12.4 Disclosure Requirements for Credit Risk and Impairment
4 min read•august 7, 2024
Credit risk and impairment disclosures are crucial for financial . They reveal an entity's exposure to potential losses from borrower defaults and how they're managed. These disclosures help investors and regulators assess a company's financial health and risk management practices.
Quantitative and qualitative disclosures provide a comprehensive view of credit risk. Numbers show exposure levels and , while descriptions explain risk management strategies. Sensitivity analyses and ECL allowance reconciliations offer insights into potential future losses and how they're estimated.
Credit Risk Disclosures
Quantitative Disclosures
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- Quantitative disclosures provide numerical information about an entity's credit risk exposure
- Includes maximum exposure to credit risk, credit quality information, and concentrations of credit risk
- Maximum exposure to credit risk represents the worst-case scenario of credit risk without considering collateral or credit enhancements (guarantees, letters of credit)
- Credit quality information categorizes financial assets based on credit risk characteristics (internal credit ratings, external credit ratings, past due status)
- Concentrations of credit risk arise when a significant number of borrowers are engaged in similar activities or located in the same geographic region
Qualitative Disclosures
- Qualitative disclosures provide descriptive information about an entity's credit risk management practices and policies
- Includes a description of the methods used to measure and manage credit risk
- Explains how the entity determines significant increases in credit risk and default events
- Describes the entity's write-off policy, including indicators that there is no reasonable expectation of recovery
- Provides information about modifications of contractual cash flows due to financial difficulties (forbearance, restructuring)
Sensitivity Analysis Disclosures
- Sensitivity analysis disclosures demonstrate the impact of hypothetical changes in credit risk parameters on the entity's financial statements
- Includes the effect of changes in PD (), LGD (), and EAD () on the ECL () allowance
- Helps users understand the sensitivity of the ECL estimate to changes in key assumptions and inputs
- Provides insight into the potential variability of credit losses under different economic scenarios (base case, upside, downside)
- Enhances transparency and allows users to assess the reasonableness of the entity's ECL estimates
Impairment Disclosures
ECL Allowance Reconciliation
- ECL allowance reconciliation provides a detailed breakdown of the changes in the loss allowance during the reporting period
- Includes the opening balance, additions due to origination or acquisition, reductions due to derecognition, changes due to modifications, and foreign exchange differences
- Disaggregates the changes in the loss allowance by stage (, , ) and by class of financial instrument (loans, )
- Helps users understand the drivers of changes in the loss allowance and assess the adequacy of the entity's provisioning
- Provides transparency on the impact of significant events (economic downturn, natural disasters) on the ECL estimate
Significant Accounting Policies
- Significant accounting policies related to impairment describe the entity's approach to measuring and recognizing ECL
- Includes the basis of segmentation for collective assessment (product type, credit risk characteristics)
- Explains the criteria for determining significant increases in credit risk and default events
- Describes the estimation techniques used to measure ECL (discounted cash flow, probability-weighted scenarios)
- Provides information about the incorporation of forward-looking information (macroeconomic factors, scenario weightings)
Key Assumptions and Estimation Techniques
- Key assumptions and estimation techniques used in the ECL measurement process are disclosed to enhance transparency
- Includes the definition of default used by the entity (90 days past due, unlikely to pay)
- Describes the approach to determining PD, LGD, and EAD (historical data, external benchmarks, management judgment)
- Explains the incorporation of collateral and credit enhancements in the ECL calculation
- Provides information about the use of practical expedients (30 days past due rebuttable presumption, low credit risk simplification)
- Discloses any significant changes in estimation techniques or assumptions during the reporting period
Risk Management Practices
Credit Risk Management Practices
- Credit risk management practices describe the entity's overall approach to identifying, measuring, monitoring, and controlling credit risk
- Includes the organizational structure and governance framework for credit risk management (risk committees, three lines of defense model)
- Describes the credit risk appetite statement and risk tolerance limits set by the entity
- Explains the credit risk assessment process, including initial credit approval, ongoing monitoring, and early warning indicators
- Provides information about the use of credit risk mitigation techniques (diversification, risk transfer, risk reduction)
Collateral and Credit Enhancements
- Collateral and credit enhancements are used to reduce credit risk exposure and mitigate potential losses
- Includes a description of the main types of collateral accepted by the entity (real estate, financial assets, guarantees)
- Explains the valuation methodology and frequency of collateral assessment (market value, discounted cash flow)
- Describes the entity's policies for obtaining, perfecting, and enforcing collateral rights
- Provides information about the quality and concentration of collateral held by the entity (loan-to-value ratios, geographic distribution)
- Discloses the extent to which collateral and credit enhancements are incorporated in the ECL measurement process
Key Terms to Review (20)
ASC 326: ASC 326, also known as the Current Expected Credit Loss (CECL) model, establishes the accounting for credit losses on financial assets. This standard requires entities to estimate and recognize expected credit losses over the life of the asset, thereby impacting the financial reporting and disclosure of credit risk and impairment significantly.
Basel III: Basel III is an international regulatory framework established to strengthen the regulation, supervision, and risk management of banks. It builds upon previous agreements and introduces more stringent capital requirements, liquidity standards, and measures to enhance financial stability, ensuring that banks can better withstand economic stress and reduce the likelihood of financial crises.
Credit quality: Credit quality refers to the assessment of a borrower’s ability to repay debt, which is crucial for determining the risk level associated with lending. It helps investors and financial institutions evaluate the likelihood of default on obligations, impacting lending decisions and interest rates. The quality of credit is often gauged through various metrics, including credit ratings, historical payment behavior, and financial ratios.
