What is credit loss?

Under the old incurred loss model a loss was recognised only after a loss event, such as a customer defaulting, which masked deterioration in credit quality. AASB 9 (the Australian equivalent of IFRS 9) replaced it with expected credit loss: a probability-weighted estimate of the shortfalls in future cash flows, using forward-looking information such as economic forecasts and industry trends.

The general approach covers most financial instruments and uses three stages. Stage 1 recognises 12-month ECL on performing assets; Stage 2 applies lifetime ECL once credit risk has increased significantly, for which 30 or more days past due is a rebuttable presumption; Stage 3 applies lifetime ECL to credit-impaired assets, for which 90 or more days past due is the rebuttable presumption of default. Either presumption can be rebutted with supportable evidence. The simplified approach, used for trade receivables, contract assets and many lease receivables, recognises lifetime ECL from initial recognition, typically through a provision matrix. Scenarios are weighted and documented, and long-dated shortfalls discounted where material.

On the balance sheet, a rising allowance reduces net receivables, total assets and equity. In the profit and loss, movements in ECL flow through as an impairment or credit loss expense, so provisioning adds volatility to reported profit. Return on assets, return on equity and, for lenders, net interest margin all fall as provisions rise, and debt covenants and regulatory capital measures can be affected.

Because ECL estimates are judgemental and forward-looking, they shape how investors, lenders and regulators read your risk appetite. AASB 7 requires disclosure of impairment policies, a reconciliation of the opening to closing allowance, the inputs used and the sensitivity to key assumptions. APRA supervises deposit-taking institutions and ASIC oversees disclosure by other entities.

Banks and other authorised deposit-taking institutions run granular models segmented by product type, collateral and borrower risk under APRA oversight. Corporates and SMEs usually rely on simpler ageing matrices with portfolio-level PD and LGD estimates. For asset finance and specialised lenders, collateral value volatility and repossession costs drive loss given default, so those assumptions need documenting and sensitivity testing.

Good practice is the same at any size: capture loan-level history, ageing schedules, cure rates and collateral values; document staging decisions, scenario weights and model changes; reconcile the allowance roll-forward (opening balance, charges, write-offs, recoveries, closing balance) to the general ledger; and never rely on historical loss rates alone. For tax, deductions for credit losses in Australia generally arise on realised losses, that is write-offs, not on accounting allowances, so check the ATO's guidance on bad debts with your accountant.