Team Paper

The Future of Measuring Expected Credit Loss

1
Term Paper

Subject: Accounting

Academic level: College

 Team Paper

Abstract
2
Different organizations are currently concerned about their earning which come as a result of

lending money to different firms and individuals. The life of the firm is usually sensitive hence

the higher the credit the higher chances of the firm’s life being shorten. The financial regulatory

bodies advice financial institution to always make a provision for the expected losses that come

as a result of the number of credit they have their portfolio. The existing accounting standard

requires that the these losses should be accounted for only after they have been incurred by the

firm which has brought about difficulties in accounting for the losses at the end of financial

year . In the year 2014, the international accounting standards board’s come up with the

guidelines to be followed when it comes to the accounting for expected losses. They developed

an expected loss model of impairment accounting. They had to mention that the model is

expected to be effective as from the year 2018 with an early adoption accepted by the board.

These papers will therefore examine the future of measuring expected credit loss in most of the

financial institution, the reasons as to why it was necessary to change this methodology, the new

expected requirement that firms should comply with when using this new method of accounting

for expected credit loss. It is therefore important that financial institution and the individuals

entrusted with the preparation of financial statement to be prepared for the use of the new

impairment model as it is expected to be in use by the international accounting standard board.

Impairment accounting approach under IFRS 9

Currently organizations and financial institutions are making use of international accounting

standards 39 (Financial instruments) which outlines the measurement and recognition of

financial assets, financial liabilities and contracts on how to buy and sell non-financial
 Team Paper

instruments. It also mentions that financial instruments will only be recognized when the
3
financial institution becomes a party to the contractual provision of such instrument. This

standard recommended the application of the incurred loss model whose main objectives was to

recognize the credit loss in the firm’s statement of comprehensive income. It is due to this late

recognition that brought about heated debates hence leading to the revision of ISA 39 by the

international accounting standard board to the latest international financial reporting standard 9

( IFRS 9) . The main reason for this revision of the standard was to ensure that accounting for

impairment of financial assets is made as simple as possible through the provision of guidance

that will be useful for decision making for financial advisers of the firm.

This newly developed standard has provided new guidelines on how financial institutions are

supposed to classify, measure financial assets, hedging accounting and also provided new

approach for accounting for impairment. This new approach is based on the excepted credit loss

rather than incurred loss as used in the previous international accounting standard 39 (Financial

Instrument). It is therefore important to note that excepted loss of financial asset is an estimated

present values of all expected cash shortfall that arise as a result of the acquisition of the asset

and it should be measured throughout the useful life of the said asset. The expected loss model

has been considered as the best model for accounting for impairment since it includes forward

looking information to access the impairment of the financial instrument of the firm.

Financial assets that are recognized in the new standard which are assets such as;

 Lease receivable

 Contract assets
 Team Paper

 Loan commitment and financial guarantee that are not measured to their fair value
4
through profit or loss

 Debt instruments that have been, measured to their amortized cost or fair value through

other comprehensive income; loans, debt securities and trade receivable.

For the purposes of estimation of expected loss, financial institutions are required by the

international financial reporting standard to ensure that that during accounting process, they have

categorized all the financial assets into three different stages of credit risk.

Stage one

At this stage, the accountant is expected to account for all the impairment allowances of all the

financial assets of the firm irrespective of their credit quality on the organization on the basis of

the expected loss by the firm and this should be carried out over a period of twelve months after

which they are expected to be moves to the second stage.

Expected loss = T* PV of cash shortfall

Where T is time (12 Months)

Stage two

Impairment of asset is moved to this stage when there is deterioration of the credit quality of the

asset. Hence it is important for the accountant to monitor the credit quality of the asset so that he

is able to know whether it should be dealt with in the first stage or second stage. In this stage,

impairment allowance is recognized based on the lifetime expected losses by the organization.

Expected Loss = T* PV of cash shortfall

 Team Paper

Where T represent the life time of the asset

5

Stage Three

Impairment of financial asset it moved to this stage if the accountant has realized that the cash

flow of the financial asset will not be fully recovered in the event that the borrower defaults. This

method also put into recognition of the lifetime expected losses that will result from the financial

asset.

Expected Loss = T* PV of cash shortfall

Where T represent the life time of the asset

The relationship between current expected credit loss model and allowance for doubtful

accounts for Accounts receivables

International financial Reporting standard 9 requires that a firm should always maintain a loss

allowance account since there is no direct write off as ISA 39 permitted. The reduction of the

carrying amount of a financial asset can only take place in the case where the firm does not have

any reasonable expectation of recovering the amount of the financial asset. Current expected

credit loss model is a method that has been developed to help organizations deal with the

problem of financial risk which has been experienced by these firms since the year 2008 when

there was a global financial crisis. Due to this problem, many organizations noticed that they

were making losses in terms of what they were to collect from the loan issued. Being that ABC

corporation wants to purchase a mortgage from Citibank , they are required to put into
 Team Paper

consideration the amount of money that they will actually be able to collect from the mortgage at
6
the maturity date.

