IFRS-9: In July 2014, the final version of IFRS-9 accounting standards was issued by International Accounting Standards Board (IASB). In the wake of financial crisis of 2008 the IASB in collaboration with the Financial Accounting Standard board launched a project to address the issues of delayed recognition of losses in IAS-39 accounting standards prevalent at that time.
The IAS-39 accounting standards were based on the concept of incurred losses i.e. credit losses will not be recognized until a credit loss event occurs. This delayed recognition of losses was one of the reasons of huge losses for financial industry in 2008. Because, during the financial crisis or economic downturn the credit quality or the value of assets tends to deteriorate. In case value of the assets become less than the value of the loan e.g. price of a house become less than the value of mortgage in itself then it would contribute to the losses for banks.
Since losses are rarely incurred evenly over the lives of loans, there will be a mismatch in the timing of the recognition of the credit spread inherent in the interest charged on the loans over their lives and any impairment losses that only get recognized at a later date.
The new IFRS-9 standards are based on expected credit loss (ECL) model. The expected credit loss model applies to debt instruments (like bank deposits, loans, debt securities and trade receivable) recorded at amortized cost or at fair value through other comprehensive income, plus lease receivables, contract assets and loan commitments and financial guarantee contracts that are not measured at fair value through profit or loss.
Classification and Staging of Financial Assets: As per IFRS-9 standards, entities will now be required to consider historic, current and forward-looking information (including macro-economic data). This will result in the earlier recognition of credit losses as it will no longer be appropriate for entities to wait for an incurred loss event to have occurred before credit losses are recognized.
The IFRS-9 introduces the concept of staging i.e. each of the loans would be categorized into different stages depending upon the credit deterioration of the account since initial recognition. Under the general approach, an entity must determine whether the financial asset is in one of three below mentioned stages in order to determine both the amount of ECL to recognize as well as how interest income should be recognized.
Stage 1 is where credit risk has not increased significantly since initial recognition. For financial assets in stage 1, entities are required to recognize 12 month ECL and recognize interest income on a gross basis – this means that interest will be calculated on the gross carrying amount of the financial asset before adjusting for ECL.
Stage 2 is where credit risk has increased significantly since initial recognition. When a financial asset transfers to stage 2 entities are required to recognize lifetime ECL but interest income will continue to be recognized on a gross basis.
Stage 3 is where the financial asset is credit impaired. This is effectively the point at which there has been an incurred loss event under the IAS 39 model. For financial assets in stage 3, entities will continue to recognize lifetime ECL but they will now recognize interest income on a net basis. This means that interest income will be calculated based on the gross carrying amount of the financial asset less ECL. The table below summarizes the general approach.
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.
Key Differences between IAS-39 and IFRS-9:
In the following sections we would cover IFRS-9 in detail along with development of IFRS-9 statistical model.
In next article we would cover default definitions. Below is the link.