What is an Expected Credit Loss?
The term expected credit loss represents the amount of loss the companies estimate to have on their credits. It is a term used in accounting under the IFRS 9. Before the expected credit losses, companies recognized bad debts or credit losses only when they occurred. However, with IFRS 9, companies must account for expected credit losses as well.
With expected credit losses, companies must look at how their current and future economic conditions affect the value of expected losses. While some may consider credit losses to be an issue for financial institutions or lenders only, they also apply to businesses. Therefore, any company that makes credit sales and accumulates account receivable balances must deal with expected credit losses.
Expected credit loss represents the probability-weight estimate of credit losses over a financial instrument’s lifecycle. The losses come in the form of the present value of any cash shortfalls. Cash shortfalls represent the difference between cash flows due in accordance with the contract and the cash flow that a company expects to receive.
What is the Expected Credit Loss formula?
The IFRS 9 standard does not provide a specific method to calculate expected credit losses. However, companies can use the probability of default approach to calculate it. This approach considers the exposure at default, probability of default, and loss given default of a particular instrument. Most financial institutions calculate it as a part of their internal risk management.
Exposure at Default
Exposure at default is the value of the financial asset exposed to credit risk. It is the amount at risk at the time when the company expects the default to occur after deducting the value of any collateral. Exposure at default does not represent the carrying value of a financial asset.
Probability of Default
Probability of Default shows the chances of default from a borrower over a specific period of time. Usually, the higher the credit period is, the higher the probability of default will be as well.
Loss Given Default
Loss given default shows the percentage of the amount that the lender expects to lose in case of a default. It is the opposite of the recovery rate that lenders can expect from a loan.
Expected Credit Loss Calculation
Companies will need to establish various scenarios and calculate the probability of default and loss given default for each of them. Once they do so, they must determine the total loss for each scenario, which would be equal to the product of exposure at risk and loss given default. They must then calculate the weighted-average expected loss.
The weighted-average expected loss is the product of the total loss and probabilities of default for each scenario. Lastly, companies must discount the expected credit losses at the effective interest rate of the financial asset in consideration. The final form for the expected credit loss formula will be as follows.
Expected Credit Loss = [EAD x (LGD1 x PD1 + LGD2 x PD2 + … + LGDn x PDn)] / (1 + r)n
In the above formula, EAD represents exposure at default, LGD is the loss given default, and PD is the probability of default. ‘n’ denotes the number of scenarios for which companies calculate the above three.
Expected credit loss represents the amount of loss that companies may estimate to have on their credits. Usually, it applies to accounts receivable balances as these are financial instruments. Companies can calculate the expected credit loss using the probability of default approach, as shown above.