IFRS

 

!@                     # IFRS 7 Financial Instruments: Disclosures  Second Edition Edition

 

 

 

Introduction This publication provides an overview of IFRS 7 Financial  Financial Instruments: Disclosures Disclosures (IFRS 7 or the Standard) in addition to discussing implementation issues and the main differences compared to the  previous disclosure requirements for financial instruments. It also includes exa examples mples of disclosures  provided by companies that have adopted IFRS 7 early. It should be read read in conjunction with Ernst & Young’s International Young’s  International GAAP 2007  which  which explains the required accounting treatment for financial instruments and much of the terminology used in IFRS 7. IFRS 7 incorporates the disclosures relating to financial instruments required by IAS 32 Financial 32  Financial  Instruments: Disclosure Disclosure and Presentation1 and replaces IAS 30 Disclosures 30 Disclosures in the Financial Statements of  Banks and Similar Financial Institutions, Institutions, so that all financial instruments disclosure requirements are located in a single standard for all types of companies. The IFRS 7 disclosure requirements are less  prescriptive than those of IAS 30 for banks and there are no longer any bank-specific disclosure requirements. The IFRS 7 disclosure requirements include both ‘qualitative’ narrative descriptions and specific ‘quantitative’ data. The level of detail of such disclosures should not overburden users with excessive detail, but equally should not obscure o bscure significant information as a result of excessive aggregation. Unlike the other disclosures required by IFRS 7, the risk disclosures do not have to be given in the financial statements, but may either be provided in the financial statements or incorporated into the financial statements by reference from another statement (eg, the management commentary or a risk report that is available to users of the financial statements on the same terms as the financial statements). However, as the risk disclosures are required by IFRS, they will be subject to audit and, for companies with US Securities and Exchange Commission (SEC) registrations, the Sarbanes-Oxley Act Section 404 attestation process. The financial instrument disclosures are intended: (1) to provide information that will enhance the understanding of the significance of financial instruments to a company’s financial position, performance, and cash flows; and (2) to assist in evaluating the risks associated with these instruments, including how the company manages those risks. IFRS 7 introduces:

 

requirements for enhanced balanced sheet and income statement disclosure ‘by category’ (eg, whether the instrument is available-for-sale or held-to-maturity)

 

information about any provisions against impaired assets

 

additional disclosure relating to the fair value of collateral and other credit enhancements used to manage credit risk

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market risk sensitivity analyses.

IFRS 7 must be applied for accounting periods beginning on or after 1 January 2007.

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 Including amendments issued in 2005 for The Fair Value Option and Financial and Financial Guarantee Contracts Contracts..  1

 

 

 Scope IFRS 7 applies to all risks arising from all financial instruments, including those instruments that are not recognised on-balance sheet, for all companies in all industries. For example, loan commitments not within the scope of IAS 39 Financial 39 Financial Instruments: Recognition and Measurement Measurement (IAS 39) are within the scope of IFRS 7. Contracts to buy or sell a non-financial item that are within the scope of IAS 39 (as derivative financial instruments) are also within the scope of IFRS 7. The Application Guidance of IFRS 7 indicates that such financial instruments should be considered a separate class for the purpose of preparing the required disclosures. The following are excluded from the scope of IFRS 7:

 

interests in subsidiaries, associates, and joint ventures v entures

 

employee benefit plan obligations

 

contingent consideration in a business combination

 

insurance contracts

 

share-based payment transactions.