They should calculate an expected credit loss using the current expected credit loss since this

will enable them to Identify the exact amount that the firm needs to set aside as allowance for

doubtful accounts receivable. This model uses the discounting method to ensure that time value

of money is put into consideration by the firm to avoid losses that may come as a result of

allocating lesser amount in the provision for doubtful debts.

From this it is clear that current expected credit loss method goes hand in hand with the amount

of allowance for doubtful debt by the lending institution. Firms are therefore required to always

recognize the expected credit loss on the financial instrument and measure the loss allowance at

an amount equal to the lifetime of that instrument since this credit risk is always expected to

increase significantly from the initial date of their recognition by the firm. The higher the risk,

the higher the allowance for doubtful debts.

Monetary loss that firms are saved from by the application of Current Expected credit loss

Many firms made huge losses through the use of the international accounting standard 39 which

recognized the credit loss as expense to the profit and loss account only on the date they are

incurred. The introduction of Current expected credit loss model which recognize this losses at

an early stage, will be able to clearly point out the expected loss by the firm hence allowing the

firm to make a provision for the doubtful debts in advance thereby making them well prepared

for the unexpected in advance.

Since this model is making use of the financial management discounting factor to ensure that

when the firm gives out loan, it is able to factor in the time value of money since amount of loan
 Team Paper

issued today will not be the same in ten years’ time. The use of discounting method leads to
7
accurate computation of the expected credit loss hence an allowance that will be allocated for

doubtful debts will be exact.

In cases where the firm that borrows loan is likely to default in the payment of the loan, the

lending institution through the use of discounting factor will be able to modify the value of asset

that has been used as collateral so that the lending institution does not suffers huge financial

losses at the end of the contract. The model also allows for modification of the contract by the

lending institution in case of unforeseen circumstances such as political risk and economic risks

that may have great impact on the price of the financial instrument.

From the above analysis it is clear that even the banking institutions could have been in

apposition to prevent the financial crisis that occurred in 2008 since they could have been in a

position to record allowances and also limit the growth of their credit portfolio to match the

foreseen economic turns during that period.

Disclosure of impairment Loss

Organization are currently requires to disclose their expected credit risk through the use of the

new model. This will ensure that they are able to show how they calculated their expected credit

loss, how the measure credit losses and also show how they assess changes in the credit risk.

Since the new model requires that firms maintain a separate allowance account, they should be

able to should the opening and closing balances of this accounts during the financial year end.

The firm should also be able to should the investors some of the financial assets that have been

modified during the financial year and the credit risk in relation to those financial assets.
 Team Paper

8
Operational Issues

 Since most of the financial institutions around the globe always manage their interest

income and credit risk separately through the use of loan accounting system for

determination of interest and credit system for determining credit losses, this method will

make it difficult for this institutions to determine their expected interest rate.

 Through the use of this method, firms will find it difficult to develop expected credit

throughout the useful life of the of the asset since they do not store their expected cash

flow hence they are only able to calculated the expected loss rate for a period of twelve

months.

 The occurrence of the credit loss at an early stage leads to inadequate allocation of

allowance of the remaining loan in the portfolio.

Benefits of Using the Current expected credit loss model

As compared to the previous IAS 39, IFRS 9 ensures that there is only one method that is used

for the calculation of impairment of financial assets hence it has reduced that complexity of

computing impairment loss using different methods for different assets as provided by IAS 39.

This method ensures that there is consistency in the computation of impairment have making it

easier for users of financial statement to follow the firms trend of impaired assets.

This method ensures that when a firm is measuring its expected credit loss, it must have used

reasonable and supportable information about that expected credit loss which is always based on

the present economic conditions and the future economic conditions that the firm expects to

experience.
 Team Paper

This model also ensures that there is valuation of financial instruments since it relays on the
9
historical information when coming up with the current price of the financial instrument.

Conclusion

This model will see firm that operate in different nations reduce financial risks which have been

facing them for a longer duration and it will also ensure that they are able to estimate the

expected credit loss as a result of using the twelve month expected credit losses which ensures

that this losses are recognized at the original or purchase date of those financial assets. For this

method, the loss allowances are always expected to increase as the firms invest in more of debt

instruments.

Firms are also expected to use the probability weighted estimates for assets whose losses can

only be measured if their lifetime is also put into consideration since the economy is subject to

unforeseen changes hence there is need for the organization to obtain sufficient information

about the current and future economic conditions.

It is also important that they disclose this information in their financial report since it is very

crucial for decision making.

Finally the development of this international financial reporting standard means that

organizations have a new task of getting more information from the previous, current and future

economic conditions. As they do this, they will be required to identify some of the reliable data

that will help them in the forecasting of the expected loss.

 Team Paper

References
10
IFRS 9(2014) Financial Instruments, July 2014, IASB.

IAS 39 Financial Instruments: Recognition and Measurement, 1997, IASC.

IFRS 9(2009) Financial Instruments, October 2009, IASB.

Project Summary: IFRS 9 Financial Instruments, July 2014, IASB.

IFRS 9(2010) Financial Instruments, November 2010, IASB.

Implementation Guidance: IFRS 9 Financial Instruments, July 2014, IASB.