An Overview of Approaches and Resources for Estimating and Managing Credit Risk
As a knowledgeable professional in the field of accounting and finance, you are likely familiar with the International Financial Reporting Standard IFRS- 9, which sets out the requirements for financial instruments. One of the key aspects of IFRS-9 is the Expected Credit Loss (ECL) model, which requires entities to estimate the expected credit losses on their financial assets. In this article, we will provide an overview of the ECL study and its Impact on financial reporting.
What is the Expected Credit Loss (ECL) model?
The ECL model is a forward-looking approach that aims to provide a more accurate estimation of credit losses on financial assets. Under the ECL model, entities are required to estimate the probability of default and the loss given default for each financial asset, considering both historical and forward-looking information. These estimates are then used to calculate the expected credit losses over the remaining life of the asset.
The Impact of the ECL Model on Financial Reporting
The Impact of ECL on financial reporting is significant. By requiring entities to take a forward-looking approach to estimating credit losses, the ECL model provides a more accurate representation of the entity's financial position and performance. It also enhances the comparability of financial statements across entities, as it requires a consistent approach to estimating credit losses.
The Impact of the ECL Model on Budgeting
The ECL model also has an impact on budget planning and preparation. By providing a more accurate estimate of credit losses, entities can better plan for the potential Impact on their cash flows and financial position. This can help them make more informed decisions about their
investment and financing activities.
Approaches Used in Preparing ECL Study
Preparing an ECL study can be a complex process, requiring a deep understanding of the requirements of IFRS-9 and the entity's specific circumstances.
In general, there are two main approaches to preparing an expected credit loss (ECL) study:
1) The general approach.
2) The simplified approach.
The general approach involves estimating the expected credit losses over the entire life of a financial instrument, considering all possible future scenarios that could affect the borrower's ability to repay the loan. This approach requires a significant amount of data and analysis, including:
- Historical loss data,
- Economic forecasts,
- Borrower-specific information such as credit ratings and financial statements.
The general approach is typically used for more complex financial instruments, such as long-term loans or structured products.
On the other hand, the simplified approach is used for financial instruments with lower credit risk, such as short-term trade receivables. This approach involves estimating the credit losses expected over a 12-month period based on the historical loss experience of similar financial instruments and any current economic conditions that may affect the borrower's ability to repay. The simplified approach requires less data and analysis than the general approach, but it is still subject to certain requirements and limitations set by regulatory bodies such as the International Financial Reporting Standards (IFRS).
The framework for conducting the ECL study:
Regardless of the approach used, there are several key steps involved in preparing an ECL study. These include:
- Identifying the financial instruments subject to the study,
- Selecting an appropriate approach,
- Gathering and analyzing relevant data,
- Developing and validating models for estimating expected credit losses,
- Reporting the results in accordance with applicable accounting standards.
Overall, the purpose of an ECL study is to provide investors and other stakeholders with a more accurate picture of the credit risks associated with a financial institution's portfolio of loans and other financial instruments. By estimating expected credit losses, financial institutions can better assess their overall risk exposure and make more informed decisions about lending and investment activities. And with an active ecosystem of investments and startups, understanding and conducting ECL is becoming more fundamental in companies.
At Ahmed Mamdouh & Co. Kreston Egypt, we offer a range of services to assist entities in preparing their ECL studies. Our team of experts has extensive experience in financial reporting and can provide tailored solutions to meet the needs of each client.
In conclusion, the ECL model under IFRS-9 is a significant development in financial reporting, requiring entities to take a forward-looking approach to estimating credit losses. The Impact of the ECL model on financial reporting and budget planning cannot be overstated, and entities must ensure they have the necessary expertise to prepare accurate ECL studies.
At Ahmed Mamdouh & Co. Kreston Egypt, we are committed to helping our clients meet these requirements and achieve their financial reporting objectives.
References:
- International Financial Reporting Standards (IFRS): https://www.ifrs.org/
- Financial Accounting Standards Board (FASB): https://www.fasb.org/
- Basel Committee on Banking Supervision (BCBS): (https://www.bis.org/bcbs/)
- Risk Management Association (RMA):](https://www.rmahq.org/)
- Global Association of Risk Professionals (GARP): ](https://www.garp.org/)
- Journal of Credit Risk: (https://www.risk.net/journal-of-credit-risk)