IFRS 7 Comprehensive Risk disclosures

IFRS 7 Comprehensive Risk disclosures – Management should disclose information that enables users of its financial statements to evaluate the nature and extent of risks arising from financial instruments to which the entity is exposed at the end of the reporting period [IFRS 7 31]. IFRS 7 Comprehensive Risk disclosures

IFRS 7 requires certain disclosures to be presented by category of an instrument based on the IFRS 9 recognition and measurement categories of financial instruments (previously the IAS 39 measurement categories). IFRS 7 Comprehensive Risk disclosures

Certain other disclosures are required by class of financial instrument. For those disclosures an entity must group its financial instruments into classes of similar instruments as appropriate to the nature of the information presented. [IFRS 7 6] IFRS 7 Comprehensive Risk disclosures

The two main categories of disclosures required by IFRS 7 are: IFRS 7 Comprehensive Risk disclosures

  1. information about the significance of financial instruments [IFRS 7 7 – 30] IFRS 7 Comprehensive Risk disclosures
  2. information about the nature and extent of risks arising from financial instruments [IFRS 7 31 – 42] IFRS 7 Comprehensive Risk disclosures

So IFRS 7 bets on two disclosure options for these two main categories of disclosures: IFRS 7 Comprehensive Risk disclosures

  • specific disclosure requirements by a defined set of categories of financial instrument [IFRS 9 4.1 – 4.4], and IFRS 7 Comprehensive Risk disclosures
  • specific disclosure requirements by appropriate classes of financial instruments grouped based on the nature of the presented information [IFRS 7 B1 – B5].

The disclosures require focus on the risks that arise from financial instruments and how they have been managed. These risks typically include, but are not limited to, credit IFRS 7 Comprehensive Risk disclosures risk, liquidity risk and market risk [IFRS 7 32]. IFRS 7 Comprehensive Risk disclosures

In an ideal (very theoretical) world these comprehensive risk disclosures would result in a situation that an analyst could re-work these disclosures to make his/her own risk assessment between similar but not identical entities and grade investments in entity A as more risk or less risk than investments in entity B.

Just keep the thought! Here are the explanations case-by-case!

Qualitative and quantitative disclosures are required. Management should therefore disclose, for each type of risk arising from financial instruments:

  • The exposures to risk and how they arise, and its objectives, policies and processes for managing the risk and the methods used to measure the risk (qualitative disclosure) [IFRS 7 33]; and
  • Summary quantitative data about its exposure to that risk at the end of the reporting period (quantitative disclosures) [IFRS 7 34].

If the quantitative data disclosed at the end of the reporting period is unrepresentative of an entity’s exposure to risk during the period, management should provide further information that is representative [IFRS 7 35].

Table – Overview exposure to financial risks, possible disclosures and management of risk

Financial risk

Exposure arising from

Possible disclosure

Management of risk

Market riskCurrency risk

Future commercial transactions

Recognised financial assets and liabilities not denominated in LC

Cash flow forecasting

Sensitivity analysis

Foreign currency forwards and foreign currency options

Market risk – Interest rate risk

Long-term borrowings at variable rates

Sensitivity analysis

Interest rate swaps

Market risk – Other price risks

Investments in equity securities

Sensitivity analysis

Sensitivity of equity financial instruments to equity index benchmark prices (also known as Beta)

Portfolio diversification

Credit risk

Cash and cash equivalents, trade receivables, derivative financial instruments, debt investments and contract assets

Ageing analysis

Credit ratings

Diversification of bank deposits, credit limits and letters of credit

Investment guidelines for debt investments

Liquidity risk

Borrowings and other liabilities

Rolling cash flow forecasts

Maturity analysis

Availability of committed credit lines and borrowing facilities

Case: Fund with two distinct investment portfolios (a bond portfolio and an equity portfolio). Management monitors each portfolio separately.

A fund with two distinct investment portfolios should present the disclosures based on the management reporting [IAS 7 34(a)] separately for the bond portfolio and the equity portfolio, if that is the way management monitors the financial risks. IFRS 7 Comprehensive Risk disclosures

Case: The minimum risk disclosures (IFRS 7 34(b) and IFRS 7 36 – 42) for a fund with two distinct investment portfolios (a bond portfolio and an equity portfolio).

