What Is Incurred Loss Model?
The incurred loss model is an accounting methodology primarily used to recognize losses on financial assets, particularly loans and other credit exposures. Under this model, an entity records an impairment loss only when there is objective evidence that a loss event has occurred, and the amount of the loss can be reasonably estimated. This approach means that potential future losses, even if anticipated, are not recognized until they are deemed "incurred." The incurred loss model falls under the broader category of accounting principles and financial reporting.
Historically, this model was foundational in both Generally Accepted Accounting Principles (GAAP) in the United States, notably under Financial Accounting Standard (FAS) 5 (now codified as ASC 450-20), and International Financial Reporting Standards (IFRS), specifically IAS 39. The core premise is that until a "trigger event" signals an actual loss, the financial asset is assumed to be fully recoverable. This contrasts with more forward-looking approaches that recognize expected losses sooner.
History and Origin
The concept of recognizing losses only when incurred has deep roots in accounting. In the U.S., Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies" (FAS 5), issued in 1975 by the Financial Accounting Standards Board (FASB), established the criteria for recognizing loss contingencies. It mandated that an estimated loss from a loss contingency be accrued if it was probable that an asset had been impaired or a liability incurred at the financial statement date, and the loss amount could be reasonably estimated.15
Internationally, the International Accounting Standards Board (IASB) adopted a similar approach with International Accounting Standard (IAS) 39, "Financial Instruments: Recognition and Measurement," first published in 1998. IAS 39's incurred loss model recognized impairment losses on financial assets only when there was objective evidence of impairment as a result of a past event. This meant that an entity would assume loans would be repaid until a "loss or trigger event" was identified, at which point the impaired loan would be written down.14 This "backward-looking" characteristic was a defining feature of the incurred loss model.
Key Takeaways
- The incurred loss model recognizes losses only when a loss event has occurred and the loss can be reasonably estimated.
- It was the predominant model for credit loss provisioning under both U.S. GAAP (FAS 5/ASC 450-20) and IFRS (IAS 39).
- A "trigger event" indicating an actual loss is necessary for recognition under this model.
- The model faced significant criticism for delaying the recognition of credit losses, particularly during economic downturns.
- It has largely been superseded by "expected loss" models (e.g., CECL in U.S. GAAP and IFRS 9) which require earlier, more forward-looking recognition of potential losses.
Interpreting the Incurred Loss Model
Under the incurred loss model, financial institutions would assess their portfolio of loans and other financial instruments for signs of impairment. Interpretation centered on whether sufficient "objective evidence" existed to confirm that a loss had been incurred. This evidence could include events such as a borrower's significant financial difficulty, bankruptcy, a breach of contract (like payment default), or observable data indicating a measurable decrease in the estimated future cash flows from a group of financial assets.
For instance, if a bank held a portfolio of consumer loans, it would not record loan loss provisions for potential future defaults based on economic forecasts. Instead, it would wait until specific events occurred, such as a loan becoming severely delinquent or a borrower filing for bankruptcy. The amount recognized as an incurred loss would then be the difference between the asset's carrying amount (its original cost less any principal repayments and write-downs) and the present value of the expected future cash flows, discounted at the financial asset's original effective interest rate. This delayed recognition meant that the balance sheet might not fully reflect emerging credit issues until a downturn was already underway.
Hypothetical Example
Consider "LendCo Bank," which has a loan portfolio totaling $100 million. Under the incurred loss model, LendCo Bank does not proactively set aside funds for future, anticipated loan defaults based on economic forecasts. Instead, it waits for specific trigger events.
Suppose a borrower, "XYZ Corp," has a $1 million loan from LendCo Bank. For months, XYZ Corp has been making its payments on time. However, due to unexpected market shifts, XYZ Corp experiences severe financial distress and misses its scheduled payment in Q3. This missed payment serves as the objective evidence and a trigger event for LendCo Bank.
LendCo Bank's credit department then assesses the situation. They determine that while XYZ Corp may eventually repay some amount, it is probable that LendCo will not collect the full $1 million. After analyzing XYZ Corp's remaining assets and business prospects, LendCo estimates it will only recover $600,000.
