Expected credit losses: Meaning, Criticisms & Real-World Uses

What Is Expected Credit Losses?

Expected credit losses (ECL) represent an accounting estimate of the credit losses that are anticipated to occur over the lifetime of a financial instrument. This forward-looking measurement falls under the broader category of financial accounting and plays a critical role in how financial institutions and other entities assess the collectability of their financial assets. Unlike older models that recognized losses only when they were probable or incurred, ECL frameworks require the recognition of potential losses at the point of origination, or as soon as an asset is acquired, by considering historical loss experience, current conditions, and reasonable and supportable forecasts of future economic conditions⁶⁷, ⁶⁸.

The concept of expected credit losses is a cornerstone of modern accounting standards, particularly the Current Expected Credit Loss (CECL) model in the United States, formalized under Accounting Standards Codification (ASC) Topic 326, and International Financial Reporting Standard 9 (IFRS 9) in many other parts of the world⁶⁵, ⁶⁶. Both standards aim to provide more timely recognition of potential credit losses on a wide range of financial assets, including loans, debt securities, and trade receivables ⁶³, ⁶⁴.

History and Origin

The concept of expected credit losses gained prominence in the aftermath of the 2008 global financial crisis. During this period, a significant criticism of existing accounting standards, specifically the "incurred loss" model (IAS 39 internationally and previous Generally Accepted Accounting Principles (GAAP) in the US), was that they led to a "too little, too late" recognition of credit losses⁶¹, ⁶². Under the incurred loss model, losses were only recognized when there was objective evidence that an impairment event had occurred, which often meant that significant losses were recorded only after a crisis had already unfolded⁵⁹, ⁶⁰.

In response to calls from the G20 and other regulatory bodies for more proactive and forward-looking impairment models, both the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) embarked on projects to revise their respective standards. The IASB issued the complete version of IFRS 9, "Financial Instruments," in July 2014, with an effective date for annual periods beginning on or after January 1, 2018⁵⁷, ⁵⁸. IFRS 9 introduced an expected credit loss (ECL) framework for recognizing impairment, requiring entities to consider past events, current conditions, and forecast information when estimating credit losses⁵⁶.

Similarly, in the United States, the FASB issued Accounting Standards Update (ASU) No. 2016-13, "Financial Instruments—Credit Losses (Topic 326)," in June 2016, commonly referred to as the Current Expected Credit Loss (CECL) model. This standard replaced the previous incurred loss methodology in U.S. GAAP and became effective for public business entities that are SEC filers with fiscal years beginning after December 15, 2019, and for most other entities, after December 15, 2022. ⁵³, ⁵⁴, ⁵⁵The primary objective of CECL was to provide financial statement users with more insightful information about expected credit losses by requiring immediate recognition of estimated expected credit losses over the life of the financial instrument.
⁵²

Key Takeaways

Expected credit losses (ECL) represent an estimate of anticipated credit losses over the lifetime of a financial instrument.
ECL frameworks, such as CECL (US GAAP) and IFRS 9 (International Financial Reporting Standards), require a forward-looking assessment of credit risk.
These standards were developed to address the "too little, too late" criticism of previous "incurred loss" models.
ECL calculations incorporate historical data, current conditions, and reasonable forecasts of future economic scenarios.
The implementation of ECL models can significantly impact a company's financial statements, particularly the balance sheet and profit and loss (P&L) statement.

Formula and Calculation

The calculation of expected credit losses (ECL) generally involves a probability-weighted estimate of credit losses, taking into account the time value of money. While specific methodologies can vary, a common conceptual formula for ECL can be expressed as:

ECL = PD \times LGD \times EAD

Where:

PD (Probability of Default): The likelihood that a borrower will fail to meet its contractual obligations over a specified period or the entire life of the financial instrument. This considers current conditions and forward-looking economic information.
LGD (Loss Given Default): The estimated proportion of the exposure that will be lost if a default occurs. This factor accounts for collateral, recovery rates, and other mitigating factors.
EAD (Exposure at Default): The total outstanding amount of the exposure that is subject to default risk at the time of default.