A fund with two distinct investment portfolios could provide the minimum disclosures on a consolidated basis for the bond portfolio and the equity portfolio. All disclosures should be provided on a consolidated basis unless there is a specific exception (such as for those disclosures that are based on management’s reporting). IFRS 7 Comprehensive Risk disclosures

The fund could provide the minimum disclosures separately for the bond portfolio and the equity portfolio to reflect the way management monitors the financial risks, unless there were material transactions between the portfolios. In this case, the separate disclosures could be potentially misleading. IFRS 7 Comprehensive Risk disclosures

Case: Fund A and Fund B have similar portfolio compositions investing solely in stocks included in the S&P 500 stock index.

Management of Fund A follows a ‘top-down’ approach when selecting investments, deciding first how much of the fund’s portfolio to allocate to different industry sectors, then deciding what stocks within those sectors to invest in.

Management of Fund B follows a ‘bottom-up’ approach. Fund B management does not manage the portfolio by industry sector or utilise any analysis of the portfolio by sector. When making investment decisions, Fund B management focuses solely on each individual investment.

In such situations similar portfolio compositions need different risk disclosures.

The basis for much of the risk disclosures under IFRS 7 is ‘through the eyes of management’ – that is, based on the information provided to key management IFRS 7 Comprehensive Risk disclosures personnel. Two funds with different management approaches but similar portfolio compositions would be expected to provide differing risk disclosures in some areas. However, there are specific risk disclosures applicable to all entities, so management should provide a common benchmark for financial statement users when comparing risk disclosures across different entities.

Case: Fund A invests solely in S&P 500 stocks. Management of Fund A follows a ‘top-down’ approach when selecting investments, deciding first how much of the fund’s portfolio to allocate to different industry sectors, then deciding what stocks within those sectors to invest in. IFRS 7 Comprehensive Risk disclosures

At year end, Fund A invested in two stocks, together comprising 35% of the portfolio. One stock was in the banking sector and represented 15% of the total portfolio and 75% of the ‘banking’ sector; the other stock was in the oil and gas sector and represented 20% of the total portfolio and 100% of the oil and gas sector. IFRS 7 Comprehensive Risk disclosures

Information provided to management is by sector and then by stock. IFRS 7 Comprehensive Risk disclosures

Fund A’s exposure to equity price risk under IFRS 7 34(a), IFRS 7 34(c) in combination with the use of the above ‘top-down’ approach leads to summary quantitative risk disclosures being provided by industry sectors, given this is how management views risk and manages the portfolio. Such disclosure would show the industry concentrations.

However, stock-specific concentrations also exist and would therefore need to be disclosed in addition to the industry sector information – for example, 75% of the banking sector and 100% oil and gas sector were in a single investment. IFRS 7 Comprehensive Risk disclosures

Case: Instead of the ‘top-down’ approach (mentioned above) Fund A follows a ‘bottom-up’ approach, not managing the portfolio by industry sector and not utilising any analysis of the portfolio by sector? IFRS 7 Comprehensive Risk disclosures IFRS 7 Comprehensive Risk disclosures

The answer is different if a ‘bottom-up’ approach was used by management. IFRS 7 Comprehensive Risk disclosures

Summary quantitative data would not need to be provided at the industry sector level. However, Fund A should disclose, as a minimum, that two stocks comprise 35% of the portfolio and the industry concentrations they form part of, irrespective of whether the fund is managed by industry sector. IFRS 7 Comprehensive Risk disclosures

IFRS 7 has a ‘through the eyes of management’ approach to risk disclosures, but it also has a list of minimum disclosures. Concentration of risk is one of them. So even though information is not provided to management by sector, the above investments do represent an individual-plus-sector concentration and should therefore be disclosed in accordance with IFRS 7 34(c).