Under the incurred loss model, LendCo Bank would recognize an impairment loss of $400,000 in its income statement for Q3. This loss is calculated as the difference between the loan's amortized cost ($1 million) and the estimated recoverable amount ($600,000). Prior to this trigger event, even if internal analysts at LendCo had concerns about XYZ Corp's industry, no loss would have been recognized.
Practical Applications
The incurred loss model was widely applied in various financial sectors, most notably in banking and lending, to account for potential defaults on loans, trade receivables, and other debt instruments. Before the shift to expected loss models, banks used the incurred loss model to calculate their allowance for loan losses, which is a contra-asset account on the balance sheet designed to absorb future credit losses.
Regulators also considered these reported loan losses when evaluating a bank's asset quality and overall financial health. For example, U.S. banks operating under GAAP applied the incurred loss methodology, primarily guided by ASC 450-20 (formerly FAS 5), for recognizing credit losses.13 Similarly, institutions reporting under IFRS relied on IAS 39 until its replacement. The Financial Stability Forum (now the Financial Stability Board) highlighted in a 2009 report that under both U.S. GAAP and IFRS, the accounting model for recognizing credit losses was commonly referred to as an "incurred loss model" because the timing and measurement of losses were based on estimating losses that had been incurred as of the balance sheet date.12
Limitations and Criticisms
Despite its widespread use, the incurred loss model faced significant criticism, particularly in the aftermath of the 2008 global financial crisis. A primary critique was that it led to a "too little, too late" recognition of credit losses.11 Because losses could only be recognized once a trigger event had occurred, banks were often perceived as delaying the recognition of credit problems on their financial statements until a downturn was already severe.10
This delayed recognition was seen as contributing to procyclicality in the financial system, meaning that accounting rules exacerbated economic booms and busts. During periods of economic prosperity, banks might under-provision for potential losses, as actual loss events were low. When an economic downturn hit, losses would materialize rapidly and simultaneously, leading to a sudden, sharp increase in loan loss provisions. This, in turn, could reduce banks' regulatory capital and further constrain lending, intensifying the crisis.9
The International Accounting Standards Board (IASB) itself acknowledged this limitation, stating that under the incurred credit loss model, "the effects of possible future credit loss events were not considered, even when they were expected."8 The inherent backward-looking nature meant that the financial reporting did not provide timely information about emerging credit risk, a weakness highlighted by various stakeholders including the G20.7
Incurred Loss Model vs. Expected Loss Model
The most significant distinction for the incurred loss model lies in its contrast with the expected loss model. While the incurred loss model requires objective evidence of a loss event that has already occurred, the expected loss model mandates the recognition of losses based on anticipated future credit losses over the lifetime of a financial asset, even before a default event takes place.6
The incurred loss model is a "backward-looking" approach, reacting to past events. In contrast, the expected loss model is "forward-looking," requiring entities to use historical information, current conditions, and reasonable and supportable forecasts to estimate potential losses from the moment a loan or financial asset is originated.5
This fundamental difference means that under an expected loss framework, such as the Current Expected Credit Loss (CECL) standard in U.S. GAAP or IFRS 9, financial institutions record valuation allowances for anticipated losses much earlier in the credit cycle. This aims to provide a more realistic and timely view of an entity's credit exposures and strengthen financial stability.
FAQs
What prompted the shift away from the incurred loss model?
The 2008 global financial crisis was a major catalyst. Regulators and stakeholders criticized the incurred loss model for delaying the recognition of credit losses, which made financial statements appear healthier than they were and contributed to the procyclicality of the banking system.4
Which accounting standards replaced the incurred loss model?
In the U.S., the FASB replaced the incurred loss model with the Current Expected Credit Loss (CECL) standard (ASC Topic 326), effective for public business entities that are SEC filers in 2020.3 Internationally, the IASB replaced IAS 39 with IFRS 9, which introduced an Expected Credit Loss (ECL) model, effective January 1, 2018.2
Does the incurred loss model still have any relevance today?
While superseded by expected loss models for most financial instruments, the principles of assessing whether a loss has been "incurred" and can be "reasonably estimated" are still relevant in other areas of accounting for contingencies, particularly under ASC 450-20 for non-credit related loss contingencies, such as litigation or environmental liabilities.1