Trade Receivables and Expected Credit Losses

Chandra Mohan [Managing Director]
Founder / Senior Audit Partner / FCA [Singapore] / FCCA / CPA / MBA
Published 08 November 2024

Introduction:

As an accountant, bookkeeper or financial decision-maker in a small company in Singapore, understanding how to manage Expected Credit Loss (ECL) on trade debtors is crucial for maintaining accurate financial records and ensuring financial stability. This general guide explores what ECL is, the reasons for its implementation under Financial Reporting Standard [‘FRS’] 109, how it differs from previous methods, and provides detailed guidance on managing trade receivables effectively.

What is Expected Credit Loss (ECL) and why is it important?

Expected Credit Loss (ECL) is a forward-looking approach to estimating potential credit losses on financial assets, such as trade receivables. Under FRS 109, companies are required to recognize credit losses at the time of asset recognition, considering past events, current conditions, and future economic forecasts. This anticipatory model enhances financial reporting accuracy and decision-making by recognizing potential losses earlier.

Understanding the Implementation of ECL under FRS 109 and Its Differences from the Incurred Loss Model

The Expected Credit Loss (ECL) model was implemented under FRS 109 to overcome the limitations of the incurred loss model, which only recognized credit losses when there was clear evidence of impairment. This often resulted in delayed acknowledgment of losses, potentially leading to financial instability during economic downturns. By adopting the ECL model, companies can present a more accurate picture of their financial health and enhance their preparedness for future uncertainties, especially in volatile markets.

In contrast to the incurred loss model, which delayed the recognition of credit losses until impairment was realized, the Expected Credit Loss (ECL) model under Singapore FRS 109 ensures timely and sufficient provisioning for anticipated credit losses. This transition improves the precision and reliability of financial statements, making it particularly crucial during financial crises.

Reasons Why Small Companies Provide Credit:

Small companies often choose to offer credit terms to customers for several strategic reasons:

• Increased Sales: Credit terms make products or services more accessible, boosting sales.
• Competitive Advantage: In competitive markets, providing credit can help attract and retain customers.
• Customer Loyalty: Extending credit strengthens relationships with customers and encourages repeat purchases.

Disadvantages of Providing Credit Terms:

While there are clear benefits, small businesses must be aware of potential drawbacks:

• Risk of Bad Debts: Customers may default on payments, resulting in bad debts.
• Cash Flow Strain: Delayed payments can negatively impact cash flow and working capital.
• Administrative Complexity: Managing credit accounts requires additional time and resources.

How Can Small Companies Check if Customers Can Pay Them Back?

When small businesses want to give customers credit (which means letting them buy now and pay later), it’s important to make sure these customers can actually pay back what they owe. This helps protect the business from losing money. Here are some important things to look at when checking if a customer is trustworthy with credit:

• Credit History and Scores: This is like a report card for how well someone has paid their bills in the past. A good credit score usually means they pay on time.
• Financial Statements and Ratios: Businesses should request the customer’s financial statements, which include important documents like income statements and balance sheets. These documents show how much money the customer makes, how much they spend, and how much debt they have. By comparing these numbers, businesses can understand if the customer is in good financial shape. This analysis helps them make informed decisions about extending credit.
• Character and Reputation: This means checking what others say about the customer. If they’re known for paying their bills and being honest, that’s a good sign.
• Deposits: Sometimes, customers can give a deposit (which is a sum of money paid upfront) to show they are serious about paying back the rest later. This makes it safer for the business to extend credit.
• Current Economic and Market Conditions: It’s also important to consider what’s happening in the economy. If the economy is struggling, people may have a harder time paying their debts.

Thorough credit assessments help identify reliable, low-risk customers. Companies should establish clear credit policies and procedures to guide these evaluations.

Strategies to Manage Trade Debtors:

Effective management of trade debtors is critical for maintaining healthy cash flow. Best practices include:

• Offering Early Payment Discounts: Incentivize timely payments.
• Setting Clear Payment Terms: Define and enforce payment expectations consistently.
• Automating Invoicing and collection Processes: Streamline procedures to reduce errors and improve efficiency.
• Monitoring Accounts Regularly: Follow up promptly on late payments.

What are the approaches for recognizing and measuring ECL under FRS 109?

There are two main approaches:

• The General Approach: under Singapore FRS 109 is suitable for debt securities, intercompany loans, trade debtors, and financial guarantee contracts. It involves recognizing Expected Credit Losses (ECL) in two stages: the 12-month ECL and the lifetime ECL.

The 12-month Expected Credit Loss (ECL) is not applicable to all debtors universally. Under Singapore FRS 109, the 12-month ECL is specifically relevant for financial assets that have not experienced a significant increase in credit risk since their initial recognition. This means that for trade debtors and other financial assets, if there is no significant deterioration in credit quality, the 12-month ECL approach can be applied. However, if there has been a significant increase in credit risk, the lifetime ECL must be recognized instead.

• The Simplified Approach: Ideal for trade receivables and contract assets without significant financing components. Companies recognize a loss allowance equivalent to the lifetime ECL without assessing credit risk changes, simplifying the process.

Important Note: Companies can select either the general or simplified approach but must apply their chosen method consistently throughout their reporting periods.