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Consistent with IAS 30 and IAS 32, there is no scope exemption for the financial statements of subsidiaries or, as yet, for small- and medium-sized companies. The IASB has issued an Exposure Draft (ED) of a proposed IFRS for Small- and Medium-sized Companies that proposes to provide such companies with the option of applying either: (1) the special rules for financial instruments contained in the ED and no requirement to apply IFRS 7, or (2) the recognition and measurement rules in IAS 39 and disclosure requirements in IFRS 7. The application of IFRS 7 to subsidiaries may present a challenge to companies that are members of a consolidated group, as they often manage risk on a consolidated basis. Furthermore, the requirement to  provide the disclosures for each company may be of limited value to users of financial statements statements (compared to the cost of compilation) when the information is already disclosed at the group level. Insurance contracts as defined by IFRS 4 Insurance 4 Insurance contracts are contracts are excluded from the scope of IFRS 7. However, IFRS 4 requires that qualitative and quantitative information regarding credit risk, liquidity risk, and market risk, as required by IFRS 7, be provided as if such insurance i nsurance contracts were included within the scope of IFRS 7. The Basis for Conclusions of IFRS 4 indicates that it is more useful to the users and  preparers of the financial statements statements if the risk disclosures for financial instruments and insurance contracts contracts are similar. All derivatives embedded in insurance contacts cont acts that are required to be accounted for separately in accordance with IAS 39 are within the scope of IFRS 7.

General points to note IFRS 7 disclosures must be based on the accounting policies used for the financial statements prepared in accordance with IFRS, including consolidation adjustments. It is possible that the internal information made available to management for risk management purposes is not prepared using such accounting  policies, in which case it will need to be adjusted. The Standard repeatedly requires disclosure by ‘class’ of financial instrument, a group that is appropriate to the nature of the information disclosed and the characteristics of the instruments. A class of financial instrument is a lower level of aggregation than a category, such as ‘available-for-sale’ or ‘loans and receivables’. For example, government debt securities, equity securities, or asset-backed securities could all  be considered classes of financial instruments. instruments.

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Balance sheet Like IAS 32, IFRS 7 does not prescribe the location of the required balance sheet-related disclosures. A company is permitted to present the required disclosures either on the face of the balance sheet or in the t he notes to the financial statements. The Standard requires disclosure of additional detail for each category of financial instrument, such as financial assets held at fair value through profit or loss or available-for-sale. By contrast, IAS 32 requires separate disclosure only of financial instruments carried at fair value through profit or loss, although the level of detail prescribed by IFRS 7 is not as extensive as the requirements of IAS 30. The required core  balance sheet disclosures for each each category of financial assets and financia financiall liabilities in IFRS 7 are similar to those in IAS 32 and include the carrying amount and related fair value, along with the amount of and reason for any reclassifications between categories. Disclosures relating to financial instruments held for trading should be presented separately from those designated at fair value through profit or loss.

Disclosure of fair value of financial instruments

Danske Bank  Annual Report 2006, p.119 Most companies should be familiar with the disclosure of the fair value of financial instruments as this disclosure is currently required by IAS 32. Similar to most companies, Danske Bank presents this information in the notes to the financial statements:

 

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Nordea  Annual Report 2006, p.129  Nordea, similar to most of the companies companies that adopted IFRS 7 early, provides infor information mation relating to the categories of financial instruments in the notes to the financial statements rather than on the face of the  balance sheet:

The required balance sheet disclosures include the following:

Financial liabilities at fair value through profit or loss IFRS 7 reiterates the requirement in IAS 32 to disclose the change in the fair value of a financial liability that is attributable to changes in the credit risk of that th at liability during the period and cumulatively. Since it may be difficult for many companies to identify and reliably measure the change in fair value due to changes in own credit risk, IFRS 7 permits companies to determine this amount as the amount of change in the liability’s fair value that is not attributable to changes in market conditions that give rise to market risk. Companies may use another method if they can demonstrate that it results in a more faithful representation of the change in fair value attributable to changes in the credit risk of the asset. IFRS 7 requires the method used to determine the change in fair value due to credit risk to be disclosed. Additionally, a company must disclose the difference between the carrying amount of financial liabilities at fair value through profit or loss and the amount the company will be contractually required to pay at maturity. The difference could be significant in the case of a long-dated financial liability whose creditworthiness has deteriorated.

