Incurred credit losses

What Is Incurred Credit Losses?

Incurred credit losses refer to a financial accounting methodology where losses on loans and other financial assets are recognized only when objective evidence indicates that a loss event has already occurred. This approach, central to older accounting standards, falls under the broader category of Financial Accounting and plays a significant role in Credit Risk management for financial institutions. Under this model, a bank or lender would only record an expense and set aside Loan Loss Reserves once there was evidence that a specific borrower or a portfolio of loans had deteriorated in credit quality. The core principle of incurred credit losses is that losses must be "probable" and estimable before they are recognized in a company's Financial Statements.

History and Origin

The concept of incurred credit losses has been a foundational element of global accounting standards for decades. In the United States, it was primarily governed by U.S. Generally Accepted Accounting Principles (GAAP), specifically Statement of Financial Accounting Standards No. 5 (SFAS 5), and later SFAS 114, which stipulated that a loss contingency, such as an uncollectible receivable, should be accrued when it is probable that an asset has been impaired and the amount of the loss can be reasonably estimated. Similarly, the International Accounting Standards Board (IASB) employed an incurred loss model under IAS 39 (Financial Instruments: Recognition and Measurement) for financial assets carried at Amortized Cost⁸.

The adoption and evolution of the incurred-loss model, particularly under IAS 39, were subjects of extensive debate. This approach restricted the recognition of loan losses to situations where "objective evidence" of "loss events" existed before the balance sheet date⁷. Critics argued that this backward-looking approach led to significant overstatements of financial assets by placing tight restrictions on the recognition of loan losses, especially during economic downturns when losses might be anticipated but not yet "incurred." The global financial crisis of 2007-2008 highlighted these deficiencies, prompting both the Financial Accounting Standards Board (FASB) in the U.S. and the IASB to develop new, more forward-looking models⁶.

Key Takeaways

• Incurred credit losses represent a historical accounting methodology where credit losses are recognized only after a "loss event" has occurred.
• This approach was used under U.S. GAAP (SFAS 5/114) and International Financial Reporting Standards (IFRS), specifically IAS 39.
• Recognition of incurred credit losses was contingent on objective evidence of impairment and a probable loss.
• The model was criticized for delaying loss recognition, particularly during economic downturns, potentially leading to "too little, too late" provisioning.
• It has largely been replaced by more forward-looking "expected loss" models, such as the Current Expected Credit Loss (CECL) standard in the U.S. and IFRS 9 globally.

Interpreting the Incurred Credit Losses

Under the incurred credit loss model, the interpretation of an entity's financial health relied heavily on the occurrence of observable events. For instance, if a borrower missed a payment, filed for bankruptcy, or experienced a significant decline in credit rating, these would serve as the "trigger events" indicating an incurred loss. Without such objective evidence, even if future losses were anticipated, they generally could not be formally recognized.

This meant that the Allowance for Loan and Lease Losses (ALLL) on a bank's Balance Sheet was intended to cover losses that had already occurred but had not yet been fully realized. The Provision for Loan Losses, an expense on the Income Statement, reflected the current period's estimated incurred losses. The inherent limitation of this approach was that it prevented banks from reserving for losses that were expected but not yet incurred, potentially leading to a sudden surge in provisions during economic downturns when loss events became widespread.

Hypothetical Example

Consider "LendWell Bank" in 2005, operating under an incurred credit loss model. LendWell Bank has a portfolio of small business loans. One borrower, "BrightFuture Corp.," has consistently made its monthly loan payments of $5,000.

In September 2005, BrightFuture Corp. announces unexpectedly that it has lost its largest contract, forcing it to significantly reduce operations and lay off most of its staff. Immediately, BrightFuture Corp. misses its October loan payment to LendWell Bank. This missed payment serves as the objective evidence of a "loss event."

Under the incurred credit loss model, LendWell Bank would then assess the loan for impairment. Based on the missed payment and the adverse news, LendWell Bank determines that it is probable it will not collect all future payments. It estimates that it will only recover 60% of the outstanding loan balance. At this point, LendWell Bank recognizes an incurred credit loss on BrightFuture Corp.'s loan and increases its Impairment allowance, impacting its current period earnings. Before the missed payment, even if economic indicators hinted at trouble for small businesses, LendWell Bank could not recognize a loss on BrightFuture Corp.'s loan because no specific loss event had yet occurred.

