Incurred credit loss

What Is Incurred Credit Loss?

Incurred credit loss refers to a model of recognizing credit risk where financial institutions record losses on financial assets only when there is objective evidence that an impairment event has occurred. This backward-looking approach contrasts with more forward-looking methods, falling under the broader category of financial accounting principles related to loan loss provisioning. Under an incurred credit loss model, the recognition of a loss is delayed until a specific trigger event has taken place, signaling that a loss is probable and estimable. Such events might include a borrower's default on payments, bankruptcy, or significant financial difficulty. The incurred credit loss model historically influenced how banks and other entities prepared their balance sheet and income statement by dictating the timing of loan loss provision entries.

History and Origin

The concept of incurred credit loss gained prominence with the development of international accounting standards. Specifically, International Accounting Standard (IAS) 39, issued in 1998, codified the incurred loss model for financial instruments. This standard required that credit losses on assets measured at amortized cost be recognized only when objective evidence of impairment existed. This meant that banks and other entities could not provision for losses based on future expectations; instead, a loss event had to have already occurred.

The introduction of the incurred-loss model in IAS 39 between 1998 and 2003 was a significant development in accounting for credit losses, although the distinction between "incurred-loss" and "expected-loss" models was still evolving at the time.²¹, ²², ²³ Prior to this, practices varied, and the incurred loss approach was partly aimed at curbing practices like "cookie jar reserves" where companies might over-provision in good times to smooth earnings in bad times.²⁰

However, the global financial crisis of 2008 highlighted a significant drawback of the incurred credit loss model: it led to delayed recognition of credit losses.¹⁸, ¹⁹ As the crisis unfolded, critics argued that the model prevented financial institutions from recognizing potential future losses until it was often too late, exacerbating the crisis by masking the true financial health of institutions.¹⁷ This criticism spurred a global effort by accounting standard-setters, including the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB), to develop a more forward-looking approach to credit loss provisioning.

Key Takeaways

• Trigger Event: Incurred credit loss requires a specific event to occur before a loss can be recognized, such as a missed payment or a change in credit rating.
• Backward-Looking: This model focuses on past events and existing conditions rather than forecasting future potential losses.
• Delayed Recognition: A primary criticism is the delayed recognition of losses, which can obscure the true financial health of an entity during economic downturns.
• Historical Accounting Standard: It was a cornerstone of accounting for credit losses under IAS 39 and certain aspects of Generally Accepted Accounting Principles (GAAP) before more recent reforms.
• Impact on Capital: Delayed recognition under an incurred credit loss model could lead to insufficient capital requirements for banks to absorb sudden, unforeseen losses.

Interpreting the Incurred Credit Loss

Interpreting incurred credit loss primarily revolves around understanding the point at which a loss becomes recognizable on an entity's financial statements. Under this model, an entity could only recognize an impairment when there was objective evidence of a loss event, such as a significant financial difficulty of the borrower, a breach of contract (like a default or delinquency in interest or principal payments), or a high probability that the borrower will enter bankruptcy.

The assessment for incurred credit loss required a judgment call based on observable data, rather than projections. For instance, if a bank had a portfolio of performing loans, no impairment would be recognized until a borrower individually experienced a qualifying loss event, or until a collective group of similar loans showed evidence of impairment due to, for example, adverse economic conditions affecting a specific industry. The inherent subjectivity in determining the "objective evidence" was a challenge, as was the potential for procyclicality, where losses were recognized heavily during economic downturns, further constricting lending.

Hypothetical Example

Consider "LendCo," a small financial institution operating under an incurred credit loss model for its loan portfolio. LendCo provides a $100,000 business loan to "Baker's Dozen," a local bakery, due in monthly installments.

For the first six months, Baker's Dozen makes all its payments on time. LendCo recognizes interest income but no incurred credit loss, as there's no objective evidence of impairment.

In the seventh month, Baker's Dozen misses a payment. Under the incurred credit loss model, this missed payment serves as the objective evidence and trigger event. At this point, LendCo would assess the likely loss given default on the $100,000 loan. If LendCo determines, for example, that it is probable it will only recover 70% of the outstanding principal due to the missed payment and the bakery's deteriorating financial situation, it would then record an incurred credit loss of $30,000 (30% of $100,000) as a loan loss provision. This provision would reduce the carrying value of the loan on LendCo's balance sheet and be expensed on its income statement. Before this specific event, even if internal analysis suggested a rising probability of default for similar small businesses, LendCo could not recognize a loss.

