Adjusted advanced provision

What Is Adjusted Advanced Provision?

Adjusted advanced provision refers to the estimated amount that financial institutions set aside for potential future credit losses on their financial assets, determined through a forward-looking assessment and subject to subsequent refinement or adjustment. This concept falls under the broader field of financial accounting and risk management within the financial sector. Unlike older "incurred loss" models that recognized losses only after a specific event occurred, adjusted advanced provision anticipates potential defaults based on current conditions and future expectations. It aims to provide a more timely and accurate reflection of an entity's financial health by proactively accounting for expected reductions in the value of assets due to credit risk.

History and Origin

The concept behind adjusted advanced provision emerged largely in response to the global financial crisis of 2008. Prior accounting standards, such as IAS 39 (International Accounting Standard 39) and the incurred loss model it prescribed, were criticized for delaying the recognition of credit losses, exacerbating financial instability during downturns. Regulators and standard-setters identified a need for a more forward-looking approach to loan loss provisioning.

In response, the International Accounting Standards Board (IASB) introduced IFRS 9 Financial Instruments, effective January 1, 2018, which fundamentally shifted from an incurred loss model to an Expected Credit Loss (ECL) model. The ECL framework requires entities to recognize credit losses at all times, taking into account past events, current conditions, and reasonable and supportable forecast information, and to update these amounts at each reporting date to reflect changes in an asset's credit risk.⁵,⁴ Similarly, in the United States, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016-13, Topic 326, known as Current Expected Credit Loss (CECL), which became effective for most large public companies in fiscal years beginning after December 15, 2019.³, These new standards embody the principles of advanced provisioning, requiring banks and other financial institutions to estimate future losses even before they occur. The "adjusted" aspect comes from the continuous reassessment and refinement of these initial estimates based on evolving economic conditions and specific asset performance.

Concurrently, international banking regulations, particularly the Basel Accords, have evolved to support more forward-looking provisioning. Basel III, for instance, emphasized the importance of timely loan loss provisions and a shift towards an expected loss model to enhance financial stability., Early discussions from the Bank for International Settlements (BIS) highlighted the need for banks to anticipate losses, moving away from a backward-looking approach.

Key Takeaways

• Adjusted advanced provision is a forward-looking approach to estimating potential future credit losses on financial assets.
• It is a core component of modern accounting standards like IFRS 9's Expected Credit Loss (ECL) and US GAAP's Current Expected Credit Loss (CECL) models.
• The approach requires entities to consider historical data, current conditions, and reasonable and supportable future macroeconomic indicators.
• Provisions are recognized proactively on the balance sheet, even before a loss event has occurred.
• The "adjusted" aspect implies ongoing reassessment and modification of these provisions as circumstances change.

Formula and Calculation

While "Adjusted Advanced Provision" is a conceptual term rather than a specific formula, its calculation is rooted in the Expected Credit Loss (ECL) models prescribed by IFRS 9 and CECL. The general approach for calculating Expected Credit Loss involves the following components:

$\text{ECL} = \text{PD} \times \text{LGD} \times \text{EAD}$

Where:

• (\text{PD}) = Probability of Default: The likelihood that a borrower will default on their obligation over a specified period. This is estimated based on historical data, current economic conditions, and forward-looking forecasts.
• (\text{LGD}) = Loss Given Default: The proportion of the exposure that an entity expects to lose if a default occurs. This considers collateral and expected recovery rates.
• (\text{EAD}) = Exposure At Default: The total exposure that an entity expects to have to a borrower at the time of default. For a loan, this might be the outstanding principal balance.

For financial assets, the ECL is typically calculated for either a 12-month period (for assets where credit risk has not significantly increased) or for the lifetime of the asset (for assets where credit risk has significantly increased or are already credit-impaired).,² The "adjusted" element refers to the continuous update of these variables ((\text{PD}), (\text{LGD}), (\text{EAD})) based on new information and changing economic forecasts, leading to revisions of the reported allowance for credit losses.

Interpreting the Adjusted Advanced Provision

The adjusted advanced provision, presented as an allowance for credit losses on an entity's balance sheet, reflects management's best estimate of future credit losses. A higher adjusted advanced provision indicates a more conservative outlook on asset quality or an expectation of deteriorating economic conditions that could lead to increased defaults. Conversely, a lower provision might suggest an improving credit environment or robust portfolio quality.

Analysts use this provision to gauge an institution's financial resilience and its proactive risk management. It influences the reported profit and loss statement through credit loss expenses, which can fluctuate significantly with changes in economic forecasts. The level of adjusted advanced provision also impacts regulatory capital requirements for financial institutions, as sufficient provisions help absorb potential losses.

Hypothetical Example

Consider a regional bank, "Horizon Lending," with a portfolio of commercial loans. Under the adjusted advanced provision methodology, at the end of its fiscal quarter, Horizon Lending assesses its loan portfolio for potential future losses.

1. Initial Assessment: Horizon Lending has a $100 million loan to "Bright Future Corp." The initial probability of default (PD) for this type of loan, considering current economic stability, is estimated at 0.5% over the next 12 months. The estimated loss given default (LGD) is 40%, and the exposure at default (EAD) is the full $100 million.

