements: Providing comprehensive disclosures about the ECL model and its inputs.

What are the three stages of the ECL model in IFRS 9?

Stage 1: No significant increase in credit risk (12-month ECL). Stage 2: Significant increase in credit risk (lifetime ECL). Stage 3: Credit-impaired (lifetime ECL).

What are the three primary inputs for calculating Expected Credit Losses?

Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD).

Learning Resources

IFRS 9 Financial Instruments - EY(documentation)

Provides a comprehensive overview of IFRS 9, including detailed explanations of the ECL model and its implications.

IFRS 9 Expected Credit Losses - PwC(documentation)

A detailed guide from PwC focusing specifically on the expected credit loss model, covering its application and challenges.

IFRS 9: Expected Credit Loss Model - Deloitte(documentation)

Deloitte's publication offers insights into the practical application and implementation of the ECL model under IFRS 9.

IFRS 9 Financial Instruments - KPMG(documentation)

KPMG's overview of IFRS 9, with a dedicated section on the expected credit loss model and its accounting treatment.

IFRS 9 Expected Credit Loss (ECL) Model Explained - CPA Australia(documentation)

A clear explanation tailored for accounting professionals, breaking down the ECL model and its impact on financial reporting.

IFRS 9: The Expected Credit Loss Model - IASB(documentation)

A presentation from the International Accounting Standards Board (IASB) itself, providing authoritative guidance on the ECL model.

IFRS 9 Expected Credit Loss Model - Video Tutorial(video)

A video tutorial that visually explains the core concepts and stages of the IFRS 9 Expected Credit Loss model.

IFRS 9 Expected Credit Loss Model - AccountingTools(blog)

Provides a concise explanation of the ECL model, its components, and practical examples.

IFRS 9 Financial Instruments - Wikipedia(wikipedia)

Offers a broad overview of IFRS 9, including historical context and the evolution to the ECL model.

IFRS 9: Expected Credit Losses - A Practical Guide(blog)

A practical guide from Grant Thornton that delves into the implementation challenges and considerations for the ECL model.