Continuous Improvement in Valuation Practices at Valtech – ECL

Continuous improvement in ECL Valuation Practices

To achieve continuous improvement, Valtech is committed to identifying better methodologies and more relevant data sources to enhance the valuation process, particularly in response to evolving regulatory expectations. In our approach to estimating expected credit losses (ECL), we have adopted more direct and specific data sources to better align the credit risk profile of the underlying entities with the estimation of default rates.

We have identified two key areas of improvement:

1. Enhanced Credit Rating Estimation Using Market-Relevant Data

Traditionally, financial metrics such as debt/EBITDA, interest coverage ratio, and operating margin are used as proxies for estimating credit ratings. Many practitioners rely on aggregated financial ratios by rating category as published in research from leading credit rating agencies such as Moody’s, S&P, and Fitch. However, a major limitation of this approach is that the data sets are heavily skewed toward US-based issuers.

Regulators and auditors have increasingly emphasized the importance of market-specific relevance in credit assessments. In response, Valtech has incorporated alternative methodologies that draw on data from more representative capital markets. For instance, when assessing an issuer in mainland China, we now reference the financial metrics of Hong Kong and PRC-based issuers with external credit ratings to derive a more regionally relevant credit score.

2. Justifiable and Transparent Forward-Looking Adjustments under IFRS 9

IFRS 9 requires the incorporation of forward-looking information in the estimation of expected credit losses. Feedback from regulators and auditors has indicated that while forward-looking adjustments are often applied, the rationale behind these adjustments is frequently unclear or unsupported by meaningful correlation with the debtor’s actual credit risk.

For example, a common issue is the use of credit default swap (CDS) spreads from sovereign bonds or large issuers without establishing a credible link to the subject issuer’s credit profile, which is a small to medium sized private company. Challenges include:

1. Translating CDS data into quantitative adjustments for historical default rates, and
2. Determining whether the CDS reference entities (e.g., sovereign or large corporations) are truly reflective of the credit environment of the subject entity.

IFRS 9 guidance states:

“This comprehensive credit risk information must incorporate not only past due information but also all relevant credit information, including forward-looking macroeconomic information, in order to approximate the result of recognising lifetime expected credit losses when there has been a significant increase in credit risk since initial recognition on an individual instrument level.”

Forward-looking macroeconomic information includes key indicators such as GDP growth, inflation, unemployment, and interest rates, which provide insights into the overall economic environment.

At Valtech, we recognize that there is no one-size-fits-all approach. Establishing a transparent and logical link between macroeconomic forecasts and credit risk assumptions is crucial and strongly favored by regulators.

For example, when evaluating the credit risk of accounts receivable from a provincial or state government, it may be more appropriate to analyze forecasted fiscal budgets and projected changes in net debt levels at state or provincial level, rather than relying solely on the country’s sovereign credit rating.

Valtech Valuation is a professional valuation firm accredited with ISO-9001 in valuation advisory services. The firm is renowned for its expertise in advanced valuation techniques, customized valuation models, data-driven insights, and adherence to compliance and reporting standards. The firm has a solid track record in valuation advisory for listed companies, private equity, fund managers, and financial institutions. Valtech’s qualified team comprises members with PhDs, CPA (HKICPA), CFA, Chartered Valuation Surveyors of the Royal Institution of Chartered Surveyors, and valuers accredited with Business Valuation (ABV) by AICPA and CVA qualifications in Singapore. Valtech continues to expand into more markets by leveraging its valuation platform and recruiting local experts.