Impairment and expected credit loss (ECL) are accounting terms used to describe reduction in value of an asset. Some industries, such as banking, are especially sensitive to impairment and ECL. The intention of this article is to explain concept of these two terms in simplified way, so that even if you are not accountant, you are able to interpret the financial reports correctly.
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What is impairment loss?
All assets, including intangible assets such as good will, have a carrying amount (i.e. book value) recorded in financial reports. If market value of these assets drop below book value due to unforeseen circumstances, company must adjust value of these assets in balance sheet of financial report. In addition, the decrease of asset value must be recognized as loss in income statement, this loss is what we call “impairment loss”.
As you can imagine, impairment loss is a non-cash item. The capital used to purchase the asset has been paid before. This is why in cash flow statement, you can see impairment loss added back into operating cash flow.
Let’s take a property investment as an example. You bought a house for $500,000 with a home loan. Due to unforeseen reason, market value of your house dropped to $400,000. In this case, you suffered an impairment loss of $100,000. But do you need to actually fork out $100,000 at this point of time? No, the loss is an non-cash item. But you still need to continue to service the debt based on initial loan amount. Your loss will be slowly paid off as you service your loan. Same concept applies to company.
Here I’m giving four typical examples on how impairment loss occurs for companies.
Example 1: Impairment loss on trade receivable
It is common when a company sells goods or service, the customer will only pay after a period of time called “credit term”. The amount owed by customers are recorded in financial reports as “trade receivable”. Because customers do not pay immediately, there is a risk of customer not paying after receipt of the goods or service. This longer is the customer not paying after expiry of credit term, the bigger is the probability of customer not paying.
Trade receivable is an asset of company. If customer decides not to pay or if customer decides to only pay partially, the value of trade receivable reduces therefore in this case company has to record an impairment loss on trade receivable.
Example 2: Impairment loss on plant, property and equipment
A good example is impairment taken by oil and gas companies since oil price crash in 2014.
Before year 2014, many oil and gas companies invested heavily in plant and equipment. Based on the oil price before the crash, these investments were expected to make a decent return. However, the projected return from these assets took a huge toll from the oil price crash. As a result, these assets were not valuable as initially planned and an impairment loss has to be recognized.
Example 3: Impairment loss on goodwill
When company A acquires company B, company A decides to pay additional $100,000 than value of assets recorded in financial report of B. This is because company A believes acquisition of B can bring value of more than $100,000. In this case, the additional amount of $100,000 paid needs to be recorded as an asset called “goodwill” after acquisition.
However after a period of time, it turns out that company A made a wrong judgement and the acquisition could only bring additional value of $80,000 to company. In this case, $20,000 impairment on goodwill has to be taken.
Example 4: Impairment loss on loans
Compared to other businesses which impairment is normally due to unforeseen events, banking have impairment as part of their normal business. Banks consistently record impairment to account for borrowers that are not paying for their loans. Total amount of loans falling under impairment is called “gross impaired loan (GIL)”, and it is an important metric to evaluate credit control quality of a bank.
What is expected credit loss (ECL)?
Before financial crisis in 2008, impairment was only recognized as loss event occurred. Following the crisis, it was deemed that entities should book loss associated with expected impairment in the future. Expected credit loss (ECL) is the term used to describe this forward-looking impairment.
Concept of expected credit loss started implementation following adoption of new accounting standard IFRS 9 (or MFRS 9 in case of Malaysia) in 2018.
Extended reading of my other article: MFRS update summary
Note that ECL is only related to financial instruments, i.e. contractual obligation that involves right to receive cash flow in future, such as trade receivable, loan receivable and lease receivable.
There are two methods to account for ECL, simplified approach and general model.
ECL simplified approach
Simplified approach is used for items that do not involve significant financing component, such as trade receivable. With this approach, company is only required to recognize a life time expected credit loss over the financial asset.
For instance, company A looks into their past records to work out a matrix on default rate based on number of days due past credit term.
- Non-past due: 0.3%
- 30 days past due: 1.6%
- 31-60 days past due: 3.6%
- 61-90 days past due: 6.6%
- more than 90 days past due; 10.6%
So based on matrix above, company can work out lifetime ECL to book a loss in financial report.
Note: The example above is taken from PWC’s paper. If you are interested, click here will bring you to the original resource from PWC’s website.
ECL general model
This model is more sophisticated, and it is used by financial institutions such as banks.
General model splits expected credit loss into three stages.
| Time of recognition | Loan status | ECL basis | Interest income recognition | |
| Stage 1 | Initial recognition | Performing loan | 12 months ECL | Gross loan amount |
| Stage 2 | Significant increase in credit risk | Under-performing loan | Lifetime ECL | Gross loan amount |
| Stage 3 | Objective evidence of impairment | Non-performing loan | Lifetime ECL | Net loan amount |
| Write-off | At discretion of management | Non-performing loan | None. Loan amount is removed from book and recognized as loss | None |
Example: Bank A has a loan offered to customer with loan amount of $100,000 and effective interest rate of 5%.
Stage 1: During initial recognition, Bank A determins that this loan has a 1% probability of default in the next 12 months. Therefore, impairment loss calculated based on 12-month ECL is $100,000 x 0.01 = $1,000. Interest revenue = $100,000 x 0.05 = $5,000.
Stage 2: For instance, the customer is an oil and gas company and impacted badly by oil price crash. Bank A recognizes that credit risk has increased and determines that this loan now has a default probability of 15%. Therefore, impairment loss calculated based on lifetime ECL becomes $100,000 x 0.15 = $15,000. Interest revenue remains unchanged = $100,000 x 0.05 = $5,000.
Stage 3: Customer has now missed loan repayment for 3 months so Bank determines that this becomes a non-performing loan with default probability of 30%. Therefore, impairment loss calculated based on lifetime ECL becomes $100,000 x 0.30 = $30,000. Interest revenue is now based on net loan amount = $100,000 x 0.70 x 0.05 = $3,500.
Write off: Bank A decided that it would not spend more time to recover the loan from borrower. So all the outstanding loan amount will be removed from financial record and booked as loss
(Note: Example above is simplified to illustrate the concept. The actual calculation is much more complicated to factor in time value of money, timing of payments, bad debt recovery rate etc. If you are interested to learn the detailed calculation, the excel file I found online here might be useful for you)