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Home / ... / FRS 29 - How Sensitive is your information?

On 9 December 2005 the Accounting Standards Board (ASB) issued FRS 29 “Financial Instruments: Disclosures” based on IFRS 7, issued by the International Accounting Standards Board (IASB) in August 2005. Both standards will be effective for accounting periods commencing on or after 1 January 2007 but earlier adoption is permitted.

This article explains the new market risk disclosure requirements included within the standards and looks at how they are likely to be implemented in practice, and in particular refers to experience of similar disclosures in the United States introduced by the SEC in 1997. Many companies are now considering these standards in preparing their interim financial statements for 2007. It should be noted that disclosures in respect of the year ended 31 December 2006 will be required to be presented as comparative information in the 2007 year end financial statements, and these comparatives could be prepared now to avoid delays in year end reporting.

FRS 29 is applicable to all entities that come within the scope of FRS 26 (i.e. listed entities and unlisted companies). IFRS 7 applies to all entities applying IFRS.

Market risk disclosures The new standard requires the presentation of a sensitivity analysis as part of the financial statements. Similar type disclosures were suggested but were not mandatory in FRS 13 (and consequently largely ignored) so the idea is not new. However the ASB and IASB have not been swayed by objections that such information would not be comparable between different companies and difficult to audit. A sensitivity analysis will be a mandatory part of the financial statement disclosures under the new standards.

Two methods of presentation are permitted- a basic sensitivity analysis focusing on the effect of changes in single risk variables, and in certain circumstances a more complex sensitivity analysis reflecting interdependencies between risk variables, such as value-at-risk (VaR). The basic sensitivity analysis must be presented separately for each type of market risk to which the entity is exposed at the reporting date.

The standard identifies three types of market risk – interest rate risk, currency risk and other price risk. Other price risk includes equity price risk and commodity price risk. The sensitivity analysis should show how profit or loss and equity would have been affected by changes in the relevant risk variable that were reasonably possible at the reporting date.

Interest rate risk Paragraph IG36 of the implementation guidance that comes with the standard, provides two examples of how the disclosures would be made in practice for (a) interest rate risk and (b) foreign currency risk. The disclosures are in narrative form rather than tabular and easy to understand. An extract from the example reads:

“At 31 December 20X2, if interest rates at that date had been 10 basis points lower with all other variables held constant, post-tax profit for the year would have been CU1.7 million (20X1- CU 2.4 million) higher, arising mainly as a result of lower interest expense on variable borrowings, and other components of equity would have been CU2.8 million (20X1-CU3.2 million) higher, arising mainly as a result of an increase in the fair value of fixed rate financial assets classified as available for sale…”

The effect of changes in interest rates for variable rate securities should be calculated as if the changed variable rates had applied for the entire accounting period to the securities held at the period end. The effect of fair value changes that arise at period end on fixed rate securities, based on reasonably possible interest rate changes must also be determined. The assumptions used in preparing the sensitivity analysis should be made clear.

Equity price risk An analysis based on changes of 10%, 20% or even 30% may be appropriate. It is likely for most entities that the effect on profit or loss will bear a linear relationship to the fair value of equity securities at year end (i.e. if the fair value of equity securities is €10 million and a change of 20% is assumed, the effect on profit will be a gain or loss of €2 million). However for certain entities, for example those that utilise derivatives such as futures or equity swaps, it may be more difficult to determine the effect and the sensitivity analysis may provide interesting information that would not previously have been apparent from a review of the financial statements.

Reasonably possible changes FRS 29 only requires disclosure of the effects of changes in risk variables at the limits of a reasonably possible change. The fundamental decision as to the limits of a reasonably possible price change will need to be made by the directors in most cases. A reasonably possible change should not include remote or worst case scenarios but must involve consideration of the period until the next financial statements are presented (usually twelve months after year end). The analysis should show the effect of a movement in both directions i.e. potential gains as well as potential losses.

In certain circumstances, for example written options, a sensitivity analysis based on reasonably possible changes in market rates may fail to indicate a significant risk exposure and in such cases additional disclosure may be necessary.

The U.S. Experience Similar disclosures have been required for certain large companies in the United States for a number of years. It is perhaps informative to look at the experience in the U.S. as possible guidance to how the new disclosures might be implemented here in practice. Financial Reporting Release No.48 “Qualitative and Quantitative Market Risk Disclosures” (FRR48) was issued by the U.S. SEC in 1997. Unlike here, the market risk disclosures do not form part of the financial statements – they are only required to be made as part of the Management Discussion and Analysis (MD&A) section in the annual filing form 10-K.

A second significant difference is that the SEC views risk as risk of loss and does not require disclosure of potential gains. Further, the effect of the sensitivity analysis under FRR48 could be measured in terms of effect on income, cashflow or fair value (choice was available). Finally whereas FRS 29 does not try to quantify what “reasonably possible” changes in risk variables might be, the SEC specified that such a change should be no less than 10 percent of period end rates unless otherwise justified.

Value-at-risk (VaR) An entity that uses an analysis such as value-at-risk to manage its financial risks, may present such an analysis as an alternative to using the basic sensitivity analysis discussed above. Value-at-risk is a measure of the maximum expected loss under normal market conditions over a specific time interval that can be expected with a certain confidence level. It is a single statistic that provides an all encompassing measure of market risk. However, variability in the choice of its two key parameters- time period and confidence level- may mean that loss amounts are not directly comparable between entities. Value-at-risk became increasingly popular in the 1990s as a practical tool for measuring risk, especially after the Basel Committee on Banking Supervision implemented market risk capital requirements for banks based on VaR in 1995.

Where an entity elects to present such an analysis, an explanation of the method used, of the main parameters and assumptions underlying the data, the objective of the method, and any limitations must be provided.

Conclusion The new disclosures are particularly relevant for entities with many different financial instruments and preparing the disclosures may not be straightforward where derivative financial instruments are held. The disclosures will undoubtedly present a challenge for auditors and the issue of what constitutes a reasonably possible change will likely be subject to different viewpoints from different organisations. The preparation of the sensitivity analysis is likely to involve a considerable additional effort on the part of both preparer and auditor.

interesting article

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