In recent years, there have been significant developments in risk management concepts and practices. New techniques have evolved for measuring and managing exposures to risks arising from financial instruments. As a result, the need for more relevant information and greater transparency about an entity’s exposures arising from financial instruments and how those risks are managed has become greater. Financial statement users and other investors need such information to make more informed judgements about risk that entities run from the use of financial instruments and their associated returns. However, it became clear that the disclosure in IAS 30, ‘Disclosures in the financial statements of banks and similar institutions’ and IAS 32, ‘Financial Instruments: Disclosures’ were not in keeping with such developments and there was a need to revise and enhance the disclosure framework for risks arising from financial instruments. IFRS 7 is the product of that revision. It should be noted that IFRS 7 applies to all entities not just financial institutions.
Objectives of IFRS
IFRS 7’s objective is to provide information to users of financial statements about an entity’s exposure to risks and how the entity manages those risks. To this end, the standard requires an entity to provide disclosures in its financial statements that enable users to evaluate:
- The significance of financial instruments for the entity’s financial position and performance disclosures about the figures in the balance sheet and the income statement; and
- The nature and extent of risks arising from financial instruments to which the entity is exposed (quantitative disclosure) and how the entity manages those risks (qualitative disclosures).
These disclosures incorporate many of the requirements previously in IAS 32, but IFRS 7 requires extensive new disclosures.
It is in this area, the disclosure of qualitative and quantitative information and of an entity’s exposure to risks arising from financial instruments, that IFRS 7 takes a very different approach from the previous standards. IFRS 7 expands the qualitative disclosure to include information on the process that an entity uses to manage and measure risk. IFRS 7 introduces new quantitative risk disclosures that should be given ‘through the eyes of management’, that is, based on information provided internally to key management personnel. Entities are required to communicate to the market how they perceive, manage and measure risk. This change to a ‘through the eyes of management’ approach will enable the market to better evaluate the strength (or otherwise) of an entity’s risk management activities.
Classes of Financial Instruments
IFRS 7 requires certain disclosures to be given by class of financial instruments. When disclosures by class of financial statements are required, an entity should group financial instruments into classes that are appropriate to the nature of the information disclosed and that take into account the characteristics of those financial instruments.
The classes described in the above paragraph are not the same as the categories of financial instruments specified in IAS 39 (which determine how financial instruments are measured and where changes in fair value are recognised). Therefore, they should be determined on an entity specific basis. However, in determining classes of financial instruments, an entity should, at a minimum distinguish instruments measured at amortised cost from those measured at fair value and treat as a separate class or classes those financial instruments outside IFRS 7’s scope.
As classes of financial instruments should be determined by the entity and reconciled back to the balance sheet, the level of detail will vary from entity to entity. For example, in the case of banks, the category ‘loans and advances’ would comprise more than one class, unless all the loans have similar characteristics. In that situation, it may be appropriate to group financial instruments into the following classes - types of customers (e.g. commercial loans and loans to individuals) or types of loans (e.g. mortgages, credit cards, unsecured loans and overdrafts).
Hedge Accounting Disclosures
An entity should disclose the following separately for each type of hedge described in IAS 39 (that is, fair value hedges, cash flow hedges and hedges of net investments in foreign operations) a description of each type of hedge; a description of the financial instruments designated as hedging instruments and their fair values at the reporting date; and the nature of the risks being hedged.
For cash flow hedges, an entity should disclose the periods when the cash flows are expected to occur and when they are expected to affect profit or loss; a description of any forecast transaction for which hedge accounting had previously been used, but which is no longer expected to occur; the amount that was recognised in equity during the period; the amount that was removed from equity and included in profit or loss for the period, showing the amount included in each line item in the income statement; and the amount that was removed from equity during the period and included in the initial cost or other carrying amount of a non-financial asset or non-financial liability whose acquisition or incurrence was a hedged highly probable forecast transaction.
