09 May

Understanding the ECL model

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ECL stands for Expected Credit Loss, a concept used in financial accounting to account for potential losses that may occur due to credit risks associated with financial assets. The International Financial Reporting Standards (IFRS) 9 require companies to use an ECL model to calculate the potential losses on financial assets, such as loans and trade receivables.

The ECL model is based on the assumption that financial assets are subject to credit risk, which is the risk of loss that may arise if a borrower fails to repay a loan or meet other contractual obligations or if a client fails to pay the bills to the company. The ECL model requires companies to estimate the probability of default and the amount of loss that would result from default, and to incorporate this into their financial statements.

The ECL model involves three stages of analysis.

1. The first stage involves identifying the credit risk of financial assets and the probability of default over the next 12 months.
2. The second stage involves estimating the credit risk over the remaining life of the financial asset.
3. The third stage involves estimating the potential losses associated with the credit risk.

For example, the Probability of Default (PD) is 1.5%, the Loss Given Default (LGD) is 70% and the outstanding balance as of year end is QR. 10 Mn.

STAGE 01

STAGE 02

STAGE 03

No Significant Increase in Credit Risk

Significant Increase in Credit Risk

Evidence on Default

Apply 12 months ECL

Apply Life-time ECL

Apply Life-time ECL

ECL = PD * LGD * EAD

ECL = PD * LGD * EAD

ECL = PD * LGD * EAD

(1.5% * 70% * 10 Mn)

(25% * 70% * 10 Mn)

(100% * 70% * 10 Mn)

105,000

 

1,750,000

7,000,000

ECL 105,000

ECL 1,645,000 (1,750,000-105,000)

ECL 5,250,000 (7,000,000 – 1,750,000)

The ECL model is a forward-looking model that takes into account a range of factors that could impact the credit risk of financial assets, such as changes in economic conditions, industry trends, and company-specific factors. By accounting for potential losses associated with credit risks, the ECL model provides a more accurate picture of a company's financial position and helps investors and other stakeholders to make more informed decisions.

The use of the ECL model has become increasingly important since the global financial crisis, as it helps to ensure that financial institutions and companies are adequately accounting for potential losses associated with credit risks.

Overall, the ECL model is a key tool used in financial accounting to account for potential losses associated with credit risks. It is a forward-looking model that helps to ensure that financial institutions and companies are adequately accounting for potential losses, providing a more accurate picture of a company's financial position, and helping investors and other stakeholders to make more informed decisions.

Read 435 times Last modified on May 09, 2023
Antonio Ghaleb

Antonio Ghaleb is accredited in Qatar and holding the auditor’s registration number 348. Also he is a member of the following institutions: a) American Institution of Certified Public Accountant (AICPA), b) Guam Board of Accountancy, c) Certified in Risk Management Assurance “CRMA”, d) Chartered Global Management Accountant designation “CGMA”, and e) International Financial Reporting Standards (IFRS).

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