Many companies still struggle in how to fulfill the requirement to consider forward looking information in the expected credit loss adjustment. Let’s recall the standard’s requirement on this matter.
IFRS 9 paragraph 5.5. 17(a) requires an entity to measure expected credit losses (ECL) in a way that reflects an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes.
5.5.11 If reasonable and supportable forward-looking information is available without undue cost or effort, an entity cannot rely solely on past due information when determining whether credit risk has increased significantly since initial recognition.
Our ECL Assessment Direction
First of all, it is difficult to argue forward looking information is not available without undue cost or effort. We recommend companies not to go for that direction. In most cases, the default risk is affected by the general economic environment. Company may consider making reference to economic forecast announced by the government or published by major financial institutions. The economic forecast usually comes with scenarios. The aim is to determine the relationship between the expected credit loss of a company with the economic data and scenarios available. Such relationship can be estimated by statistical methods.
One can also make reference to credit default swaps (CDS). Given that CDS has reflected the most updated market expectation as of the trading date, it reflects the point-in-time probability of default. We can derive approximate probability of default from CDS pricing.
Given that the standard does not require advanced statistical and credit risk management models for ECL assessment, the core concept is to apply logical and consistent model.
On the other hand, companies usually face the difficulty in managing the expected credit loss assessment as a whole. Many companies face the challenge that there are so many trading partners, resulting a huge list of trade receivables with a lot of different partners. Similar situation can also happen in contract assets and other receivables as a result of complexity of group structure and operating environment.
B5.5.5 For the purpose of determining significant increases in credit risk and recognising a loss allowance on a collective basis, an entity can group financial instruments on the basis of shared credit risk characteristics with the objective of facilitating an analysis that is designed to enable significant increases in credit risk to be identified on a timely basis.
Our ECL Assessment Direction
Auditors do not normally accept arbitrarily putting one overall ECL rate on trade receivables or other receivables on consolidated level by arguing such rate is determined the internal rating method (acceptable under the standard). We remind companies doing ECL that risk categorization is highly important. For example, days past due (DPD) or aging are commonly used for assigning account entries into different risk categories. If general approach is applied, staging is also mandatory.
After risk categorization completes, companies may make reference to historical default information, market benchmarking or other internal rating models to derive ECL. It should be noted that the whole ECL assessment process should be consistent year over year.