   • Initial 12-month ECL = 0.005 * 0.40 * $100,000,000 = $200,000

2. Economic Shift: Halfway through the next quarter, a sudden increase in interest rates and a downturn in regional manufacturing are observed. These macroeconomic indicators suggest an increased risk of default for businesses like Bright Future Corp.

3. Adjustment: Horizon Lending's risk models reassess the PD for Bright Future Corp., increasing it to 1.5% due to the worsening economic outlook. The LGD and EAD remain unchanged.

   • Adjusted 12-month ECL = 0.015 * 0.40 * $100,000,000 = $600,000

Horizon Lending would then increase its allowance for credit losses on its balance sheet by $400,000 ($600,000 - $200,000), recognizing this increase as a credit loss expense in its profit and loss statement for the current period. This demonstrates how the "adjusted advanced provision" dynamically responds to changes in economic conditions, providing a more current view of expected losses.

Practical Applications

Adjusted advanced provisions are integral to the operations and financial reporting of various entities, particularly those with significant exposure to credit risk.

• Banks and Financial Institutions: These are primary users, applying the concept to their vast portfolios of loans, debt securities measured at amortized cost, and other financial assets. The provisions directly impact their profitability and their ability to meet capital adequacy requirements set by regulators like those under the Basel Accords.
• Corporations: Companies outside the financial sector also apply these principles, especially for trade receivables and contract assets, to recognize potential losses from customers who may not pay their debts. The complexity can vary, but the underlying forward-looking impairment model is applied across all sectors.
• Regulatory Oversight: Central banks and financial regulators monitor adjusted advanced provisions to assess the health of the financial system. The shift to expected loss models was a global regulatory response to improve financial stability post-crisis.
• Investment Analysis: Investors and analysts use the reported provisions to assess a company's asset quality, risk exposure, and management's conservatism regarding future performance. Significant changes in provisions can signal shifts in underlying credit conditions or management's outlook.

Limitations and Criticisms

Despite the intentions behind adopting a forward-looking approach, the implementation of adjusted advanced provisions, particularly through models like IFRS 9 and CECL, has faced several limitations and criticisms.

One major challenge is the inherent subjectivity and complexity in forecasting future credit losses. Estimating the probability of default and loss given default over the lifetime of a financial instrument requires significant judgment, extensive data, and sophisticated models., The reliance on forward-looking macroeconomic indicators means that provisions can be highly sensitive to changes in economic forecasts, leading to increased volatility in reported profit and loss and potentially impacting regulatory capital ratios.,

The COVID-19 pandemic highlighted some of these limitations, as the sudden and severe economic shifts stressed traditional ECL models, often requiring significant post-model adjustments. Critics argue that while the aim is to provide more timely loss recognition, the models can become procyclical, meaning they might require larger provisions during economic downturns (when capital is already constrained) and lower provisions during booms, potentially amplifying economic cycles. Moreover, the lack of prescriptive methods in CECL allows for diverse modeling approaches, which can lead to comparability challenges across different entities.¹,

Adjusted Advanced Provision vs. Expected Credit Loss (ECL)

While "Adjusted Advanced Provision" is a descriptive term for a financial accounting practice, Expected Credit Loss (ECL) is the formal accounting standard framework that underpins it.

In essence, "Adjusted Advanced Provision" is the practical result and continuous refinement of applying the formal Expected Credit Loss (ECL) methodology. The "adjusted" part emphasizes the dynamic and re-evaluated nature of these provisions based on evolving financial data and fair value assessments.

FAQs

What types of assets are subject to adjusted advanced provision?

Adjusted advanced provisions primarily apply to financial assets held at amortized cost, such as loans, debt securities, trade receivables, and certain off-balance-sheet exposures like loan commitments and financial guarantees.

How often are adjusted advanced provisions calculated?

Entities are required to calculate and update their adjusted advanced provisions at each reporting period, typically quarterly or annually, to reflect changes in credit risk and economic forecasts.

What is the impact of adjusted advanced provision on a company's financial statements?

The estimated credit losses calculated as adjusted advanced provisions are recognized as an expense on the profit and loss statement and as an allowance for credit losses (a contra-asset account) on the balance sheet, reducing the net carrying amount of the financial assets. This impacts reported earnings and asset values.

Why was this new provisioning approach introduced?

The new approach, stemming from IFRS 9's ECL and CECL, was introduced to address criticisms that older "incurred loss" models delayed the recognition of credit losses, contributing to the severity of financial crises. The goal is to provide a more timely and forward-looking view of potential losses, enhancing financial stability and transparency.

Is "Adjusted Advanced Provision" a formal accounting term?

No, "Adjusted Advanced Provision" is a descriptive phrase that encapsulates the principles and practices of modern, forward-looking impairment models, such as Expected Credit Loss (ECL) under IFRS 9 and Current Expected Credit Loss (CECL) under US GAAP. It highlights the dynamic and refined nature of these loss estimates.