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Accounting treatment of credit loss allowances amid COVID-19: Current

Expected Credit Loss (CECL) versus IFRS 9 Expected Credit Loss (ECL)

Article · June 2020

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Journal of Applied Research in the Digital Economy (JADE), Special Issue on COVID-19, June 2020

Accounting treatment of credit loss allowances amid

COVID-19: Current Expected Credit Loss (CECL) versus
IFRS 9 Expected Credit Loss (ECL)
DIRK BEERBAUM *

*Department of Accounting, Aalto University School of Business, Helsinki, Finland

Abstract
Shortly before the COVID-19 crisis emerged worldwide accounting standard boards
reformed the accounting requirements for the modeling and the accounting of
credit loss allowances. The Financial Standards Board (FASB) issues new
requirements effective 2020 and the International Accounting Standards Board
(IASB) IFRS 9 becoming effective 2018. The crisis possible evolving from COVID-19
will be the first Locums test for the recent set-up expected credit loss model, which
originally emerged out of another crisis the Global Financial Crisis in 2009. This
article will provide an overview of this new expected credit loss model. This paper
starts with a synopsis and explains main differences of the new credit models. The
main conclusion is that the expected credit loss model although reflecting
management approach the model once implemented must be mandatorily steadily
pursued without change. All available information management is aware must be
incorporated into the model. Therefore, companies cannot increase credit loss
allowance based on prudence principle, but the change of macroeconomic outlook
is a main driver of the credit model.

Keywords: COVID-19, US GAAP, Current Expected Credit Loss (CECL), IFRS 9,

Expected Credit Loss, Risk model

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1. Introduction

IFRS 9 is a game changer and will have significant impact on the European Banking
Industry according to recent literature and market studies (Gea-Carrasco, 2015,
María C. Cañamero, 2016, EY, 2016, Ramirez, 2015, Beerbaum and Piechocki, 2016,
Beerbaum, 2015, Krüger, 2018, Landini, 2018). While IFRS 9 is already had to be
implemented by January 1st, 2018, Current Expected Credit Loss (CECL) issued by
Financial Accounting Standard Boards (FASB) for US GAAP- filers has become
effective by 2020. This is one of the first instances in accounting history that US
GAAP follows IFRS with regard to due date and not vice versa: IFRS 8 Operating
Segments (applicable 2009), Segment Reporting (US GAAP, ASC 280, 2003), IFRS 3
Business Combinations 2008, (US GAAP, ASC 805, 2007), IAS 36 Intangible assets
2004 Goodwill and other intangible assets (US GAAP, ASC 350-20, 2001) were
examples in the past, when IFRS followed US GAAP. The paper develops an IFRS 9
calculation model, which is then applied to the US GAAP CECL requirements.

2. Accounting Standards Update (ASU) No. 2016-13 – the current

expected credit loss model (CECL)

In June 2016, the Financial Accounting Standards Board (FASB) issued

Accounting Standards Update (ASU) No. 2016-13 “Financial Instruments – Credit
Losses (Topic 326) Measurement of Credit Losses on Financial Instruments”, which
introduces a new measurement approach for credit losses for financial assets
measured at amortized cost. ASU 2016-13 also modifies the current impairment
approach for credit losses for financial assets measured at fair value through other
comprehensive income (FVOCI) which is covered by another change document.

This new approach is based on lifetime expected credit losses (ECL),

commonly referred to as the current expected credit loss (CECL) impairment model,
and applies to financial assets measured at amortized cost, including loans, held-to-
maturity debt securities, receivables that relate to repurchase agreements and
securities lending agreements, net investment in leases, and reinsurance and trade
receivables, as well as certain off-balance sheet credit exposures, such as loan
commitments and guarantees. Currently US GAAP requires an “incurred loss”

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methodology for recognizing credit losses that delays recognition until it is

probable a loss has been incurred.

The CECL model requires the measurement of lifetime ECL based on relevant
information about past events, including historical experience, current conditions,
and reasonable and supportable forecasts of future events and circumstances that
affect the collectability of the reported amount. The CECL model is effective
beginning January 1, 2020 (Chae, 2018).

3. IFRS 9 – Expected Credit Loss (ECL)

Whenever new reporting standards are issued by the IASB (International

Accounting Standards Board) that concern the notes to the financial statement, the
disclosures become increasingly relevant. The notes constitute an important source
for the firms’ analysis.

Modifications to previous standards become clear to investors when the new

standards are first used. This is also true for the International Financial Reporting
Standard 9 (IFRS 9), the new measurement standard for financial instruments and
for the latest IFRS 7, which, as a reaction to the financial crisis, changes the
requirements with respect to the notes for financial years from 1 January 2018. One
of the main criticisms of IAS 39 was that it augmented pro-cyclical effects for
financial institutions. According to a study published by Moody’s Analytics, based on
a qualitative questionnaire filled in by international banks in 2015, IFRS 9 will have
significant effects on the provision for loan loss provisions of financial institutions.
Therefore, it will have significant implications for the financial industry.

