Under IFRS 9, Financial Instruments, banks will have to estimate the present value of expected credit losses in a way that reflects not only past events but also current and prospective economic conditions. Clearly, complying with the 160-page standard will require advanced financial modeling skills. We’ll have much more to say about the modeling challenges in upcoming posts. For now, let’s consider the issues involved in classifying financial assets and liabilities.
The standard introduces a principles-based classification scheme that will require banks to look at financial instruments in a new way. Derivative assets are classified as “fair value through profit and loss” (FVTPL), but other financial assets have to be sorted according to their individual contractual cash flow characteristics and the business model under which they are held. Figure 1 summarizes the classification process for debt instruments. There are similar decisions to be made for equities.
The initial classification of financial liabilities is, if anything, more important because they cannot be reclassified. Figure 2 summarizes the simplest case.
That’s only the first step. Once all the bank’s financial assets have been classified they have to be sorted into stages reflecting their exposure to credit loss:
- Stage 1 assets are performing
- Stage 2 assets are underperforming (that is, there has been a significant increase in their credit risk since the time they were originally recognized)
- Stage 3 assets are non-performing and therefore impaired
These crucial determinations have direct consequences for the period over which expected credit losses are estimated and the way in which effective interest is calculated. Mistakes in staging can have a very substantial impact on the bank’s credit loss provisions.
In addition to the professional judgment that any principles-based regulation or accounting standard demands, preparing data for the measurement of expected credit losses requires creating and maintaining both business rules and data transformation rules that may be unique for each portfolio or product. A moderately complex organization might have to manage hundreds of rules and data pertaining to thousands of financial instruments. Banks will need systems that make it easy to update the rules (and debug the updates); track data lineage; and extract both the rules and the data for regulators and auditors.
IFRS 9 is effective for annual periods beginning on or after January 2018. That’s only about 18 months from now. It’s time to get ready.
IFRS 9 Figure 1
IFRS 9 Figure 2
FAQs
Stage 1 which consists of loans overdue by up to 30 days, stage 2 where loans are overdue by 31-89 days, and stage 3 for loans overdue by more than 90 days. But on November 12, 2021, RBI issued circular on the prudent norms on income recognition, asset classification, among others.
What is staging in IFRS 9? ›
Definition. Stages and Staging of credit assets denotes the assignment / classification (at the reporting date) of all credit assets accounted under amortized cost in one of three available stages. The system resembles a Credit Rating System (with a limited number of rating categories).
What are Stage 1 Stage 2 Stage 3 loans? ›
Loans are sorted into stages, where Stage 1 comprises performing loans, Stage 2 underperforming loans that have seen a significant increase in credit risk and Stage 3 credit-impaired loans (see, for example, “Snapshot: Financial Instruments: Expected Credit Losses”, IASB, 2013).
What are the three classifications of financial assets? ›
financial assets at fair value through profit or loss; 2. held-to-maturity investments; 3. loans and receivables; 4. available-for-sale financial assets.
What is the difference between Stage 2 and Stage 3 assets? ›
Stage 2 assets are underperforming (that is, there has been a significant increase in their credit risk since the time they were originally recognized) Stage 3 assets are non-performing and therefore impaired.
What is the difference between Level 1 and Level 2 assets? ›
Level 1 assets are the top classification based on their transparency and how reliably their fair market value can be calculated. Level 2 and 3 assets are less liquid and more difficult to quickly and correctly ascertain their fair value.
What is Stage 3 of IFRS 9? ›
Stage 3 – If the loan's credit risk increases to the point where it is considered credit-impaired, interest revenue is calculated based on the loan's amortised cost (that is, the gross carrying amount less the loss allowance).
What are Level 2 assets examples? ›
Level 2 assets include a variety of financial instruments such as bonds, swaps, and options. For example, a company might have a bond that is traded in a market that is not very active, but still has observable inputs, such as the bond's coupon rate, maturity date, and the current yield of similar bonds.
What is the difference between Stage 2 and Stage 3 IFRS 9? ›
If the credit risk has increased significantly (Stage 2) and if the loan is 'credit- impaired' (Stage 3), the standard requires allowances based on lifetime expected losses. The assessment of whether a loan has experienced a significant increase in credit risk varies by product and risk segment.
What are Stage 2 assets in IFRS 9? ›
Stage 2 Assets, in the context of IFRS 9 are financial instruments that have deteriorated significantly in credit quality since initial recognition but offer no objective evidence of a credit loss event.
According to IFRS 9, a company's business model refers to how an entity manages its financial assets in order to generate cash flows. It determines whether cash flows will result from collecting contractual cash flows, selling financial assets or both. An entity's business model is a matter of fact.
What are Stage 1 assets? ›
Definition. Stage 1 Assets, in the context of IFRS 9 are financial instruments that either have not deteriorated significantly in credit quality since initial recognition or have low credit risk.
How many stages are there in financing? ›
In raising funds, startup founders need to be familiar with the various stages of raising capital, as startups require capital through their life cycle. As a business grows and becomes more mature, it advances towards funding rounds, typically beginning with a seed round and continuing with A, B, and C funding rounds.
What is Stage 3 ratio in banking? ›
Thus, when the customer effectively enters default (known as 'stage 3'), either by actual default or by probability of default (subjective default), the cost of additional loan-loss provisions would imply a much lower effort than under previous accounting standards, where the effort in provisions was concentrated at ...
How are financial assets measured under IFRS 9? ›
Measurement of financial assets
A financial asset is measured at fair value through profit or loss (FVTPL) unless it is measured at amortised cost or at fair value through other comprehensive income (FVTOCI).
What are the four classifications of assets? ›
Assets are reported on a company's balance sheet. They're classified as current, fixed, financial, and intangible. They are bought or created to increase a firm's value or benefit the firm's operations.
What are financial assets and its classification? ›
Cash, stocks, bonds, mutual funds, and bank deposits are all are examples of financial assets. Unlike land, property, commodities, or other tangible physical assets, financial assets do not necessarily have inherent physical worth or even a physical form.