Practical Applications

Historically, the incurred credit loss model was a fundamental component of financial reporting for banks and other lenders. Before the adoption of more modern accounting standards, this model governed how allowances for credit losses were established. This directly impacted the reported profitability and capital adequacy of financial institutions.

Regulators, in frameworks like Basel Accords, initially considered accounting provisions based on the incurred loss model when assessing a bank's capital.¹⁶ However, the limitations of this model in a crisis spurred changes in both accounting and regulatory frameworks. For instance, the Financial Accounting Standards Board (FASB) in the U.S. eliminated specific accounting guidance for "troubled debt restructurings" (TDRs) for creditors, which were often a result of incurred losses, with the issuance of ASU 2022-02. This change mandates that all loan modifications be evaluated under general loan refinancing and restructuring guidance.¹², ¹³, ¹⁴, ¹⁵

Limitations and Criticisms

The incurred credit loss model faced significant criticism, particularly in the wake of the 2008 financial crisis. The primary limitation was its backward-looking nature, which meant that impairment losses were only recognized once objective evidence of an actual loss event had occurred.¹⁰, ¹¹ This delayed recognition had several consequences:

• Procyclicality: The model tended to be procyclical, meaning that loan loss provisions increased sharply during economic downturns when losses were already widespread, thus reducing banks' capital precisely when it was most needed. Conversely, in good economic times, banks often had insufficient provisions, which did not reflect potential future risks.
• Lack of Timeliness: Financial statements prepared under the incurred credit loss model often did not provide a timely reflection of the deterioration in the credit quality of financial assets.⁸, ⁹ This could lead to an overstatement of assets by placing tight restrictions on the recognition of loan losses.⁶, ⁷
• Inconsistency in Measurement: Critics argued that the model was internally inconsistent because while initial loan measurement implicitly factored in expected future losses (via the interest rate), subsequent accounting ignored changes in these expectations until a loss was "incurred."⁵ The distinction between "incurred losses" and "future credit losses" was often arbitrary.⁴

These criticisms ultimately led to significant reforms in accounting standards, moving away from the incurred credit loss model towards more forward-looking approaches.

Incurred Credit Loss vs. Expected Credit Loss

The distinction between incurred credit loss and expected credit loss (ECL) is a fundamental shift in how financial institutions account for potential loan defaults.

The incurred credit loss model allowed entities to recognize losses only after a specific event triggered the realization that a loss had occurred. In contrast, the ECL model, adopted by International Financial Reporting Standard (IFRS) 9, requires entities to estimate and provision for potential future losses over the lifetime of a financial instrument from the point of initial recognition, considering various scenarios and macroeconomic factors. This shift was a direct response to the perceived shortcomings of the incurred credit loss model during periods of financial stress.¹, ², ³

FAQs

What is the main problem with incurred credit loss?

The main problem with incurred credit loss is that it delays the recognition of potential losses until a specific negative event has already happened. This can lead to a sudden and significant increase in loan loss provision during economic downturns, potentially masking the true financial health of a company until it's too late.

Why did accounting standards move away from the incurred credit loss model?

Accounting standards moved away from the incurred credit loss model primarily due to its procyclical nature and delayed recognition of losses, which contributed to financial instability during crises. Regulators and standard-setters sought a more forward-looking approach to ensure that financial institutions would provision for losses earlier, based on expected future events. This led to the development of the Expected Credit Loss (ECL) model under International Financial Reporting Standards (IFRS 9) and the Current Expected Credit Loss (CECL) model under U.S. Generally Accepted Accounting Principles.

How does incurred credit loss relate to the financial crisis of 2008?

The incurred credit loss model was heavily criticized following the 2008 financial crisis because it prevented banks from recognizing significant potential losses on their loan portfolios until after the crisis was well underway. This meant that banks' reported financial positions did not fully reflect the deteriorating credit quality of their assets in a timely manner, contributing to a lack of transparency and exacerbating concerns about the stability of the financial system.

Does incurred credit loss still exist in current accounting standards?

For most significant financial instruments, the incurred credit loss model has largely been replaced by the more forward-looking Expected Credit Loss (ECL) model under IFRS 9, effective from 2018, and the Current Expected Credit Loss (CECL) model for entities reporting under U.S. GAAP. While the core concept of an "incurred" loss might still apply in specific, narrower contexts or for certain types of assets, the broad-based provisioning for credit risk has shifted to an expected loss methodology.