IFRS 9 replaced the previous IAS 39, as IAS 39 was criticized. We will now examine
the reasons that IAS 39 came under criticism and will be replaced by IFRS 9:
• Complex Framework: a very complex framework of accounting
leading to inconsistent application
• Optionality: various options under IAS 39 imply that
comparability between companies is difficult.

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• Decision Making: for example, in the case of loan loss

provisioning, IAS 39 appeared to not provide the right solution
(“Too late – too little”).
• Not reflective of business activities: accounting outcomes can
appear disconnected from business activities.
IFRS 9 became the answer:
• Simple and comprehensive framework: clear framework of
classification and measurement requirements for financial
instruments
• Reduced Optionality: simpler option based on the purpose of
holding the assets as op-posed to the intention of holding the
individual asset
• Decision Making: reflect the effect of an entity’s risk
management activities in the financial statements with more
principle-based requirements
• Picturing Business activities: reflects how an entity man-ages
its financial instruments and the contractual cash-flow
characteristics of the financial assets.

In July 2014, the IASB issued IFRS “Financial Instruments” (“IFRS 9”). The
standard substitutes IAS 39 “Financial Instruments: Recognition and Measurement”
(“IAS 39”). Summarized IFRS 9 implicates the following significant changes: new
regulations for the classification and measurement of financial assets for firms, the
fair-value accounting of financial liabilities (taking into ac-count credit risk), new
requirements for impairments, and hedge accounting.

IFRS 9 requires that the company’s business model for managing financial
assets and the contractual cash-flow characteristics of the financial asset determine
the classification and measurement of financial assets. Each financial asset is either
classified as “fair value through profit or loss”, “amortized cost” or “fair value
through other comprehensive in-come”. As the rules for the classification differ
from the existing regulations according to IAS 39, it is necessary to analyze all
financial assets regarding a possible re-classification. Dependent on the business

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model’s degree of heterogeneity, changes in the classification and measurement of

financial assets according to IAS 39 are expected.

The impairment regulations according to IFRS 9 concern the financial assets

that are either set as amortized cost or as fair value through other comprehensive
income. Moreover, the new impairment requirements must also be applied to
leasing receivables and off-balance sheet credit commitments such as loan
commitments and financial guaran-tees.

The most extensive changes according to IFRS 9 are induced by the new
impairment model causing a paradigm shift. The existing incurred loss model, in
which credit losses are captured when a triggering event occurs, is replaced by the
expected loss model. In the expected loss model, provisions for credit defaults are
made at the initial recognition of financial assets (or when the credit or guarantee is
first committed) based on the current expectation of potential (future) credit
defaults.

With IFRS 9, the IASB has introduced a two-stage process to deter-mine loan
loss provisions. The first step of the impairment model re-quires that for each
financial asset loan loss provisions are calculated at initial recognition based on
expected credit defaults within 12 months. Before each interim report, the firm
evaluates whether there has been a significant increase in the credit risk: in which
case, the loan loss provisions must reflect the lifetime expected loss. The big four
audit companies have not yet released final comments for IFRS 9, but the authors of
existing literature agree that due to the change of impairment rules, the subjectivity,
when setting loan loss provisions, will increase. The reason for this is that loan loss
provisions are based on future-oriented and probability-weighted information that
are continuously monitored and updated over the full lifetime of the financial asset.
On the contrary, IAS 39 recognizes impairments in the form of loan loss provisions
only after a triggering event of one or several loss events.

It is expected that IFRS 9 will lead to an increase in loan loss provisions. This
conclusion is based on the requirement that provisions for expected losses within
the next 12 months must be adjusted for all instruments, even for those for which
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the credit risk did not significantly increase. This means that contrary to the
incurred loss model of IAS 39, the transactions that must be included in the
provisions increase. Furthermore, it assumes that the holdings of financial assets
that must be considered for the lifetime expected loss are greater than those, for
which the loss event according to IAS 39 already occurred.

4. Synopsis

The main changes between CECL and IFRS 9 is

• CECL scopes out available-for-sale securities while IFRS 9 scopes in financial

assets at Fair Value through Other Comprehensive Income (FVOCI)(Loudis
and Ranish, 2019).

• Both CECL and IFRS 9 are ECL models. However, CECL requires lifetime ECL
be recorded at inception for all financial assets measured at amortized cost,
whereas IFRS 9 requires 12-month ECL be recognized at inception and it is
not until there is a significant increase in credit risk when lifetime ECL are
recognized (Bellini, 2019).

• The time value of money is implicitly present in credit loss methodologies

using amortized cost information for CECL, whereas IFRS 9 requires an
explicit consideration of the time value of money, which means various
methods for ECL estimation can be used under CECL (discounted cash flow,
loss-rate methods, roll-rate methods, probability of default methods or
methods that utilize an aging schedule) while the methods with
consideration of time value of money is required under IFRS 9 (Handorf,
2018).

• IFRS 9 requires the consideration of multiple probability-weighted outcomes

while CECL does not require multiple forward scenarios (Binder, 2019).