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HSBC Holdings plc Annual Report and Accounts 2006, p.372 HSBC designates financial liabilities to be carried at fair value through profit or loss and, accordingly,  provides the following disclosures:

Loans and receivables at fair value through profit and loss IFRS 7 contains the disclosure requirements for loans and receivables at fair value through profit or loss introduced in IAS 32 as a result of the IAS 39 fair value option op tion amendment. IFRS 7 refers only to loans and receivables in this regard. However, we presume that the IASB intended that the disclosure requirements apply also to hybrid instruments designated at fair value through profit or loss that contain a loan as the host contract (ie, loans with embedded derivatives that would otherwise require separation). The required disclosures include the maximum credit exposure, the impact of credit derivatives on the credit exposure, and the change in the fair value of the loan or receivable (or group of loans or receivables) and any related credit derivatives due to changes in credit risk, both during the period and cumulatively. The ‘default’ approach for the calculation of the change in fair value attributable to credit risk (ie not attributable to changes in market risk) is similar to that for financial liabilities at fair value through profit or loss (refer to discussion above). As with financial liabilities at fair value through profit or loss, if another method more faithfully represents the effect of credit risk then the company should use it.

 

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Danske Bank  Annual Report 2006, p.101 Danske Bank designates mortgage loans and issued mortgage bonds to be recorded at fair value through  profit or loss and, accordingly, provides the following disclosures: disclosures:

 Other sundry balance sheet disclosures:  Reclassifications:: disclosure is required of the amount and the reason for reclassification to or from    Reclassifications cost or amortised cost and fair value (although reclassification into or out of financial assets or liabilities at fair value through profit or loss is not permitted, so, in practice, this will relate only to transfers to or from available-for-sale). •

   Derecognition  Derecognition:: certain information is required to be disclosed for each class of financial instrument

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when transferred financial assets do not qualify for derecognition, or when the assets continue to be recognised to the extent of the company’s ‘continuing involvement’.

HSBC Holdings plc  Annual Report and Accounts 2006, p.359 HSBC provides the following disclosure of the impact of financial assets that have been transferred but that do not qualify for derecognition:

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HSBC provides the following disclosure of financial assets that have been securitised under arrangements  by which it retains a continuing involvement, and that it therefore continues to to recognise:

 

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Collateral given: given: disclosure is required of the carrying amount in addition to the terms and conditions 2

of financial assets  pledged collateral. Additionally, IAS(by 39custom requiresorcollateral when the counterparty has the right toas sell or repledge the collateral contract),provided, to be reclassified separately from other assets.

Deutsche Telekom 2006 Financial Review, p.146 Deutsche Telekom provides the following information relating to financial assets pledged as collateral:

 

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Collateral received : a company must disclose the fair value and terms and conditions of financial or non-financial assets received as collateral which the company has the right to sell or repledge in the absence of default.

Deutsche Telekom 2006 Financial Review, p.147 Deutsche Telekom provides the following information relating to financial assets received as collateral:

   Allowance for credit losses: losses: IFRS 7 requires a reconciliation to be presented of changes in the

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allowance for credit losses for each class of financial assets during the period, whereas IAS 30 requires a similar disclosure only for loans and advances. The reconciliation should include appropriate captions and explanations to highlight the components of the reconciliation.

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 IAS 16 Property, 16 Property, Plant Plant and Equipment Equipment requires disclosure of non-financial assets pledged as collateral.   

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Most companies will use a separate allowance account (ie, bad debt reserve) for credit losses only for loans and receivables, as impairment losses for most other financial assets directly reduce the carrying amount of the assets. As noted below, financial institutions and corporate companies typically present the reconciliation for the allowance for credit losses in a similar format:

Danske Bank  Annual Report 2006, p.101

Deutsche Telekom Financial Review 2006, p.147 

Nordea  Annual Report 2006, p.107  Nordea presents a reconciliation reconciliation of allowances for both the individually and the collectively assessed impaired loans, whereas most companies disclose a reconciliation of the total allowance for credit losses:

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DISCLOSURES 

 

 

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Compound financial instruments with multiple embedded derivatives derivatives:: if a company has issued an instrument that contains both a liability and an equity component and the instrument has multiple embedded derivatives whose values are interdependent (eg, callable convertible debt), the existence of those features must be disclosed.

