In calculating expected credit losses under IRS, specifically IRS nine, an entity will initially classify financial assets as what's referred to as stage one, which applies to all performing assets.

Performing assets are those that are not credit impaired.

These are assets for which contractual payments of interest and principle are being paid as scheduled.

What is important to note is that there has been no increase in credit risk since they were included in the bank's financial statements.

While all financial assets carry some level of credit risk, what is important here in stage one is that the credit risk remains broadly unchanged from origination.

Then at any subsequent balance sheet date, the bank must assess whether the credit risk of the assets has increased significantly.

If it has, the asset is moved to stage two.

If the asset is credit impaired, then it is moved to stage three.

Under IRSA financial asset is credit impaired.

If there is evidence that the borrower will not be able to make its contractual payments of interest and principle for each stage, what we are trying to do is to determine the expected credit loss, and to do this, we need three things.

First, the probability of default next, the exposure at default, and finally, the loss we would face should default occur.

This is known as loss given default.

These three elements are multiply together to get the expected credit loss.

So let's take a deeper dive into each of these stages, starting with stage one.

Stage one is for performing assets.

This includes new assets and those whose credit risk has not changed significantly since initial recognition.

Even though the risk of loss is low under IFRS, the expected credit loss over the next 12 months needs to be recognized.

So in the expected loss calculation, only the probability of default within the next 12 months is multiplied by the exposure at default and the loss given default.

When it comes to interest income, we calculate this based on the gross value or the full value of the asset without deducting the expected credit loss.

That means that when we work out the interest income for stage one assets, the expected credit loss is not taking into account at all.

Next, we've got stage two, so what's going on here? Well, here we're looking at underperforming assets for which their credit risk has increased significantly since the loan was issued or the asset acquired. Banks determine This using their own internal criteria, which includes borrower indications.

For example, a borrower facing financial stress or difficulty credit rating changes or payment delays or delinquencies.

IFRS does not specify an exact set of criteria.

It simply states that the criteria should be reasonable and consistently applied.

Essentially, IFRS requires banks to apply their own reasonable judgment when a financial asset transfers to stage two.

The IFRS rules require that the expected credit losses for the rest of the assets lifetime are recognized now in the financial statements, not just for the next 12 months, as was the case for stage one.

However, for stage two assets, interest income continues to be recognized on a gross basis as it was for stage one.

Now, let's think about stage three to be classified as a stage three financial asset.

There must be evidence of impairment.

Generally, if a loan is more than 90 days delinquent, this suggests that the loan is credit impaired, but it is important to note that while 90 days is the standard, it is not a hard rule.

If there is evidence showing that, for instance, a 120 day period is a better indicator of credit impairment, then this could also be used also in addition to the 90 days past due criteria.

Other factors can also be used to indicate whether an asset is credit impaired, such as a breach of contract or evidence of significant financial difficulty.

For stage three assets, we continue to recognize lifetime expected credit losses as was the case for stage two assets, but the treatment of interest is different for stage three.

For stage three, we recognize interest income on a net basis.

This means that interest income is calculated based on the net amount of the asset after the expected credit loss has been deducted from the gross loan amount.