• CECL requires consideration of the contractual period for credit exposure,

including prepayment but not extension unless it is related to the borrower's

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unilateral option to extend or reasonably expected Troubled Debt

Restructuring (TDR), while IFRS 9 requires consideration of the maximum
contractual period for credit exposure, including prepayment and extension
(Jordan and Sanchez, 2019).

• CECL requires reversion to historical losses for period beyond reasonable

and supportable forecast, while IFRS 9 does not have specific guidance on
how to estimate ECL for period beyond the reasonable and supportable
period. Different methods may be acceptable including adjusted historical
data or extrapolation of projections for period beyond reasonable and
supportable forecast (Knudson, 2017).

• CECL requires the use of effective interest rate (EIR) as the discount rate
when DCF method is used, while IFRS 9 allows the use of an approximation
of EIR, e.g. contractual interest rate (Breeden, 2017).

• CECL requires collective evaluation of credit losses when similar risk

characteristics (i.e. homogeneous assets) exist. IFRS 9 allows collective
evaluation of credit losses based on shared risk characteristics when such
information is not available on an individual asset basis without undue cost
or effort (Roundtable, 2017).

• CECL requires ECL for unfunded commitments to reflect the full contractual
period over which the company is exposed to credit risk via a present
obligation to extend credit. CECL does not require ECL beyond the
contractual term or beyond the point in which a loan commitment may be
unconditionally cancelled by the issuer. In contrast, for a financial asset that
contains both a loan and an undrawn commitment component (i.e. credit
cards) (Strong, 2016a).

• Differences exist for purchased credit impaired assets (PCI assets) and
originated credit impaired assets (OI assets). IFRS 9 has specific
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requirements for OI assets as well as PCI assets. US GAAP does not contain
provisions for OI assets. There are accounting and presentation differences
in measurement of ECL for PCI assets, i.e. gross-up under CECL while net
presentation under IFRS 9 (Chawla et al., 2016).

• CECL requires the ECL estimation is based on collateral's fair value when
foreclosure is probable, while IFRS 9 always considers collateral in the
probability weighted ECL estimation. In addition, as a practical expedient
CECL permits an estimate of ECL based on the collateral's fair value for
assets with collateral maintenance provision, e.g. reverse repos or for assets
that are collateral-dependent (Closs, 2016).

• US GAAP continues to permit the application of nonaccrual practices,

whereas IFRS 9 continues to preclude the use of nonaccrual practices. IFRS 9
requires to unwind interest even if a financial asset is in default and in Stage
3 (Dunn, 2016).

• US GAAP continues to treat a concession provided to a troubled borrower to

be a continuation of the original lending agreement. The concept of a
troubled debt restructuring (TDR) does not exist in IFRS 9 (Van
Doorsselaere, 2016).

• Both CECL and IFRS 9 requires disclosing a reconciliation of the financial

assets relating to the allowance for credit losses from the opening balance to
the closing balance. However, IFRS 9 additionally requires explanations of
how significant changes in the gross carrying amounts of financial assets
during the period contributed to the changes in the allowance for credit
losses, i.e. changes because of financial instruments originated or acquired,
changes arising from the measurement of ECL moving 12-month to lifetime
(or vice versa), modification of contractual cash flows, and write-off (Strong,
2016b).

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Journal of Applied Research in the Digital Economy (JADE), Special Issue on COVID-19, June 2020

• Based on PwC guidance "Contrasting the New US GAAP and IFRS Credit
Impairment Models" states on page 6 "Neither framework requires the use of
a specific methodology for the measurement of the allowance for expected
credit losses. However, the IFRS definition of credit loss explicitly requires
considerations of the time value of money in the measurement of the
allowance. Although the FASB permits methods of estimating credit losses
that include the impact of the time value of money, it is not mandated.
Therefore, the CECL model allows greater flexibility in the measurement of
expected credit loss for amortized cost assets than IFRS 9." (PwC, 2017)

• As discussed below, while there are several differences in lifetime ECL under
CECL and IFRS 9, because both the principle-based CECL and IFRS 9 models
allow for greater flexibility in the measurement of ECL, certain differences
can be resolved by making consistent policy choices between the two
frameworks (Reosti, 2017).

5. Summary

Both CECL and IFRS 9 follow an expected credit loss model, which
incorporated forward looking information. A main difference is that CECL requires
to set the Lifetime expected Loss while IFRS 9 pursues a two stage approach,
starting with a 12 month Expected Loss calculation and if a significant credit
deterioration occurred to account for the Lifetime Expected Credit Loss. Both
Expected Credit Loss Models incorporate forward looking information, which are
dependent upon macroeconomic variables. The main assumption followed by the
Standard boards is to overcome the criticism that credit loss allowance was to low
and too late. The current COVID-19 crisis is therefore a first Locums test if the
objectives could be achieved. The expectation is that banks would be better
prepared for a credit crisis, as they would already need to quickly increase anti-
cyclically credit loss allowance before the default rates increase due to the expected
credit loss concept, which anticipates future losses with current higher credit loss
allowance as kind of reserves.

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