Practical Applications

Historically, incurred credit losses were the standard for recognizing losses on Financial Instruments such as loans and trade receivables across various industries, particularly in banking and financial services. This methodology guided how banks calculated their Allowance for Loan and Lease Losses, a valuation account that reduces the recorded value of loans on the balance sheet. Regulators, including the U.S. Securities and Exchange Commission (SEC) and federal banking agencies, provided extensive guidance on applying this model, emphasizing the need for robust documentation and systematic methodologies for determining loss allowances⁵.

The incurred loss model was deeply embedded in U.S. GAAP until the adoption of the Current Expected Credit Loss (CECL) standard and in IFRS until the implementation of IFRS 9. These new Accounting Standards significantly changed how credit losses are recognized, moving away from the "probable and incurred" threshold. Despite the shift, understanding incurred credit losses remains crucial for interpreting historical financial statements and appreciating the evolution of credit risk accounting. The Federal Reserve Board, for instance, has provided extensive FAQs explaining the transition from the incurred loss methodology to CECL for financial institutions⁴.

Limitations and Criticisms

The incurred credit loss model faced significant criticism, primarily because of its backward-looking nature, which often led to delayed recognition of losses. This "too little, too late" problem became particularly apparent during the 2008 global financial crisis. Under this model, banks could not recognize losses until a specific "trigger event" had occurred, even if macroeconomic forecasts clearly indicated an impending downturn or increased probability of defaults³.

This delay in recognizing losses meant that bank financial statements might appear stronger than reality during the initial stages of an economic crisis, only to see massive provisions for losses hit earnings once widespread defaults or other loss events materialized. This procyclicality, where reserves were built up slowly during good times and rapidly depleted during bad times, was seen as exacerbating economic downturns rather than mitigating them. Critics argued that the incurred loss model hindered prudent risk management and transparency, making it difficult for investors and regulators to assess a bank's true financial health. The International Accounting Standards Board (IASB) also acknowledged these criticisms, noting that the IAS 39 impairment model was often seen as "too little too late"². The perception that European banks underprovided for loan losses was a significant justification for the Asset Quality Review conducted by the European Central Bank (ECB)¹.

Incurred Credit Losses vs. Expected Credit Losses

The fundamental difference between incurred credit losses and Expected Credit Losses (ECL) lies in the timing and basis of loss recognition.

While incurred credit losses focused on past loss events, the expected credit loss models, such as CECL and IFRS 9, require entities to estimate and provision for losses that are anticipated over the entire life of a financial asset, even if no specific loss event has yet occurred. This shift aims to provide a more timely and comprehensive reflection of potential future credit risk.

FAQs

Why was the incurred credit loss model replaced?

The incurred credit loss model was replaced primarily because it was seen as "too little, too late." It delayed the recognition of potential losses until objective evidence of a loss event existed, which often meant that significant credit losses were only recorded well into an economic downturn. This delayed recognition was criticized for obscuring the true financial health of institutions and potentially exacerbating financial crises.

What are the main characteristics of incurred credit losses?

The main characteristics of incurred credit losses include: (1) a requirement for objective evidence that a loss event has already occurred, (2) the need for the loss to be probable and estimable, and (3) its backward-looking nature, focusing on past events and current conditions rather than future forecasts.

How did incurred credit losses affect financial reporting?

Under the incurred credit loss model, the Allowance for Loan and Lease Losses on a bank's balance sheet reflected only losses that had already been incurred. This could lead to a sudden and significant increase in the Provision for Loan Losses (an expense) during economic downturns, potentially causing volatility in reported earnings as losses materialized rapidly.

Is the incurred credit loss model still used anywhere?

While the incurred credit loss model has been largely replaced by expected credit loss models (CECL in the U.S. and IFRS 9 internationally) for most financial assets, some specific accounting treatments or legacy systems might still reference its principles for certain non-financial items or in jurisdictions yet to adopt the newer standards. However, for core lending activities and financial instruments, the global trend has decisively moved towards expected credit losses.