How is credit loss calculated?

The correct approach to calculating credit loss is by determining the difference between actual cash flows received and the expected cash flows. This method focuses on the potential losses that could arise from defaults when a borrower fails to meet their obligations.

In a credit loss assessment, an organization typically estimates the expected cash flows based on a variety of factors, such as credit risk, the financial stability of borrowers, the economic environment, and payment history. When actual cash flows fall short of these expectations, a credit loss is recognized, reflecting the reality of the impairment in receivables and other financial assets.

This method allows for a forward-looking assessment, which is a key principle in modern accounting standards, particularly under IFRS 9 and ASC 326, where the emphasis is on estimating future losses rather than solely relying on past performance or historical data.

While other options may involve aspects of credit risk evaluation, they do not capture the essence of what credit loss entails. Fair market value reflects current market conditions rather than expected future cash flows, historical collection data may provide insights but is not directly used for current loss assessments, and applying the original effective interest rate does not address the changes in expected cash flows that could lead to credit loss. Thus, the correct answer is grounded