Cases: Additional information representative of an entity’s exposure to risk during the period in supplementing disclosure of period-end exposure to risk (IFRS 7 35)

Investment entities should disclose additional information if the quantitative data as at the reporting date is not representative for the financial period. A mere statement that the data is not representative is not sufficient under IFRS 7 35. IFRS 7 Comprehensive Risk disclosures

To meet the requirement in IFRS 7 35, the entity might disclose the highest, lowest and average amount of risk to which it was exposed during the period [IFRS 7 IG20].

Case

Risk disclosure during period

Investment entity A held a significant amount of US sub-prime debt for an insignificant portion of the year, which resulted in large losses. For the remainder of the year and at year end, investment entity A held virtually no sub-prime debt.

Investment entity A presents additional disclosure of risk during the period given the significance of the exposure and resultant large losses.

Investment entity B held a significant amount of US sub-prime debt for a significant portion of the year. By year end it held virtually no sub-prime debt.

Investment entity B presents additional disclosure of risk during the period because the positions at year end are not representative of the risks to which the entity was exposed during the period.

Investment entity C has liquidated its equity investments during the period in anticipation of redeeming all shareholders as part of an orderly wind-up. As at the reporting date, investment entity C has investments in cash only.

Investment entity C presents additional disclosure of risks during the period because during the year the entity was exposed to the risk inherent in the equity investments.

Investment entity D operated as a feeder fund into a master fund for a significant portion of the year. Investment entity D then reorganised itself into a fund of funds, investing directly into a portfolio of other investment entities that it was previously exposed to indirectly via its investment in the master fund.

Investment entity D presents additional disclosure of risk during the period, although such additional disclosure could simply explain qualitatively the structure prior to the reorganisation if the ultimate exposures are similar if not the same.

Investment entity E traded some equity index derivatives during the period; however, it held no such derivatives at year end. The net profit and loss from such trading during the period was insignificant; however, for a significant amount of the period, the overall exposure from such derivatives was significant to the entity.

Investment entity E presents additional disclosure of risk during the period. This is because it is the actual risk exposures that are relevant when considering compliance with IFRS 7 35 rather than how much profit and loss was made from the activity that resulted in the risk exposures.

Cases: Disclosure concentrations of credit risk under IFRS 7 34(c) IFRS 7 Comprehensive Risk disclosures

Separate disclosure of the concentration of credit risk is required, if the concentration of credit risk arising in the following cases is not apparent from other disclosures:

Case

Concentration disclosures

The issuers of debt in which the entity invests are concentrated in the manufacturing and retail sectors.

Two individual sectors

The debt instruments in which the entity invests are concentrated in the sub-prime market.

Investment in debt of similar credit quality

The entity invests in the debt of European corporate issuers. At year end, the entity’s investments are concentrated in the issuers of an individual country.

Investment in issuers in individual countries

The entity invests a significant portion of its funds in the debt of a group of closely related companies.

Investing in a limited number of issuers or groups of closely related issuers

Disclosure of the concentrations of risk include:

  • A description of how management determines the concentrations;
  • A description of the shared characteristics that identifies each concentration (for example, counterparty, geographical area, currency, market or industry); and
  • The amount of the risk exposure associated with all financial instruments sharing that characteristic. [IFRS 7 B8].

Case: Feeder fund ABC Ltd invests solely in master fund DEF Ltd, which invests solely in the Japanese equity market. ABC Ltd is not required to prepare consolidated accounts.

It has provided broad qualitative disclosure of the nature of its investment in DEF Ltd in its stand-alone financial statements; it states that DEF Ltd invests in the securities of Japanese companies listed on the Tokyo Stock Exchange. IFRS 7 Comprehensive Risk disclosures

ABC Ltd and DEF Ltd operate as an integrated structure. Management of ABC Ltd and DEF Ltd are comprised of the same parties and view the risk exposures of ABC Ltd to be the same as those of DEF Ltd. IFRS 7 Comprehensive Risk disclosures

Case: As a result of IFRS 7’s ‘through the eyes of management’ approach, additional detailed quantitative disclosure of the financial risks relating to the portfolio of DEF Ltd should be made in the financial statements of ABC Ltd in addition to the qualitative disclosures previously mentioned IFRS 7 Comprehensive Risk disclosures

