# Expected Credit Loss

## Contents

## Definition

**Expected Credit Loss** (ECL) is the probability-weighted estimate of credit losses (i.e., the present value of all cash shortfalls) over the *expected life* of a Financial Instrument. The concept is particularly important in the context of IFRS 9 ^{[1]}.

A *cash shortfall* is the difference between the cash flows that are due to an entity in accordance with a contract (*the scheduled or contractual cashflows*) and the cash flows that the entity expects to receive (*the actual expected cashflows*). Given that expected credit losses consider both the amount and timing of payments, a credit loss arises even if the entity expects to be paid in full but *later* than when contractually due.

ECL can be measured either on an *individual exposure* level or a collective *portfolio level* (grouped exposures based on shared credit risk characteristics)

## Scope

In IFRS 9 context the ECL approach applies to all instruments held at amortised cost as well as to all instruments held at fair value through other comprehensive income

## Calculation Requirements

According the the IFRS 9 standard, the measurement of expected credit losses of a financial instrument should reflect:

- an unbiased and probability-weighted amount of potential loss that is determined by evaluating a range of possible outcomes
- the time value of money; and
- reasonable and supportable information that is available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions.

## Usage

Under the new impairment approach introduced by IFRS 9 it is no longer necessary for a credit event to have occurred *before* credit losses are recognised (as with the previous incurred loss accounting approach). Instead, an entity *always* accounts for expected credit losses, and also changes in those expected credit losses.

The amount of expected credit losses is updated at *each reporting date* to reflect changes in credit risk since initial recognition and, consequently, more timely information is provided about expected credit losses.

## Example

There are many alternative ways to estimate expected credit loss, depending on the Credit Portfolio, available data and models. For a more general discussion and the standard formula see Expected Loss. The following example illustrates the concept of probability weighted loss in a modeling framework that adopts three distinct scenarios and assigns to each a probability.

Scenario Probability | Loss Year 1 | Loss Year 2 | Loss Year 3 | Loss Year 3 | Cumulative Loss | |
---|---|---|---|---|---|---|

Scenario 1 | 0.3 | 100 | 50 | 100 | 20 | 270 |

Scenario 2 | 0.5 | 200 | 100 | 150 | 50 | 500 |

Scenario 3 | 0.2 | 400 | 200 | 100 | 200 | 900 |

Probability-Weighted Loss Amount | 210 | 105 | 125 | 71 | 511 |

## Issues and Challenges

- Given IFRS 9 is a new standard, there is currently little in terms of established best practise

## References

- ↑ IFRS Standard 9, Financial Instruments