   Defaults and breaches: breaches: disclosure is required of the details of any defaults by the company during the

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 period, carrying amounts of financial financial liabilities (other than short-term trade pa payables yables on normal credit terms) that are in default at the reporting date, and whether such defaults were remedied prior to the issue of the financial statements.

Income statement Similar to the minimum balance sheet disclosures, a company is permitted to present the required income statement disclosures on either the face of the income statement or in the notes to the financial statements. The income statement disclosures required by IFRS 7 are more detailed than those required by IAS 32, although not as detailed as the requirements of IAS 30. For example, IAS 32 required separate disclosure only of the net gains or net losses on financial instruments carried at fair value through profit or loss, whereas IFRS 7 requires the disclosure of this information for each category of financial assets and financial liabilities. IFRS 7 allows a company to choose how the income statement amounts are determined, and suggests that the company discloses in its accounting policies how net gains or losses l osses on each category of financial instrument are determined. For example, interest or dividends earned on financial instruments carried at fair value through profit or loss may be included in net gains or losses for the category, or in interest or dividend income, and the policy should make it clear where they are reported. IAS 32 disclosures retained in IFRS 7 include: total interest income and total interest expense (calculated using the effective interest method) for •  financial assets and financial liabilities that are not measured at fair value through profit or loss

 

gains or losses on available-for-sale financial assets recognised in equity and the amounts reclassified from equity to profit or loss for the period

 

interest accrued on impaired financial assets.

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Disclosure requirements introduced by IFRS 7: Net gains or losses for each category of financial asset or financial liability As already noted, IFRS 7 does not prescribe whether interest and dividends must be included within net gains or losses for financial instruments at fair value through profit or loss, or in interest or dividend income. It would be possible to treat the various categories of financial instruments, and possibly even different classes, differently, as long as there is consistent application from period to period and the company’s accounting policy is disclosed. For example, a company may present interest income for debt securities held for trading as a component of total interest income, whereas dividend income received on equity securities held for trading may be recorded in net gains or losses lo sses on financial instruments at fair value through profit or loss. Funding costs related to a company’s trading portfolio are not considered to be part of a company’s trading activities and should be included in interest expense. There are different views as to how to treat interest or dividend expense on short positions – our o ur view is that they should be classified in a manner consistent with the treatment of interest and dividends on long positions and included in either interest or dividend expense, or in gains and losses on financial instruments at fair value through profit or loss, as appropriate.

 

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Danske Bank  Annual Report 2006, p.74-75 and 88 Danske Bank provides a detailed analysis of the sources and components of net gains and losses, total interest income and total interest expense. This disclosure is supplemented by the explanation below:

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Deutsche Telekom Financial Review 2006, p.138 Deutsche Telekom discloses the net gains or net losses for each category of financial instruments included in total interest income and expense:

Impairment losses for each class of financial asset As already noted, a class of financial instruments is a lower level of aggregation than a category. For example, a company would probably disclose impairment losses for available-for-sale debt securities separately from impairment losses for available-for-sale equity securities if the classes are material.

 

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Deutsche Telekom 2006 Financial Review, p.152 Deutsche Telekom includes this disclosure in the notes to the financial statements:

Fee income and expense (other than amounts included in the determination of the effective interest rate) for:

  financial assets and financial liabilities not measured at fair value through profit or loss, (such as

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certain syndication fees, credit card annual fees and some commitment and guarantee fees)

  fee income and expense from trust and other fiduciary activities (such as fixed management and safe

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custody fees).

