What is Expected Credit Losses?

Expected credit losses are the average default-weighted value of possible credit losses introduced in IFRS 9.

Definition

Expected credit losses are an important concept introduced in IAS 9, meaning the average default-weighted value of possible credit losses. IFRS 9 also introduces the concepts of expected credit losses for the entire term and 12-month expected credit losses.

Full-term ECL — ECL arising from all possible default events during the expected life of a financial instrument.

12-month ECL is a part of the ECL for the entire term. It is the ECL arising from defaults on a financial instrument possible within 12 months after the reporting date.

In mathematical terms, the full-term ECL is the mathematical expectation of credit losses (the probability-weighted sum of possible credit losses), and the 12-month ECL is the 12-month probability of default multiplied by the conditional mathematical expectation of credit losses, provided that the default occurs within 12 months of the reporting date.

A credit loss is the present value (discounted at the original effective interest rate) of the difference between the contractual and expected cash flows from a financial asset (i.e., the present value of the cash loss). These cash flows include flows from the sale of collateral or from other credit enhancement mechanisms that are an integral part of the contractual terms. In the case of loan commitments (unused credit lines), cash flows are assumed to arise when the right to receive the loan is used.

Thus, in IFRS 9, credit losses are actually defined as present (discounted) credit losses, so they occur even if the cash flows are shifted over time without changing the amounts. Accordingly, expected credit losses are current expected credit losses (CECL), i.e. the present value of expected cash flow shortfalls.

If a financial asset has not experienced a significant increase in credit risk and /or has not become credit-impaired, provisions are made under IFRS 9 for expected 12-month credit losses. Otherwise, the reserve is formed in the amount of ECL for the entire period.

The difference between the gross carrying amount of a financial asset and the provisions for ECL is the amortised cost of the financial asset.

The model of expected credit losses introduced by IFRS| 9 replaced the model of incurred losses under IAS 39.