For financial assets, the credit loss itself is defined as the difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flows that the entity expects to receive, discounted at the original effective interest rate.
⁵¹
Under IFRS 9, entities generally follow a three-stage model for recognizing impairment:

Stage 1: For financial instruments that have not experienced a significant increase in credit risk since initial recognition, 12-month ECLs are recognized. These are the expected credit losses from default events possible within 12 months after the reporting date.
⁴⁹, ⁵⁰* Stage 2: If there has been a significant increase in credit risk since initial recognition, lifetime ECLs are recognized. These are the expected credit losses from all possible default events over the expected life of the financial instrument.
⁴⁸* Stage 3: When a financial asset becomes credit-impaired (e.g., defaulted), lifetime ECLs continue to be recognized, and interest revenue is calculated on the net carrying amount (amortized cost less the allowance for loan and lease losses).
⁴⁷
CECL, while similar in its forward-looking nature, generally requires the recognition of lifetime expected credit losses for most financial assets measured at amortized cost from the date of initial recognition.
⁴⁵, ⁴⁶

Interpreting the Expected Credit Losses

Interpreting expected credit losses involves understanding the implications of the calculated amount for an entity's financial health and its future prospects. A higher ECL indicates that an entity anticipates greater losses from its financial assets, suggesting potential deterioration in the credit quality of its borrowers or a more pessimistic economic outlook. Conversely, a lower ECL suggests stronger credit quality and a more favorable economic environment.

For financial institutions, the allowance for expected credit losses directly impacts their retained earnings and regulatory capital. An increase in expected credit losses leads to higher provisions for credit losses on the income statement, which reduces reported earnings and, consequently, retained earnings. ⁴³, ⁴⁴This can affect a bank's capital ratios, potentially limiting its capacity for new lending.
⁴¹, ⁴²
The interpretation of expected credit losses also requires an understanding of the forward-looking nature of the accounting standards. Unlike prior "incurred loss" models that were reactive to actual defaults, ECL models are proactive, requiring management to exercise significant judgment in forecasting future economic conditions. ⁴⁰This forward-looking element means that changes in expected credit losses can serve as an early indicator of shifts in credit quality or macroeconomic trends. For example, during an economic downturn, an entity would generally increase its allowance for expected credit losses to reflect the heightened probability of defaults, even if actual defaults have not yet materialized.

Hypothetical Example

Consider "LendPro Bank," which issues a new loan of $1,000,000 to "Construction Co." for a five-year term. Under the CECL model, LendPro Bank must estimate the expected credit losses over the entire five-year life of the loan at its inception.

Historical Data Review: LendPro Bank examines its historical data for similar construction loans. It finds that historically, 1% of such loans default over their lifetime.
Current Conditions: The bank assesses current economic conditions. Unemployment rates are stable, and the construction sector is performing well.
Forward-Looking Forecasts: LendPro Bank's economists predict a slight slowdown in economic growth in the next two years, which could marginally increase the risk of default for some borrowers. Based on this, they adjust the historical 1% default rate slightly upward to 1.2% for this specific loan portfolio.
Loss Given Default (LGD): LendPro Bank estimates that if Construction Co. defaults, it will likely recover 70% of the outstanding loan amount due to collateral. Therefore, the LGD is 30% (100% - 70%).
Exposure at Default (EAD): For simplicity, assume the initial loan amount of $1,000,000 is the EAD.

Using the simplified formula:

ECL = PD \times LGD \times EAD \\ ECL = 0.012 \times 0.30 \times \$1,000,000 \\ ECL = \$3,600

At the time the loan to Construction Co. is originated, LendPro Bank would record an allowance for expected credit losses of $3,600. This amount is recognized on the balance sheet as a contra-asset account, reducing the net carrying value of the loan. This hypothetical example demonstrates how a bank accounts for potential future losses from the outset, rather than waiting for an actual default event.

Practical Applications

Expected credit losses are a fundamental concept with widespread practical applications across various financial sectors, impacting how entities manage risk, report financial performance, and comply with regulatory requirements.

Financial Institutions (Banks and Credit Unions): The most significant impact of ECL frameworks like CECL and IFRS 9 is on banks and credit unions. These institutions must calculate and report expected credit losses for their loan portfolios, debt securities, and other financial assets. ³⁸, ³⁹This influences their capital planning, stress testing, and overall risk management strategies. ³⁶, ³⁷For instance, the Federal Reserve provides extensive resources and FAQs to assist institutions with CECL implementation.
³⁵* Corporate Finance: Non-financial corporations also apply ECL models, primarily for their trade receivables, contract assets, and other financial assets measured at amortized cost. ³⁴This provides a more realistic view of the collectability of their customer balances and affects their revenue recognition and overall profitability.
Investment Management: Investment firms and asset managers need to understand ECL calculations when evaluating the financial health of companies, particularly those in the banking or lending sectors. ECL figures provide insights into the underlying credit quality of a company's assets and its exposure to default risk.
Regulatory Compliance: Regulatory bodies, such as the Securities and Exchange Commission (SEC) in the U.S. and various international banking supervisors, enforce compliance with ECL standards. These standards are crucial for maintaining financial stability and ensuring transparency in financial reporting. The Basel Committee on Banking Supervision (BCBS) has also assessed the impact of IFRS 9's ECL framework on the regulatory treatment of accounting provisions within the Basel capital framework.
³³

Limitations and Criticisms

While expected credit loss (ECL) models aim to provide more timely and forward-looking recognition of credit losses, they also face certain limitations and criticisms.

