What is the ECL model under IFRS-9?

ECL or expected credit loss model is applied to accounts receivables. In simple words, it’s a modern approach to expect provision and apply it to the debtor balance or the balance that is to be received.

The ECL model is designed to replace the traditional incurred model. In this model, the provision was provided based on the past events of the customers. For instance, if the customer has gone bankrupt, there was a need to provide the provision. On the other hand, ECL expects companies and businesses to predict or develop expectations if the customer is going to default and provide provision in the books.

The expectations are to be developed on the basis of the probability of the risk occurrence. IFRS-9 has prescribed the following two bases to calculate the provision under ECL.

  1. Simplified approach – In this approach of calculating provision under IFRS-9, the loss rate is calculated based on the historical rate. However, macroeconomic factors are included in the loss rate to incorporate the expected risk of default.
  2. General approach – There are three functions that need to be considered for adopting a general approach to implement ECL. These functions include the following.

Default probability – It’s about expecting if the customer is going to default on the receivable balance. For instance, if expected economic conditions reflect economic conditions are going to default, there is a higher probability of default and vice versa. In more simple words, there is a need to consider macroeconomic indicators like GDP growth, unemployment rate etc. So, if expected macroeconomic conditions are good, there is a need to provide less provision and less amount for provision. 

Exposure of default- It is the total amount that is exposed to the risk of default.

Loss given default – This component intends to bring adjustment for the events after default has occurred in actual. It may be like the customer has some security to be paid out if they go default. This information can be obtained from past events of default (customer-wise)

The reason for its adoption is that provision is provided for the future balance. Hence, it should be provided for based on expected conditions and circumstances in the future rather than past events and the losses that were actually incurred in the past.

Also read, cost concept in accounting

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The expected credit loss/ECL model helps to calculate the provision. It’s a recent requirement of IFRS-9 that requires companies and businesses to include expected loss in the financial statement. There are two methods to calculate provision which include a simplified approach and a general approach. In a simplified approach, the loss rate after macroeconomic adjustment is applied to the receivable balance. On the other hand, the general approach calculates the provision rate with three components that include exposure of default risk, probability of default, and loss-given default.    

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