HSBC Holdings plc  Annual Report and Accounts 2006, p.319 HSBC provides information about the components of net operating income in the notes to the financial statements:

 Other disclosures  Accounting policiesof Financial Statements requires disclosure of a company’s significant accounting policies IAS 1 Presentation 1 Presentation  policies, including the judgments that management has used used in their application. The Application Guidance  provides guidance on how these requirements may may be applied to financial instruments. It suggests that the disclosures might include the criteria for (1) designating financial assets and financial liabilities as at fair value through profit or loss, (2) designating financial assets as available-for-sale, (3) determining when the carrying amount of impaired financial assets are reduced directly and when the allowance accounted is used, and (4) writing off amounts charged to the allowance account against the carrying amount of impaired financial assets.

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A key question with accounting policies disclosures is how detailed they should be. For example, in explaining the criteria used to determine whether there is objective evidence of impairment, as suggested  by the Application Guidance, companies are unlikely to disclose disclose specific thresholds and parameters parameters for each class of financial asset even though the amount of impairment for each category of financial asset is required to be disclosed. However, some regulators have expressed concern that some policy disclosures under IFRS have been too general—summarising the standards rather than setting out how they have been applied by the company. The extent of information provided about loan impairment criteria tends to vary from company to company, as shown by the following illustrations:

HSBC Holdings plc Annual Report and Accounts 2006, p.305-306

Danske Bank  Annual Report 2006, p.68

 

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Hedge Accounting The table below summarises the hedge accounting disclosures required by IFRS 7. IFRS 7 expands on the requirements of IAS 32 in that the gain or loss on a hedging instrument in a cash flow hedge that is transferred from equity to profit or loss must be analysed by income statement caption. Additionally, IFRS 7 introduces the requirement to disclosure the amount of ineffectiveness recognised in profit or loss for cash flow hedges and hedges of net investments in foreign operations, and the gain or loss during the period on the hedging instrument and hedged item attributable to the hedged risk for fair value hedges. Disclosure 

Description of hedged risk and hedging instrument with related fair values

Fair value  hedges 

Cash flow  hedges 

Net investment  hedges 

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When hedged cash flows are expected to occur

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If forecast transactions are no longer expected to occur

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Gain or loss recognised in equity and reclassifications to P&L

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Gain or loss from hedging instrument and hedged risk Ineffectiveness recognised in P&L during the period

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Companies may wish to separate the types of hedges (eg, into “micro” and “macro” hedges) when  preparing the required hedge accounting disclosures, in order to assist in explaining ineffectiveness.

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HSBC Holdings plc  Annual Report and Accounts 2006, p.355 HSBC provides the following disclosure related to cash flow hedges:

 

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Deutsche Telekom 2006 Financial Review, p.188 Although disclosure of the methods used to assess the effectiveness of hedge relationships is not specifically required by IFRS 7, several early adopters did provide a detailed description of the hedge effectiveness tests used. Within its disclosures relating to fair value hedges, Deutsche Telekom includes a description of the hedge effectiveness tests used:

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Nordea  Annual Report 2006, p.111  Nordea provides the required disclosures of net gains or losses from fair value value hedge accounting relationships separately for individual hedge relationships and portfolio hedge relationships:

Fair value IFRS 7 retains the IAS 32 disclosures relating to the methods and significant assumptions used to determine fair value for the different classes of financial assets and financial liabilities. The required disclosures include:

 

whether the fair value is based on quoted prices or valuation techniques  

 

whether the fair value is based on a valuation technique that includes in cludes assumptions not supported by market prices or rates, and, if so, the amount of the change in fair value recognised in profit or loss that arises from the use of the valuation technique

 

the effect of reasonably possible alternative assumptions used in a valuation technique. 

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HSBC Holdings plc Annual Report and Accounts 2006, p.305 HSBC provides the following information about its accounting policies for determining the value of financial instruments:

UBS Financial Report 2006, p.156 Although UBS has not yet adopted IFRS 7, it provides qualitative and quantitative information regarding the determination of fair value for financial instruments, which includes the effect of changes in fair value due to reasonably, possible alternative assumptions used in valuation techniques:

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UBS Financial Report 2006, p.156 (continued)

IAS 32 currently requires disclosure of the nature and carrying amount of equity instruments that are recorded at cost because their fair value cannot be reliably measured, including an explanation of why this thi s is the case. IFRS 7 expands the IAS 32 requirements by requiring information to be given about how the company intends to dispose of such financial instruments.

