Credit risk

Fundamentals of Credit Risk Disclosure and Reporting

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Fundamentals of Credit Risk Disclosure and Reporting


Summary

  • Under IFRS, the expected credit loss method is used to determine estimates of credit losses arising from the risk of credit default.
  • From a stakeholder perspective, credit risk information is critical to understanding an organization’s financial condition and performance because of the information provided on the quality of assets and liabilities held on the balance sheet.

Credit risk arises when one party to a financial instrument will cause financial loss to the other by failing to perform an obligation.

A simple example is the risk of loss to a lender resulting from a borrower’s failure to repay a loan or meet its contractual obligations.

For the lender, this loan is a financial asset. Some financial instruments are recognized on the balance sheet while others are not.

Every organization manages credit risk to varying degrees. For example, every organization has a bank account and therefore assesses the credit risk on its bank balance, i.e. the ability of its bank to provide deposited funds on demand.

Under IFRS, the expected credit loss method is used to determine estimates of credit losses arising from the risk of credit default. IFRS 7 is the global financial reporting standard on credit risk disclosures for financial instruments.

From a stakeholder perspective, credit risk information is critical to understanding an organization’s financial condition and performance because of the information provided on the quality of assets and liabilities held on the balance sheet.

Therefore, organizations should recognize the great harm done to their stakeholders and themselves by failing to give such disclosures the due diligence and care necessary to make them relevant to stakeholders. Each credit risk disclosure or report must achieve at least three objectives.

It should provide information about (1) an organization’s credit risk management practices and their impact on the recognition and measurement of expected credit losses, (2) the amount and basis of expected credit losses and (3) the organization’s credit risk profile.

These objectives are met using a combination of quantitative and qualitative information. Some of the relevant information that enables stakeholders to assess the credit risk arising from financial instruments held by an organization involves the following.

Information on credit risk management practices includes:

How an organization monitors and measures increases in credit risk relative to when the asset was originally acquired or recognized by the group.

The organization’s internal policies and their basis regarding the definition of a credit default, grouping of financial instruments, write-offs, modifications, determination of impaired financial assets and more.

Disclosures of amounts arising from expected credit losses include changes in expected credit loss amounts and the reasons for those changes for each class of financial instruments.

Organizations should also consider disclosures that allow stakeholders to understand the effect of collateral and other credit enhancements on expected credit loss amounts.

It includes the maximum credit risk exposure for each financial instrument, description of the collateral held as collateral, quantitative collateral information and other credit enhancements.

In addition, organizations should provide information on the contractual amount outstanding on written-off financial assets.

Loan commitments

An organization’s credit profile information should include details of significant concentrations of credit risk, credit risk ratings for each financial instrument exposed to credit risk, including off-balance sheet arrangements such as covenants loan.

In addition, organizations should provide information on their policies for the assignment or use of repossessed collateral.

In light of their circumstances, organizations must decide on the level of detail to meet the credit risk disclosure requirements of IFRS 7.

However, there is a need to strike a balance between excessively detailed information and the obfuscation of critical information resulting from too much aggregation.

Organizations would increase the trust placed in them by stakeholders by preparing appropriate and relevant credit risk information and reports.

Awodumila, Managing Partner at PwC Kenya and author who writes and speaks widely on corporate reporting topics