Measurement of Expected Credit loss, part 2

In our previous article, measurement of expected credit loss, we discussed the components of expected credit. With the application of IFRS 9, credit losses are measured based on 12 months’ expected credit loss and lifetime expected credit loss of the financial instrument.

So, what’s 12 months expected credit loss?

The objective of IFRS 9 is to provide guidelines for the financial reporting of financial assets and financial liabilities to enable users to assess the amount, timing and uncertainty of an entity’s future cash flows.

It was January 2011, the climax of presidential elections amidst rising prices for household commodities especially sugar. The price shot up to Ugx8000! I saw chaos in our village. I come from the Mid-Western region, Hoima District, a region where tobacco was the cash cow of the area at the time. You probably have heard about Hoima District because of the oil deposits. Much as tobacco was the thing in our village, my grandmother never picked interest in the cash crop. Instead, she ventured into the retail shop business to tap into the money of the tobacco farmers.

With a well-established commercial building at Munteme Trading Centre, the two tobacco companies set up their offices on my grandmother’s building. My grandmother’s shop was strategically positioned with tobacco company offices on either side of the shop.

Farmers would get items on credit from our shop. As an experienced business lady, my grandmother always told me to be mindful of the debtors. Little did I know that she would make provisions on the receivables. For this particular season, the two tobacco companies took longer to pay the farmers.

One evening, I returned from school. In a low tone, my grandmother whispered, “my grandson, we need to talk.”

“As you can notice, the shop is not doing good. We have cashflow challenges. Most of the debtors especially tobacco farmers are likely not to pay in the next three months. Already, we have debtors from the previous season, said my grandmother.”

Luck enough, we had made savings and therefore business normalized. Had my grandmother not planned well, I am pretty sure she would have closed shop in 2011. I am lucky that she is still operating today! That’s what IFRS 9 expected credit loss is about. Debtors not paying within the next three months gives us the 12 months expected credit while debtors over a year give us the lifetime expected credit loss.

Consider example 1.

On 31 December 2010, SACCO A lends a tobacco farmer (Byaruhanga) Ugx100,000. Byaruhanga B will repay the loan in 5 annual equal installments amounting to Ugx25,000 (i.e. Ugx125,000 in total). Calculation of ECL will be based on PD/LGD/EAD model:

PD – the probability of default (assessed by SACCO A)EAD – exposure at default (amortized cost of the loan)
LGD – loss given default (i.e. what % of EAD will not be recovered at default)

The calculation of both the 12 months ECL and lifetime ECL is illustrated in the Excel format. Click here to download.

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