IFRS 7 34(a) requires the disclosure of quantitative data about ABC Ltd’s exposure to the risks of investing in DEF Ltd. The disclosures should be based on how ABC Ltd views and manages its risks – that is, using the information provided to management [IFRS 7 BC47]. IFRS 7 Comprehensive Risk disclosures

Given the integrated structure and management’s view that the risk exposures of ABC Ltd are the same as those of DEF Ltd, full disclosure of the risks inherent in the portfolio of DEF Ltd should be made in the stand-alone financial statements of ABC Ltd. In other words, in this instance, a ‘through the eyes of management’ approach should be adopted.

Case: An investment entity invests in a foreign currency bond maturing in one year and simultaneously enters into an FX forward contract with a corresponding maturity to offset the foreign currency risk. IFRS 7 34(b) requires specific risk disclosures for material risks. IFRS 7 Comprehensive Risk disclosures

The materiality of the foreign currency risk on the bond is assessed as follows: IFRS 7 Comprehensive Risk disclosures

The materiality of the foreign currency risk on the bond is assessed without the FX forward contract. The bond and the FX forward are dissimilar items [IAS 1 29]; the materiality assessment of the foreign currency risk is therefore performed without considering the FX forward contract. IFRS 7 Comprehensive Risk disclosures

If it is established that the foreign currency risk is material, the disclosure required in the sensitivity analysis [IFRS 7 40 – 41] is based on the net FX exposure − that is, after offsetting the foreign currency bond against the FX forward contract. IFRS 7 Comprehensive Risk disclosures

The same approach would apply for the assessment of credit risk, liquidity risk and other market risk. IFRS 7 Comprehensive Risk disclosures

Case: Management of an investment entity claims it does not ‘manage’ currency risk, it simply ‘trades’ it. Management does not therefore intend to make any risk disclosures under IFRS 7.

Even if management believes risks are not managed IFRS 7 still require risk disclosure. IFRS 7 Comprehensive Risk disclosures

IFRS 7 requires qualitative [IFRS 7 33(a)] and quantitative [IFRS 7 34] disclosures of risk, irrespective of whether such risks are considered by management to be managed. IFRS 7 IG15(b) refers to the need for management to disclose the reporting entity’s policies and processes for accepting risk, in addition to those for measuring, monitoring and controlling risk.

Case: Investment entity ABC Ltd, with a functional currency of New Zealand dollars, invests in a global equity portfolio. As a result, it has significant foreign currency exposure through its investments in the yen, euro and US dollar. So ABC Ltd is exposed to currency risk. IFRS 7 Comprehensive Risk disclosures

IFRS 7 does not consider currency risk to arise from financial instruments that are non-monetary [IFRS 7 B23], such as equity investments. The foreign currency exposure arising from investing in non-monetary financial instruments would be reflected in the other price risk disclosures as part of the fair value gains and losses.

Case: ABC Ltd, in the prior year, reported its policies and processes for managing risk. In response to an increase in the risks arising from the markets in which ABC Ltd invests, management of ABC Ltd developed its risk management systems during the year and designed additional policies and processes for dealing specifically with credit risk.

IFRS 7 33(c) requires an entity to report any change in qualitative disclosures from the previous period and explain the reason for the change – specifically, in this instance, changes in the policies and process for managing and measuring risk. IFRS 7 Comprehensive Risk disclosures

Note: If the change in policies and processes results in a change in accounting policies, additional disclosures may be required [IAS 8 29].

Case: An investment entity observes changes in volatility – for example, the reasonably possible change in an exchange rate changes from 5% in the prior year to 8% in the current year

The prior-year disclosures should not be restated if the volatility (and therefore the range for a reasonable change) increases or decreases between two balance sheet dates. Each balance sheet date has its own volatility assessment and disclosure. IFRS 7 Comprehensive Risk disclosures

See also: The IFRS Foundation

IFRS 7 Comprehensive Risk disclosures

Leave a comment