Expected Credit Loss Calculations Laura Fallon lfallon@arlingclose.com

ECLs or ‘Expected Credit Losses’, also known as ‘impairments’ were brought in for local authorities in April 2018 under the new IFRS 9 Accounting Standard applying to financial instruments. This brought about a change in how you accounted for financial instruments where you have a contractual right to receive payments of principal and interest, such as loans, bonds and deposits. Under the previous regime no loss could be recognised up front until something bad (such as a default) had actually happened. This was criticised for, amongst other things, causing the 2008 global financial crisis (don’t let anyone tell you that accountants don’t matter!). The accounting treatment meant that if you were a bank lending to hundreds or thousands of individuals you could account for all the interest income straight away, but could not account for the fact that some individuals will inevitably default until this actually happened. This incentivised risk taking: lend to higher risk individuals, get more income now from higher interest payments but no extra costs until the future when it may be someone else’s problem. 

The requirement to make ECLs was brought in to help fix this. It is based on the notion that no loan is risk free. At the point in time when you either lend someone money, or contractually agree to lend them money (known as a ‘commitment’) there is some probability that you may lose some (or at worst all) of that money. A loan being secured on something, for example property, does not mean that there is zero risk of losing money. The fact that there has not historically been a default also does not mean that there is zero risk of losing money. Unless it can clearly be demonstrated to not be material, or it is a loan to central or local government where there is a specific exemption in place, an ECL will be required for every loan or deposit made.  

There is more than one way to calculate an ECL and the accounting standard does not specify an exact method. Commonly the ECL is based on how likely a counterparty is to default and, in the event of a default, how much of the original amount due would be received and how late. Even if 100% of monies are eventually recovered this would be considered a cost due to the time value of money. Where a loan is contractually committed but not actually made the ECL will also involve a judgement on the likelihood of money being lent.  

Almost all local authorities make ‘loans’ as part of ordinary day to day treasury management, a common example being bank deposits. Normally treasury management investments are with large, well established and credit rated institutions making it more straight forward to get an estimate for how likely they are to default and what subsequent loss could be expected. When local authorities make loans for service or commercial reasons estimating an ECL is often much less straight forward. Common examples are loans to local sports clubs, subsidiary companies, property companies, local businesses or charities. These institutions usually do not have a credit rating and may be small and newly formed. This can make forming judgements as to the likelihood of default and loss given default difficult.  

ECLs for service or commercial loans are also typically going to be larger than for loans for treasury purposes. These loans are almost always inherently riskier than investments made under a ‘security, liquidity, then yield’ treasury mandate. Smaller, newly formed entities are riskier than large, well-established ones. If a local authority is lending to an organisation because no-one else will, or to provide something that the market generally does not provide, this may also be because the organisation is considered to be high risk.  

Currently any loans that are for purposes that would be considered capital expenditure are required to be capitalised by the local authority. Under practice for capital assets in local authorities, ECLs for these loans are not considered a true charge to the council taxpayer. For many loans this means that the ECL charge has no budgetary impact. This may well change under new Minimum Revenue Provision legislation proposed (but not yet finalised) in England. This is likely to require MRP to be made at least equal to the ECL charge. If brought in, we can expect greater emphasis on the ECL calculation and greater scrutiny of it by auditors going forward.  

If this all sounds a bit scary then fortunately Arlingclose are here to help! We have many years of experience in calculating ECLs for a wide range of local authority investments. Our tried and tested models enable us to form a reasoned and consistently applied judgement as to how likely a borrower is to default and what impact a default would have on expected future cash flows. We are thus able to calculate an ECL that should stand up to audit scrutiny. We are also able to calculate the associated fair value for any loan or investment, which will also be required for the year end accounts.  

For more information on how Arlingclose can assist with ECL calculations please contact Laura Fallon on lfallon@arlingclose.com or 07702 788303.

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