One significant challenge lies in the complexity and subjectivity of forecasting. Estimating expected credit losses requires entities to make significant judgments about future economic conditions, which can be inherently uncertain and difficult to predict accurately. ³¹, ³²As a result, the allowance for expected credit losses can be highly sensitive to management's assumptions and economic forecasts, potentially leading to increased volatility in reported earnings. ³⁰Some academic literature has even explored whether the managerial discretion in applying ECL models could lead to increased earnings management.
²⁹
Another criticism, particularly noted with the CECL model in the U.S., is the potential for it to be procyclical, meaning it could exacerbate economic downturns. By requiring banks to recognize lifetime expected losses immediately, CECL can lead to a significant increase in loan loss allowances during periods of economic stress, which in turn reduces bank profitability and potentially their willingness to lend. ²⁷, ²⁸The Bank Policy Institute, for example, points out that CECL forces banks to recognize future losses immediately but does not allow for immediate recognition of future interest earnings, which could result in a decrease in lending availability, especially to non-prime borrowers, potentially stunting economic recovery.

Furthermore, the implementation of these complex models has presented operational challenges for many entities, particularly smaller financial institutions that may lack the resources and technical expertise to build and maintain sophisticated credit models. ²⁵, ²⁶The need for more granular data and advanced modeling methodologies represents a substantial undertaking compared to previous incurred loss approaches.
²⁴
Despite these criticisms, accounting standard setters like the FASB continue to review and refine the ECL standards, considering stakeholder feedback and conducting post-implementation reviews to assess whether the objectives are being met and if improvements can be made.
²², ²³

Expected Credit Losses vs. Incurred Losses

The primary distinction between expected credit losses (ECL) and incurred losses lies in the timing and nature of loss recognition. This difference is fundamental to understanding the shift in accounting philosophy brought about by standards like CECL and IFRS 9.

Feature	Expected Credit Losses (ECL)	Incurred Losses
Timing of Recognition	Recognized before a credit event occurs, at initial recognition of the financial asset and ongoing, based on expectations of future losses. ²⁰, ²¹	Recognized after a credit event has occurred and objective evidence of a loss exists. ¹⁸, ¹⁹
Forward-Looking	Highly forward-looking, incorporating historical data, current conditions, and future forecasts. ¹⁷	Backward-looking, based on past events and current conditions. ¹⁶
Proactivity	Proactive in recognizing potential losses. ¹⁵	Reactive to actual loss events. ¹⁴
Impact on Reserves	Generally leads to higher and more volatile loss allowances, particularly at the inception of loans or during economic downturns. ¹², ¹³	Leads to lower allowances until an actual loss is probable, potentially delaying recognition. ¹¹
Philosophy	"Expected loss" approach.	"Probable loss" or "objective evidence" approach.
Governing Standards	IFRS 9 (International) and ASC 326 (CECL in US GAAP). ⁹, ¹⁰	IAS 39 (International) and previous US GAAP. ⁷, ⁸

The confusion between the two often stems from the fact that both relate to potential uncollectible amounts from financial assets. However, the paradigm shift from incurred losses to expected credit losses aims to provide a more realistic and timely representation of the credit risk embedded in an entity's portfolio, rather than waiting for an actual default to materialize. This proactive approach ensures that an allowance for loan losses is established much earlier in the life of the financial instrument.

FAQs

What types of financial instruments are subject to expected credit losses?

Expected credit losses generally apply to a broad range of financial instruments measured at amortized cost. This includes, but is not limited to, loans, trade receivables, contract assets, lease receivables, and held-to-maturity debt securities. ⁵, ⁶It also applies to certain off-balance-sheet credit exposures, such as loan commitments.
³, ⁴

How do economic forecasts affect expected credit losses?

Economic forecasts are a crucial component of calculating expected credit losses. Entities are required to consider reasonable and supportable forward-looking information when estimating future cash flows and the likelihood of default risk. ¹, ²This means that changes in economic outlooks, such as predicted recessions or periods of growth, will directly influence the amount of expected credit losses recognized. A deteriorating economic forecast typically leads to an increase in expected credit losses, reflecting a higher probability of borrowers failing to repay their obligations.

Is expected credit loss the same as bad debt expense?

No, expected credit loss is not the same as bad debt expense, although they are related. Expected credit loss refers to the estimate of future credit losses over the life of a financial asset, which is used to establish the allowance for credit losses on the balance sheet. The bad debt expense, on the other hand, is the income statement charge that reflects the periodic adjustment to this allowance. When the estimate of expected credit losses increases, it results in an increase to the bad debt expense (or provision for credit losses), which reduces current period earnings.