IFRS 7 Nature and extent Financial instruments risks

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IFRS 7 Nature and extent Financial instruments risks provides the disclosure requirements regarding the nature and extent of risks arising from financial instruments to which the entity is exposed during the period.

The IFRS 7 backbone is summarised as follows:

  • Classes of Financial Instruments and Level of Disclosures
  • Significance of financial instruments
  • Nature and extent of risks arising from financial instruments
    • Qualitative disclosures
      1. the exposures to risk and how they arise;
      2. its objectives, policies and processes for managing the risk and the methods used to measure the risk; and
      3. any changes in 1. or 2. from the previous period.
    • Quantitative disclosures on types of risks, being:
      • Credit risk
        • Credit risk management practice
        • Expected credit losses quantifications and
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Hedged items General requirements

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Hedged items General requirements discusses the eligible hedged item and risk components in non-financial items. The general requirements of what qualifies as an eligible hedged item are unchanged compared to IAS 39. A hedged item can be: Hedged items General requirementsHedged items General requirements

  • A recognised asset or liability Hedged items General requirements
  • An unrecognised firm commitment Hedged items General requirements
  • A highly probable forecast transaction Hedged items General requirements

Or  Hedged items General requirements

All of above can either be a single item or a group of items, provided the specific requirements for a group of items are met (see ‘Groups of items‘).

Only assets, liabilities, Read more

Hedge Risk components General requirements

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Risk components General requirements is about hedging risk components be it financial or non-financial risks (new in IFRS 9).

Instead of hedging the total changes in fair values or cash flows, risk managers often enter into derivatives to only hedge specific risk components. Managing a specific risk component reflects that hedging all risks is often not economical and hence not desirable, or not possible (because of a lack of suitable hedging instruments). Risk components – General requirements

However, under IAS 39, a non-financial item can only be designated as the hedged item for its foreign currency risk or all its risks in their entirety. There is no such restriction for financial items, Risk components General requirementstherefore creating an inconsistency in Read more

Contractually specified risk components

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Contractually specified risk components – Under IFRS 9, risk components can be designated for non-financial hedged items, provided the component is separately identifiable and the changes in fair value or cash flows of the item attributable to the risk component are reliably measurable. This requirement could be met where the risk component is either explicitly stated in a contract (contractually specified) or implicit in the fair value or cash flows (non-contractually specified). Contractually specified risk components

Purchase or sales agreements sometimes contain clauses that link the contract price via a specified formula to a benchmark price of a commodity. Examples of contractually specified risk components are each of the price links and indexations Read more

Non-contractually specified risk components

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Non-contractually specified risk components – Under IFRS 9, risk components can be designated for non-financial hedged items, provided the component is separately identifiable and the changes in fair value or cash flows of the item attributable to the risk component are reliably measurable. This requirement could be met where the risk component is either explicitly stated in a contract (contractually specified) or implicit in the fair value or cash flows (non-contractually specified).Non-contractually specified risk components

Not all contracts define the various pricing elements and, therefore, specify risk components. In fact, most risk components of financial and non-financial items are not to be contractually specified. While it is certainly easier to determine that a risk component is separately identifiable and Read more

IFRS 9 Inflation as a risk component

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Inflation as a risk component – Under IAS 39, inflation cannot be designated as a hedged risk component for financial instruments, unless the inflation risk component is contractually specified. For non-financial instruments, inflation risk cannot be designated under IAS 39 as a risk component at all. Inflation as a risk component

Highlight – For financial instruments, IFRS 9 opens the door for designating a non-contractually specified inflation component as a hedged risk component – but only in limited circumstances. For non-financial instruments, the inflation component will be eligible for designation as the hedged item in a hedging relationship provided that it is separately identifiable and reliably measurable. Inflation as a risk component

For financial instruments, IFRS 9 Read more

The sub-LIBOR issue

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The sub-LIBOR issue  (see further below) related to contractually specified risk components: Purchase or sales agreements sometimes contain clauses that link the contract price via a specified formula to a benchmark price of a commodity. Examples of contractually specified risk components are each of the price links and indexations in the contracts below:

  • Price of natural gas contractually linked in part to a gas oil benchmark price and in part to a fuel oil benchmark price
  • Price of electricity contractually linked in part to a coal benchmark price and in part to transmission charges that include an inflation indexation
  • Price of wires contractually linked in part to a copper benchmark price and in part to a variable
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Components of a nominal amount

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Definition Components of a nominal amount

Components of a nominal amount are specified part(s) of the amount of an item. This could be a proportion of an entire item (such as, EUR 60 million of a fixed rate loan of EUR 100 million) or a layer component (for example, the bottom EUR 60 million of a EUR 100 million fixed rate loan). Components of a nominal amount

Nominal components are frequently used in risk management activities in practice. Examples include: Components of a nominal amountNatural disasters - Hedge accounting

  • Part of a monetary transaction volume, e.g., the first USD1 million cash flows from sales to customers in a given period
  • Part of a physical volume, e.g., the 50 tonnes bottom layer
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Credit risk exposures

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Many financial institutions hedge the credit risk (i.e. insure credit risk exposures) arising from loans or loan commitments using credit default swaps (CDS). This would often result in an accounting mismatch, as loans and loan commitments are typically not accounted for at fair value through profit or loss. The simplest accounting would be to designate the credit risk as a risk component in a hedging relationship. However, the IASB noted that due to the difficulty in isolating the credit risk as a separate risk it does not meet the eligibility criteria for risk components. As a result, the accounting mismatch creates profit or loss volatility.

The IASB spent a considerable amount of its deliberations for the IFRS Read more

Hedging instruments

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IAS 39 placed several restrictions on the types of instruments that can qualify as hedging instruments for hedge accounting purposes. This is to reflect that hedge accounting was mainly intended to address accounting mismatches that resulted from requiring derivatives to be accounted for at fair value through profit or loss. IFRS 9 takes a different approach that focuses on which instruments are used for hedging. As a result, entities are also now permitted to designate, as hedging instruments, non-derivative financial assets or non-derivative financial liabilities that are accounted for at fair value through profit or loss. Consequently:

  • A liability designated as at fair value through profit or loss (for which the amount of its change in fair
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