‘Day 1’ profit or loss IAS 39 does not permit a profit or loss to be recorded when a financial instrument is initially recognised (a ‘Day 1’ profit or loss), unless the fair value of the instrument is based on a valuation technique whose variables include only data from observable markets. IFRS 7 requires disclosure of any Day 1 profit or loss not recognised in the financial statements, the change in the amount previously deferred, and the company’s  policy for determining when amounts deferred deferred are recognised in profit or loss.

HSBC Holdings plc  Annual Report and Accounts 2006, p.354 HSBC provides a reconciliation of the Day 1 profit deferred in the notes to the financial statements:

 

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disclosures ures  Qualitative risk disclos IFRS 7 retains the qualitative disclosures required by IAS 32 relating to risks (ie, credit risk, liquidity risk, and market risk) arising from financial instruments to which a company is exposed, including a discussion of management’s objectives and policies for managing such risks. The qualitative disclosures are intended to complement the required quantitative disclosures and assist readers of the financial statements to understand the company’s risk management activities. IFRS 7 expands the qualitative risk disclosure requirements to include information on the processes that a company uses to manage and measure its risks. Although integrated qualitative information market risk are not specifically required,disclosures a companyof may find thatand the quantitative disclosures will be more about understandable when the qualitative disclosures are combined with the required quantitative disclosures. The qualitative disclosures should include a narrative description of the risks the company is exposed to and how they arise. The policies and processes for managing the risks would typically include:

 

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the structure and organisation of the risk management function, including a discussion of independence and accountability

  the scope and nature of the risk reporting and measurement systems   the policies and procedures for hedging or mitigating risks, including the taking of collateral    processes for monitoring the continuing effectiveness effectiveness of hedges and other risk mitigating devices concentrations of risk.    policies and procedures for avoiding excessive concentrations

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Companies are strongly recommended to keep the description of their risk management processes factual, and not to make assertions as to their adequacy to meet their risk management objectives. To provide an assertion would entail a process of evaluation and testing, which would be expensive to carry out and to audit, similar to the process required for financial information by the Sarbanes-Oxley Act for US SEC registrants. The Guidance on Implementing IFRS 7 suggests that the information concerning the nature and extent of risks will be more helpful if it highlights any relationships between financial instruments that can affect the amount, timing, or uncertainty of future cash flows. Disclosure is also required of any changes in the qualitative information from one period to the next that arises from changes in exposure to risk or from changes in the way those exposures are managed.

 Quantitative risk disclos disclosures ures IFRS 7 expands on the quantitative disclosures contained in IAS 32, which are intended to provide information about the extent to which a company is exposed to risks based on the information available to key management personnel3. If the company uses several methods to manage risk exposures, it should disclose information using the methods that are most relevant and reliable. There is an expectation that information provided to management is reliable, although some companies are upgrading the quality of their risk information to ensure that it is robust enough for disclosure in the annual report. The Standard requires disclosure of all risk concentrations to which a company is exposed in relation to financial instruments, based on financial instruments that have similar characteristics (such as geographical area, currency, industry, market, and type of counterparty) and the amount of the risk exposure concerned. Additionally, IFRS 7 requires a description of how management determines such concentrations. When the quantitative data disclosed at the reporting date is not representative of the company’s exposure to risk during the period, further information that is representative must be provided. US foreign private issuers should note that the market risk disclosures required by the US SEC include all ‘market risk sensitive instruments’. These are defined as derivative financial instruments, other financial instruments, and derivative commodity instruments. Whilst some derivative commodity instruments do not meet the US GAAP definition of a financial instrument, the SEC specifically includes them in the required disclosures. This will include, for example, the foreign currency or price risk for commodity contracts that 3

