Valtech recently completed an engagement in Expected Credit Loss (ECL) assessment, assisting a client in enhancing its ECL assessment methodology, calculation process, and accounting disclosures. The client operates an international business distributing imported goods to both business customers and sub-distributors.
For companies with a large volume of trade receivables, it is common to apply the practical expedient under the simplified approach, where lifetime expected credit losses are recognised using a provision matrix. The accounting standards recognise the provision matrix as an acceptable and practical method when historical loss patterns are relatively stable.
Following this approach, valuation professionals must determine an appropriate methodology to derive loss rates used in the provision matrix. Common and acceptable approaches include:
- Roll-rate methods, analysing historical migration of receivables between ageing buckets
- Historical ageing and loss analysis, examining default patterns over time
- Incorporating forward-looking macroeconomic information to adjust historical loss experience (View more here: https://valtech-valuation.com/forward-looking-information-for-ecl/)
However, a common audit finding is that the basis for determining the loss rate is insufficiently supported or documented. In some cases, companies determine loss rates based on judgmental credit ratings mapped to external credit rating agency reports. This approach may unintentionally mix elements of the simplified approach with the general approach, which requires a more detailed assessment of the counterparty’s credit risk.
For trade receivables applying the simplified approach, it is important that the loss rates are primarily supported by historical credit loss experience and receivable ageing patterns, with appropriate adjustments for forward-looking information. Proper documentation of the methodology and assumptions is essential for audit defensibility.
Expected Credit Loss Assessment on Other Receivables
Understanding ECL and Its Impact on Financial Reporting
For other financial assets such as other receivables, deposits, and loans to counterparties, the accounting standards require a credit risk assessment to determine whether there has been a significant increase in credit risk (SICR) or whether default indicators are present.
Such assessments may incorporate:
- Qualitative credit analysis of counterparties
- Available financial information of the debtor
- Industry and macroeconomic conditions
- Non-statistical quantitative indicators
Valtech supports clients by performing structured credit analysis when financial information of counterparties is available. This allows for a more robust evaluation of credit risk and facilitates the determination of appropriate probability of default (PD) assumptions.
When financial information of the counterparty is limited or unavailable, Valtech can develop analytical risk assessment frameworks that evaluate relevant attributes of the counterparty, such as industry characteristics, geographic exposure, payment behaviour, and transaction history. These attributes can then be mapped to forward-looking adjusted default rates.
Through research and review of auditors’ expectations and regulatory practices, Valtech has also refined its approach to selecting appropriate ECL inputs. In particular, we prioritise the use of market-specific default and recovery data that better reflect the economic environment in which the receivables arise. This approach reduces reliance on general or global statistics from credit rating agencies, which may not always be representative of the actual credit risk profile of the counterparties.
Enhancing Reliability and Audit Defensibility
A well-designed ECL framework should achieve several objectives:
- Ensure methodological consistency with IFRS 9 / HKFRS 9 requirements
- Incorporate reliable historical loss data and forward-looking information
- Provide transparent documentation of assumptions and calculations
- Improve audit defensibility and financial reporting quality
By combining valuation expertise, credit analysis techniques, and market data research, Valtech helps clients develop ECL methodologies that are both practical for implementation and robust from an audit perspective.
