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Home / 2008 / April 2008 / IFRS 7 Disclosures

In the past few years, the risk management techniques, concepts and the instruments used in the financial services industry have evolved constantly. Entities are now using more complex and sophisticated techniques and instruments. It has become more difficult for shareholders to interpret the financial statements correctly and get a true understanding of the risk an entity is exposed to and the management processes that have been applied to those risks. The IASB developed IFRS 7 Financial Instruments: Disclosures in an attempt to provide more relevant and transparent information to shareholders. Fergus Condon takes a look at the background and explores some key issues for investment funds.

Background IFRS 7 supersedes IAS 30 Disclosures in the financial statements of Banks and Similar Financial Institutions and the disclosures requirements of IAS 32 Financial Instruments: Presentation. The presentation requirements of IAS 32 remain unchanged. The Standard contains two types of disclosures: accounting disclosures that are based on requirements previously in IAS 32 and new risk disclosures. As a result all of the disclosure requirements for financial instruments are now contained in a single standard for all types of entity.

Key Issues for Investment Funds Although some of the accounting discloses may be more detailed than previously required, for example disclosure of financial assets and liabilities by class rather than category, funds are more likely to have difficulty in providing the new risk-based disclosures required by IFRS 7. Given the business model adopted by funds, preparation of adequate risk disclosures requires coordination between at least two parties external to the fund and its directors. Risks are mostly managed by the investment manager and accounting records and other information is normally held by the administrator. The investment manager and administrator are required to work closely together in preparing the risk disclosures and this mutual involvement will have an obvious knock on effect on the timing of the preparation of the financial statements. In addition, the level of detail will be compounded by the fund structure as in case of sub funds quantitative information is required on an individual sub fund basis.

New Risk Disclosures Users of financial statements value information about the risks arising from financial instruments to which an entity is exposed, and the techniques used to identify, measure, monitor and control these risks. The IFRS 7 disclosure requirements encompass both qualitative narrative descriptions and specific quantitative data. The level of detail is not intended to overburden users but, equally, should not obscure significant information as a result of excessive aggregation.

With respect to a fund, the financial instruments disclosures aim to:

-Provide information that will enhance the understanding of the significance of financial instruments to a fund’s financial position, performance and cashflows; and -Assist in evaluating the risks associated with those instruments, including how the fund manages those risks.

Within the qualitative analysis, an entity must disclose what risks the business is exposed to and how these risks have arisen. Having identified that information it must then go on to give the shareholder adequate information as to the policies and processes it has employed to manage those risk factors. Typically, one might expect disclosure of some of the following policies and processes which would affect the funds industry:

-The procedure in place for the initial selection of the underlying investee funds; -The policies and procedures to manage redemption requests and lock-up periods; -The policies and procedures to monitor the compliance with applicable investment policies and restrictions and the liquidity of investments held; and -The use of master netting agreements.

The disclosures should be based on information as seen ‘through the eyes of the management’. In other words, disclosures under the Standard needs to be based on how an entity views and manages its risks by, for example, using information provided internally to key management personnel. For many entities key management personnel may just mean the Board of Directors. However, given the operational strategy of a fund one would have to consider whether key management personnel might include the investment manager to the fund. This could potentially mean that the funds industry may be providing a greater volume of information than other entities. To the extent that the fund lodges information relating to business strategies with the Regulator or other third parties, then clearly management need to ensure consistency of information.

Market Risk Market risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. Market risk comprises three types of risk: currency risk, interest rate risk and other price risk (such as equity and commodity risks). The traditional schedule of investments provided by a fund for information and regulatory purposes will provide sufficient detail to cover off part of this requirement, but additional detail (for example, interest rates) may be required in order to satisfy the interest rate risk disclosures.

IFRS 7 requires a sensitivity analysis for each type of market risk to which a fund is exposed. The fund could present this information based on either of two methods. A general sensitivity analysis should show upward and downward movement effects of a reasonably possible change in the relevant risk variable on the fund’s profit and loss account and equity. In determining what is a reasonably possible change in the relevant risk variable, the fund should consider the economic environment in which it operates and would generally not include remote or worst case scenarios. Alternatively the fund could prepare a sensitivity analysis that reflects interdependencies between risk variables such as a value at risk methodology (VaR). Where such an approach is used, the fund must disclose the main assumptions and parameters used in the methodology. Furthermore, the objectives and the limitations of the method must be disclosed. In reality, this is only an option if VaR is actively used as a risk management process within the fund.

Sensitivity analysis in the case of fund of funds will not reflect the potential for risks inherent in each portfolio. The standard requires that where a sensitivity analysis is unrepresentative of risk inherent in the financial instrument further disclosure is needed.

Whilst IFRS 7 requires a currency risk sensitivity analysis, judgement is required to determine what is material for the fund. If a currency is not significant then no disclosure for that currency is required.

Although IFRS 7 does not require integrated disclosure of qualitative and quantitative information about market risk, a fund might find that presentation of information on a combined basis may be more understandable.

Credit Risk Credit risk is the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation. Additional disclosures are required under the standard for credit risk (credit quality, etc.,) as compared to the previous IAS 32 requirements. Funds which have substantial investment in equity securities are not likely to be significantly impacted by credit risk disclosures. However, funds with investment in bonds and derivatives are required to disclose their credit risk exposure to these instruments.

In determining credit risk, the fund should disclose the amount that best represents its maximum exposure to credit risk at the balance sheet date, without recognition of any collateral or other credit cover features. In the funds industry, such credit risk disclosures may be impacted by master netting arrangements which the fund may have entered into with counterparties to restrict its exposure to losses on derivative instruments. Only the net credit risk should be disclosed where the master netting arrangement permits netting off of balances on default. The credit risk note should cover the asset balance only where netting is not permitted and thus may result in the fund disclosing significant credit risk balances.

For funds, these credit risk disclosures will likely be a combination of qualitative discussion and extensive quantitative information provided in the risk management section of the notes to the financial statements or the financial review section of the annual report.

Liquidity Risk Liquidity risk is the risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities. IFRS 7 requires disclosure of a contractual maturity analysis for all financial liabilities on an undiscounted basis. This analysis should include the redeemable participating shares of the fund given they meet the definition of a financial liability. They should be classified as redeemable on demand as the shareholder has the right to request repurchase at any time and thus the fund is exposed to that underlying credit risk.

To the extent that the fund’s financial liabilities are all short term or repayable on demand, the fund may decide to provide a separate maturity analysis based on the expected maturity dates together with limits or other measures used by the fund to manage its liquidity exposures. Such disclosure does not negate the requirement to provide a contractual liability analysis as required by IFRS 7.

Conclusion The introduction of the IFRS 7 comes at a time when the nature of the financial markets means there may well be increased focus on the disclosures relating to risks such as credit and liquidity exposures. The requirement for comparative information to be provided combined with the need for mutual cooperation between the fund and the administrator and investment manager to produce discloses makes implementation of IFRS 7 a challenge for the funds industry. However, given that at least some of the increased focus will be from Regulators, can a fund really contemplate not giving adequate disclosures?

Fergus Condon is Director of the Financial Reporting Advisory Group at Ernst & Young.

Is it considered that the Investment Manager's own financial statements need to disclose the market risks created by virtue of the funds holdings since the Manager's fee is based on the value of 'funds under management'? That is, even though the Investment Manager does not hold or deal in instruments itself, are IFRS 7 disclosures triggered since it still has exposure to market risk (thereby affecting management fee income) ?