Estimating ECL for Trade Receivables Using the Simplified Approach under provision matrix:

For small companies using the simplified approach to estimate Expected Credit Loss (ECL) for trade receivables, the following steps are typically involved:

1. Determine Appropriate Groupings of Trade Receivables Balance: Group trade receivables based on similar credit risk characteristics. This could include factors such as geographic location, industry, or customer credit ratings.
2. Determine the Historical Loss Rate: Analyze historical credit loss data to establish a baseline loss rate. This involves reviewing past records to understand the average rate at which receivables have typically been written off as bad debts.
3. Consider the Impact of Forward-Looking Information and Probability-Weighted Outcomes: Incorporate forward-looking information, such as economic forecasts and industry trends, to adjust the historical loss rate. This ensures that the ECL estimate reflects expected future conditions.
4. Calculate Estimated ECL by Group: Use the determined loss rate and groupings to calculate the lifetime ECL for each category of receivables. This calculation should be updated regularly to reflect any changes in conditions or company policy.

Remember: The key advantage of the simplified approach for small companies is its practicality and reduced complexity in implementation. While it may result in earlier recognition of losses compared to the general approach, it saves significant time and resources in monitoring credit risk changes.

Exploring Advanced ECL Methodologies: Resources for In-Depth Understanding

For those seeking more detailed methodologies or examples, numerous accounting firms provide comprehensive write-ups and guidance on computing ECL available online. These resources can offer additional insights into industry best practices and advanced calculation techniques.

Effective Strategies to Reduce ECL for Small Companies

Step 1: Set Clear Payment Terms

Start by clearly defining your payment terms. This means you should have specific deadlines for payments and make sure your customers know when and how to pay. Putting these terms in writing and getting customers to agree helps create a strong base for managing what they owe you.

Step 2: Use Automation

Take advantage of modern banking tools and accounting software to automate your invoicing and collection processes. Use software that allows you to raise invoices, send them electronically to debtors, and receive acknowledgments of receipt. This ensures that debtors are reminded of their due dates effectively. Encourage them to pay using electronic methods, such as online banking or giro, to make transactions easier and faster. This approach saves time and reduces mistakes, streamlining your overall financial management.

Step 3: Keep a Close Eye on Payments

Make it a priority to monitor accounts regularly. Track payments closely and follow up right away if a payment is late. For debts that are over 90 days old, start formal recovery actions, like sending written demands or using debt collection services. Consistency is important – stay in touch with customers and apply your collection policies fairly. This proactive approach helps stop small delays from turning into bigger problems.

Step 4: Set Up Allowances for Old Debts

Create specific allowances for debts that are over, say, 180 days old. This helps protect your year-end receivables and keeps your financial statements healthy. Regularly review aging reports to stay aware of potential risks.

The Result: When you make these four steps a regular part of your business, you’ll find that adjustments for expected credit losses (ECL) become minimal or unnecessary. Success comes from being proactive in managing credit rather than just reacting to payment problems.

What’s Another Way to Avoid ECL Calculations?

Here’s a simpler alternative for small businesses: Consider adopting the Singapore Financial Reporting Standard for Small Entities (SFRS for Small Entities). Under this standard, you’ll use the incurred loss model, which is much simpler than ECL calculations.

The key difference? You only need to recognize credit losses when there’s clear evidence of impairment – no need for complex forward-looking calculations.

This approach is especially beneficial because:

• It’s more straightforward than ECL
• You only record losses when they’re actually evident
• It reduces accounting complexity
• It’s specifically designed for small businesses

Think of it as a practical alternative that still maintains accurate financial reporting while saving you time and resources. Many small businesses find this approach more manageable for their day-to-day operations.

Need Help Managing Your Credit Losses? We’re Here to Support You!

Our experienced team can assist you with both ECL management and SFRS for Small Entities adoption. Here’s how we can help:

Setup & Implementation

• Set up accounting software
• Set up chart of account and primary statements
• Set up automated invoicing and email reminders
• Set up monthly statements to debtors

Ongoing Support

• Regular review of debtors, creditors aging list, bank reconciliations
• Training for your staff on invoicing and bookkeeping
• Backup support for your accounting team
• Advisory on complex accounting situations and Year-end closing matters
• Preparation of financial statements for stakeholders
• Preparation of tax computation and submission

Strategic Guidance

• Help you choose between SFRS and SFRS for Small Entities
• Assist with transition to your preferred standard
• Provide ongoing compliance support
• Offer Assurance and other related services

Common Questions We Address:

1. “Which approach is better for my business – FRS or SFRS for Small Entities?”
2. “How can I automate my credit control process?”
3. “What software solutions would work best for my business?”
4. “Can you help train my staff on accounting software and functions?”
5. “How do I set up an effective credit monitoring system?”

For a free consultation on how we can assist you in accounting for ECL and other related matters, please contact us at +65 9144 1840 or email accounts_1@scmohan.com.sg or office@scmohan.com.sg. Let us help streamline your credit management process!

Disclaimer

The information in this blog is for general informational purposes only and does not constitute professional advice. While we make every effort to ensure accuracy, we recommend seeking professional guidance before making any business decisions. The opinions expressed are those of the writer, and specific circumstances may vary. For technical implementation of ECL or SFRS for Small Entities, please consult qualified accounting professionals.