In fair value hedges, an entity should disclose separately gains or losses on the hedging instruments and the hedged item attributable to the hedged risk.
An entity should also disclose the ineffectiveness recognised in profit or loss that arises from cash flow hedges and the ineffectiveness recognised in profit or loss that arises from hedges of net investments in foreign operations.
Risks Arising From Financial Instruments
As mentioned earlier IFRS 7 requires a significant amount of qualitative and quantitative disclosure about risks associated with financial instruments. In the context of financial instruments, risk arises from the uncertainty in cash flows, which in turn affects the future cash flows and fair values of financial assets and liabilities. The following are the types of financial risk that are related to financial instruments:
- Market risk - the risk that the fair value or cash flows of a financial instrument will fluctuate, because of changes in market prices. Market risk embodies not only the potential of loss, but also the potential for gain. It comprises three types of risk as follows:
- Interest rate risk – the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates.
- Currency risk - the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates.
- Other price risk – the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices (other than those arising form interest rate risk or currency risk), whether those changes are caused by factors specific to the individual financial instrument or its issuer, or factors affecting all similar financial instruments traded in the market.
- Credit risk – the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation.
- Liquidity risk – the risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities.
An entity should disclose information that enables users of its financial statements to evaluate that nature and extent of risks arising from financial instruments to which the entity is exposed at the reporting date
When an entity uses several methods to manage a risk exposure, it should disclose information using the method or methods that provide the most relevant and reliable information.
The disclosures should be given either in the financial statements or incorporated by cross-reference from the financial statements to some other statement, such as a management commentary or risk report, that is available to users of the financial statements on the same terms as the financial statements and at the same time. Without the information incorporated by cross-reference, the financial statements are incomplete.
Qualitative Disclosure
For each type of risk arising from financial instruments, an entity should disclose:
- The exposures to risk and how they arise - information about risk exposures might describe exposures both gross and net of risk transfer and other risk-mitigating transactions.
- Its objectives, policies and processes for managing the risk and the methods used to measure the risk. This might include, but is not limited to:
- The structure and organisation of the entity’s risk management functions, including a discussion of independence and accountability.
- The scope and nature of the entity’s risk reporting or measurement systems.
- The entity’s policies for hedging or mitigating risk, including its policies and procedures for taking collateral.
- The entity’s processes for monitoring the continuing effectiveness of such hedges or mitigating devices.
- The entity’s policies and procedures for avoiding excessive concentrations of risk. Concentrations of risk arise from financial instruments that have similar characteristics and are affected similarly by changes in economic or other conditions. The identification of concentrations or risk requires judgement taking into account the entity’s circumstances.
- Any changes in the above for the period. Entities should disclose the reason for the change. Such changes may result from changes in exposure to risk or from changes in the way those exposures are managed.
Quantitative Disclosures
For each type of risk arising from financial instruments, an entity should disclose summary quantitative data about its exposure to that risk at the reporting date. This disclosure should be based on the information provided internally to the entity’s key management personnel, for example, the entity’s board of directors or Chief Executive Officer.
If the quantitative date disclosed as at the reporting date are unrepresentative of an entity’s exposure to risk during the period, and entity should provide further information that is representative. To meet this requirement, an entity might disclose the highest, lowest and average amount of risk to which it was exposed during the period. For example, if an entity typically has a large exposure to a particular currency, but at year-end unwinds the position, the entity might disclose a graph showing the exposure at various times during the period, or disclose the highest, lowest and average exposures.
Preparation Required
As you can see, IFRS 7 has significantly expanded the scope and depth of the disclosures required in relation to how an entity measures and manages risk arising from financial instruments. Complying with these disclosure requirements will not be an easy task. An entity will have to examine its processes to ensure that the information required to prepare the appropriate disclosures is available. If not, it will be necessary to put the necessary measures in place as soon as possible.
Illustrations have been omitted from the online version of this article.
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© The Institute of Chartered Accountants in Ireland 2007.