The current expected credit loss model (International Financial Reporting Standard – IFRS 9 or its equivalent in USGAAP, ASU 2016-13), requires the immediate recognition of an estimate for expected credit losses (ECL) during the life of a financial instrument, including accounts receivable, net investments in leases (for lessees with sales-type or direct financing leases) and for certain credit exposures maintained in memorandum accounts. The estimate (i.e., reserve, provision or equivalent) of expected credit losses considers not only historical information but also future events and economic conditions.
This standard, IFRS 9 (later codified as ASC 326 in the US), is current and applicable to all non-profit organizations (NPOs) for reporting periods beginning on or after December 15, 2022. .
I would like to highlight below some of the most relevant aspects of the PCE model that are described in the publication that I quote below, in relation to the financial assets that are most frequently used by NPOs.
Basic principles of PCE (or CECL under USGAAP)
NPOs must recognize the expected credit losses during the life of the instrument (“lifetime credit losses”) for all their instruments that are within the scope of the ECP, recording an estimate (originally in English “allowance”) for credit losses. As a result, the financial statements will normally reflect the net amount expected to be recognized for the assets recognized.
This estimate is measured and recorded on the date of initial recognition of the financial instrument, regardless of whether it is measured, purchased or acquired in a business combination. Prior to the adoption of the ECP, credit loss expense (or what was commonly known as the provision for “doubtful or uncollectible accounts”) was recognized only if it was probable that a credit loss had been incurred. Now, under the PCE model, an estimate is recorded at the time of initial recognition of the asset for all the credit losses that would be expected over the life of that asset.
The ECP model requires that an entity’s estimate of its expected credit losses include a measurement of the assessed risk of expected credit losses even though that risk may be remote. The table below provides a comparison between the current expected credit loss model under ASC 326 and the previous incurred loss model.
Comparison between PCE and previous model of incurred losses
Below is the comparison:
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Previous expected credit loss model |
Incurred loss model |
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Losses are recorded when it is probable that losses will be incurred. |
There is no threshold or limit for recognition, all expected credit losses over the life of the instrument are recorded on day 1, leading to more timely identification and recognition of future losses. |
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If there are no indicators of possible loss, the estimate or reservation is not required. |
The provision or estimate is required to be made even when the risk is remote. |
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Mainly based on historical experience. |
Based on reasonable and documented forecasts regarding total future credit losses, factoring both historical and current data, as well as forecasts about the future. |
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Normally applied to overdue amounts of accounts receivable. |
It must be applied to all balances, including those that are about to expire. |
Principles for Measurement
IFRS 9 (ASC 326-20-30 according to U.S. GAAP) requires a reporting entity to determine the estimate for expected credit losses based on the amortized cost of the financial asset. The amortized cost principle is defined in ASC 326-20-20 as follows:
“The principle of amortized cost is the amount by which a financing receivable or an investment originated or acquired is adjusted for accrued interest, accumulation, or amortization of premiums, discounts, and deferred charges or costs, cash collection, write-offs, foreign currency exchange and fair value hedge accounting adjustments.”
ASC 326-20-30-2 requires a reporting entity to measure expected credit losses based on the aggregate (“pool”) of similar risk characteristics that exist in multiple financial instruments. These sets or aggregates are also called portfolio segments. If a financial instrument does not share similar risk characteristics with other assets subject to the ECP model, its expected credit losses may be measured individually.
The PCE model does not require that a specific model be used to calculate the estimate (reserve or provision, for clarity) for expected credit losses. The selection of a particular method will depend on the facts and circumstances of the entity, including the complexity and importance of the financial instruments being measured, as well as other relevant considerations.
All organizations, including NPOs, will be able to continue to calculate the estimate using their current methodologies, such as their aging analyzes (also called provision matrices), but the factors considered and additional qualitative adjustments will likely change as the principles underlying the definition of a credit loss have changed significantly.
An entity shall develop an estimate of credit losses based on historical information, current conditions, and reasonable and objectively demonstrable forecasts.
An NPO could begin the process of measuring expected credit losses by analyzing its historical experience with credit losses arising from its financial assets with risk characteristics similar to those of the assets measured. However, as explained in ASC 326-20-30-8, this estimate should be adjusted, as necessary, to reflect the extent to which management expects current conditions and reasonable and supported forecasts to differ from conditions that existed. during the period whose historical information was being evaluated and due to differences in the composition of its current portfolio. When evaluating conditions that require adjustments to historical data used to measure credit losses, a reporting entity should consider risk factors relevant to the assets being evaluated. These factors may include data that is specific to the borrower, specific to a group of aggregated assets, relevant to all assets at a macroeconomic level, or some combination of the above.
If an organization or company’s quantitative models and historical data fail to reflect current conditions or reasonable and supported forecasts of such organization or company, these factors must be included using qualitative adjustments so that the estimate is reasonable.
The ECP model requires an organization or company to estimate and recognize an estimate for expected credit losses of a financial instrument, even when the risk of expected credit loss is remote. ASC 326-20 requires an entity to estimate expected credit losses over the life of the instrument. In doing so, a reporting entity is not required, however, to develop economic forecasts for the life of the asset, if such estimates are not reasonable and demonstrable; but rather, the entity may use a combination of economic forecasts and re-evaluate historical experience with losses to arrive at its estimate.
IFRS 9 (ASC 326-20-30-7) requires a reporting organization/company to evaluate both internally generated data and reasonably accessible external data to estimate expected credit losses. However, the rule also states that an entity may well determine that using its internally generated data is sufficient. The estimate should consider all relevant data that is reasonably accessible to an organization/enterprise at the balance sheet date without requiring excessive costs or efforts.
Luis Acosta
Managing Partner
Russell Bedford Peru