Fundamentals of credit risk disclosures and reporting

Credit risk happens when one party to a financial instrument will cause a financial loss for the other by failing to discharge an obligation.

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

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

Every organisation manages credit risk to varying degrees. For example, every organisation maintains a bank account and, therefore, assesses the credit risk on its bank balance, which is the ability of their bank to provide deposited funds when requested.

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

From a stakeholder perspective, credit risk disclosures are critical to understanding an organisation's financial position and performance because of the insight provided on the quality of the assets and liabilities held on the balance sheet.

Therefore, organisations should recognise the great disservice to their stakeholders and themselves by failing to accord these disclosures the diligence and care to make them relevant to stakeholders. Every credit risk disclosure or reporting should achieve three objectives at a minimum.

It should provide information on (1) an organisation's credit risk management practices and how this impacts the recognition and measurement of expected credit losses, (2) the amount and basis of expected credit losses and (3) the organisations' credit risk profile.

These objectives are satisfied using a mix of both quantitative and qualitative disclosures. Some of the relevant information that enables stakeholders to evaluate the credit risk arising from the financial instruments held by an organisation involves the following.

Information on credit risk management practices includes:

How an organisation monitors and measures increases in credit risk relative to when the asset was initially acquired or recognised by the group.

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

Information on the amounts arising from expected credit losses includes the changes in the expected credit loss amounts and the reasons for these changes for each class of financial instruments.

Organisations should also consider information that enables stakeholders to understand the effect of collateral and other credit enhancements on the amounts of expected credit losses.

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

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

Loan commitments

Information on the credit profile of an organisation should include details on significant credit risk concentrations, credit risk rating grades for each financial instrument exposed to credit risk, including off-balance sheet arrangements such as loan commitments.

Also, organisations should provide information on their policies for disposing of or employing repossessed collateral.

In light of their circumstances, organisations should decide on the level of detail to satisfy the credit risk disclosure requirements in IFRS 7.

However, it is necessary to strike an information balance between excessive detail and obscuring critical information resulting from too much aggregation.

Organisations would increase the confidence placed by stakeholders in them by preparing tailored and relevant credit risk disclosures and reporting.

Awodumila, Associate Director at PwC Kenya and an author who writes and speaks widely on corporate reporting topics