Debt Securities: Debt securities are financial instruments that represent a loan made by an investor to a borrower, typically in the form of bonds or notes. These instruments provide investors with fixed interest payments over a specified period, and the return of principal at maturity, making them an essential component of investment portfolios and financial markets.
Dodd-Frank Act: The Dodd-Frank Act is a comprehensive piece of financial reform legislation enacted in 2010 to promote financial stability and protect consumers in the aftermath of the 2008 financial crisis. This act established new regulatory frameworks for the financial services industry, impacting various aspects such as risk management, capital requirements, and transparency in financial transactions.
Expected Credit Loss: Expected credit loss refers to the estimate of the likelihood of a borrower defaulting on a loan, taking into account the potential loss incurred if default occurs. This concept is essential for financial institutions to assess and recognize credit risk accurately, especially in the shift from older accounting standards that did not require proactive loss recognition. It plays a crucial role in understanding credit risk, calculating provisions, and ensuring transparent financial reporting.
Exposure at Default: Exposure at Default (EAD) refers to the total value that a financial institution is exposed to at the time of a borrower's default. This term is crucial for calculating credit risk and assessing potential losses in lending situations. Understanding EAD helps institutions determine how much capital to hold against potential losses, which is essential for maintaining financial stability and complying with regulatory requirements.
Financial statement disclosures: Financial statement disclosures are notes and additional information provided alongside the main financial statements to give stakeholders a clearer understanding of a company's financial position, performance, and risks. These disclosures enhance transparency by detailing accounting policies, assumptions, and any uncertainties that could affect the financial results. They are crucial for users to assess the quality of earnings, risks associated with assets and liabilities, and overall financial health.
IFRS 9: IFRS 9 is an international financial reporting standard that provides guidelines for the classification, measurement, impairment, and hedge accounting of financial instruments. It was developed to enhance the transparency and consistency of financial reporting, addressing issues present in previous standards by introducing more forward-looking approaches to credit losses and clearer rules for financial asset classification.
Loan portfolios: Loan portfolios are collections of loans held by a financial institution, encompassing various types of lending activities such as mortgages, personal loans, and business loans. The management of these portfolios is crucial for assessing credit risk, determining potential returns, and complying with disclosure requirements regarding credit risk and impairment. Understanding the composition and performance of loan portfolios helps institutions make informed decisions about lending practices and risk management strategies.
Loss Given Default: Loss Given Default (LGD) is a financial metric that estimates the potential loss a lender would incur if a borrower defaults on a loan, expressed as a percentage of the total exposure at default. This concept is essential in assessing credit risk, as it helps financial institutions determine the likelihood and extent of potential losses in the event of borrower default. LGD plays a critical role in impairment models and expected credit losses, influencing how banks set aside capital reserves and report their credit risk exposure.
Non-Performing Loans: Non-performing loans (NPLs) are loans in which the borrower has failed to make the required payments for a specified period, typically 90 days or more. These loans are crucial in assessing the financial health of lending institutions and their loan portfolios, as they indicate potential credit risk and can affect overall profitability and capital adequacy.
Probability of Default: The probability of default is a financial term that quantifies the likelihood that a borrower will fail to meet their debt obligations within a specified time frame. This metric is critical in assessing credit risk, as it influences the estimation of expected credit losses and impairment models used by financial institutions. Understanding the probability of default helps institutions to set appropriate provisions for potential losses and adhere to regulatory disclosure requirements regarding credit risk.
Provision for Credit Losses: Provision for credit losses is an accounting estimate used by financial institutions to recognize potential losses in their loan portfolios due to borrowers' inability to repay loans. This provision acts as a buffer against future credit losses, reflecting the institution's assessment of the expected credit risk inherent in their lending activities. It is essential for maintaining financial stability and ensuring that banks can cover potential defaults.
Risk Management Disclosures: Risk management disclosures are the reports and statements that organizations provide to communicate their exposure to various risks, how they manage those risks, and the effectiveness of their risk management strategies. These disclosures help stakeholders understand the organization's financial health and operational stability by detailing the methods used to identify, assess, and mitigate risks, particularly in relation to financial instruments and credit risk management.
Stage 1: Stage 1 refers to the classification of financial assets that have not experienced a significant increase in credit risk since initial recognition. These assets are considered to be performing, meaning they are expected to meet their contractual cash flow obligations. In this context, financial institutions are required to recognize a 12-month expected credit loss for these assets, which reflects the likelihood of default occurring within the next year.
Stage 2: Stage 2 refers to a classification within the expected credit loss model that indicates a significant increase in credit risk for a financial asset since initial recognition. This stage is crucial for measuring impairment and determining the appropriate level of credit losses that need to be recognized, as it reflects a deterioration in credit quality, thus impacting the financial reporting and disclosure requirements related to credit risk and impairment.
Stage 3: Stage 3 refers to the classification of financial assets that are considered to be credit impaired, meaning there is objective evidence of impairment, such as a default on payments. Assets in Stage 3 are subject to lifetime expected credit loss (ECL) measurement, reflecting the increased risk associated with the asset. This stage highlights the importance of assessing credit risk and impairment, as it directly impacts financial reporting and disclosure requirements.
Timeliness: Timeliness refers to the provision of information in a manner that allows stakeholders to make informed decisions promptly. In the context of credit risk and impairment, timeliness is crucial for financial institutions to provide relevant data about their credit exposures and the potential risks associated with them, ensuring that this information is disclosed before it becomes stale or irrelevant.
Transparency: Transparency refers to the openness and clarity with which financial information is presented, allowing stakeholders to understand an organization’s operations, financial performance, and risks. It is vital for building trust and accountability in financial reporting, ensuring that investors and regulators have access to accurate information for informed decision-making.