In business, the financial assets are in the form of cash, equity instruments, trade receivables, loans, and investments in venture funds, mutual funds, and preference shares, investments in commercial papers, T bills, credit-linked notes, market-linked debentures, bank balances and prepaid expenses. The financial liabilities are trade payables, redeemable preference shares, non-convertible debentures, intercompany loans, term loans, working capital overdrafts, deferred revenue, lease liabilities, and financial guarantee contracts. The financial instrument is referred to as an equity instrument if it has no obligation to deliver cash and is under a contract over its shares. The accounting standard 109 deals with the classification of financial assets and liabilities. The business model and contractual cash flow influence the classification of financial assets.
Recently, ICAI released a framework for the calculation of expected credit loss in financial instruments. The blog intrigues the readers with details on credit loss on financial instruments, ECL model and credit risk management in different business models. Credit risk management of banks, financial institutions and trading companies improves the reputation in business dealings. Creditworthiness is the sign of building healthy relationships with trust and documents. Chartered accountants check the tax calculations, financial statements, accounting standards, and risk factors and prepare the auditor report. The specialised knowledge in credit risk management promotes the skills of a chartered accountant.
ECL model:
The ECL framework, based on the publication of ICSI, improves the financial reporting and credit risk management system. ECL framework is not for the loss that happened, it is for recognizing the financial credit losses. The credit losses are adjusted on the reporting date to reflect the expected losses and changes. The three approaches of ECL are the general approach, purchased credit-impaired approach and simplified approach. The general approach is for financial instruments with no significant change in the risk from initial recognition and instruments with substantial credit risk changes. The simplified approach provides the ECL without calculating the credit risk from the initial recognition stage. The purchased credit-impaired approach is for instruments impaired at the recognition stage. The lifetime ECL applies to these financial instruments.
The measurement of ECL does not depend on a single scenario. The ECL calculates the time value of money, outcomes, supportable information and reasonable information. ECL applies to non-financial sectors. The ECL is applicable to trade receivables, lease receivables and contract assets.
Data management, robust governance, and the interest of the stakeholders are the factors that contribute to the successful implementation of the ECL model. The application of the ECL model for credit risk management requires effective compliance with regulatory standards. ICSI publication of the ECL framework provides illustrative cases, real-time examples, and FAQs. The publication helps the entities to implement the ECL model in line with Ind AS 109.
The role of an auditor and credit rating agency:
Credit rating agencies analyse the creditworthiness of individuals and businesses. The credit rating agencies are regulated by SEBI. The credit rating agencies consider many factors for calculation or credit score. The credit rating agencies check the debt type, financial statements, borrowing history, lending capacity, and repayment capacity. The job of an auditor and credit rating agencies differ in their roles and responsibilities. An auditor checks the tax filings, and financial statements, and detects fraud or risk factors. The credit rating agencies check the annual reports and adjust the ratings with re-evaluation. The credit rating shows the ability of the organization to fulfil its obligations.
Credit risk management in different business models:
The five components of credit risk management are risk identification, risk analysis, risk reporting, risk mitigation, and risk governance. Banks design credit strategies like lending standards, and setting the requirement of credit score to the borrowers to manage the credit risks. Credit risk is the risk of losing money due to the payment failure of a borrower. Banks use various techniques like diversification, pricing, mitigation, monitoring and control for credit risk management.
The manufacturing and trading companies also evaluate credit risk to maintain healthy business relationships. In trading companies, the credit risk is involved in trade receivables. One or more parties financing a portfolio of trade receivables fail to meet the financial obligation and end in credit risk.
Organisations select candidates with specialised knowledge:
Candidates in risk management get opportunities in banks, internal audits, system audits, insurance, and analytics. Candidates working in accounting get opportunities in tax audits and internal audits. In companies, the accounts manager also works as a relationship manager. The chief risk officer also takes care of the internal audit process. The risk officer also works as the head of the internal audit. The roles are designed to understand the comprehensive picture of the accounting operations, best practices, risk assessment and monitor performance status.
Risk management is part of the internal audit process. Here the employee’s focus is towards the assessment, findings, and ways to handle risks and meet organisational goals. Auditing is checking the financial statements, tax laws, regulatory practices and accuracy. Auditing is a reactive process. Risk management is a proactive process. Risk management identifies the potential threats to a business. Professional courses like CA and CMA are suitable for an accountant with experience in financial concepts and challenges.
In a world of high competition, specialised knowledge and experience help for professional growth. Identify the areas of strength and weakness. Decide on the specialised expertise. Then, choose the professional course that interests you. RR Academy prepares students for accounting, auditing, and finance jobs. Place an enquiry to understand the latest syllabus of the auditing and accounting professional courses. Learning is the ladder that helps one grow. Auditing, accounts, finance, investment and risk management require the same foundation knowledge. Decide at the right age and enhance specialised expertise to get promoted in the focused job.
Conclusion:
Creditworthiness and proof-based transactions reduce credit risks. By following an efficient credit risk management model organisations can enhance credit quality and profitability.