 IAS 24 Related 24 Related Party Party Disclosures defines Disclosures defines key management personnel as “those “ those persons having authority and responsibility for  planning, directing and  planning, and controlling controlling the activitie activitiess of the company, company, directly or in indirectly, directly, includ including ing any director director (whether executive executive or otherwise) of that company.” company.” 20

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are considered to be within the company’s ‘expected purchase, sale or usage requirements’. US foreign  private issuers may wish to make make similar disclosures in their IFRS financial statem statements. ents. If so, the amounts relating to financial instruments within the scope of IFRS 7 should be shown separately from those relating to financial instruments outside the scope of the Standard.

 Credit risk Credit risk is defined as “the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation.” For each class of financial instrument, IFRS 7 requires disclosure of the maximum credit exposure before consideration of collateral or other credit enhancements received (eg, master netting agreements), plus a description of collateral and other credit enhancements available.

Maximum credit exposure The Standard considers the maximum credit exposure for loans and receivables granted and deposits  placed to be the carrying amount, net of any impairment losses, losses, and for derivatives to be the current fair fair value. For financial guarantees and loan commitments, this amount would be the maximum amount the company could be required to pay (or fund), without consideration of the probability of the actual outcome.

Danske Bank Annual Report 2006, p.123 Danske Bank provides the required disclosure of maximum credit exposure in the risk management section of the notes to the financial statements:

 

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Financial assets that are neither past due nor impaired IFRS 7 introduces disclosure of information relating to the credit quality of financial assets that are neither  past due due nor impaired. impaired. This This dis disclosur closuree may includ includee a discussio discussion n of the the nat nature ure of the co counterp unterpartie arties, s, historica historicall information relating to counterparty default rates, and other information used to assess credit risk (eg, an analysis of credit exposure using internal or external credit ratings). It should be noted that all financial assets, except for equity instruments held by a company, have some level of exposure to credit risk. For financial services companies, the credit risk disclosures in IFRS 7 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.

Danske Bank  Annual Report 2006, p.124-125 The required credit risk disclosures may, among other items, include a distribution of loans by industry sector and geographical location, such as the following provided by Danske Bank:

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For companies outside the financial services industry, the IFRS 7 credit risk disclosures will not normally  be as extensive as those for financial services services companies. Accordingly, D Deutsche eutsche Telekom provides the required credit risk disclosures in narrative form in the risk management section of the notes to the financial statements:

Deutsche Telekom 2006 Annual Repor t,  t, p.188

Financial assets that are either past due or impaired IFRS 7 introduces disclosure of information relating to financial assets that are either past due or impaired. This includes (1) an analysis of the age of financial assets that are past due but not impaired, (2) an analysis of those financial assets that are impaired, and (3) a description and the fair value, unless impracticable, of collateral held against financial assets that are either past due or impaired. The disclosures for financial assets that are past due but not impaired may present a number of operational issues:

 

information about past due financial assets may not be captured by a company’s credit system until the assets concerned have been past due for a period of time (eg, 30 days)

 

it may not be possible to allocate a collective impairment provision to individual loans and receivables and an age analysis may need to be prepared gross of any collective impairment provision

 

while a bank may evaluate periodically the fair value of its collateral for corporate loans, large residential mortgages and impaired loans, such updates may not be performed for smaller residential mortgages and, therefore, the only value available may be that obtained at inception of the loan.

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It may be helpful to link this disclosure to the company’s policy for determining whether a loan or receivable is impaired.

 

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Deutsche Telekom 2006 Financial Review, p.146 Deutsche Telekom provides the analysis of the age of past due loans and receivables in the notes to the financial statements:

company mpany has taken control of during the period  Collateral the co IFRS 7 also introduces disclosure of information about the extent of assets recognised by a company during the period as a result of taking possession of collateral or calling on other credit enhancements such as guarantees, and their disposition. The required disclosures relate to both financial instruments (eg, cash, debt securities, equity securities) and non-financial items (eg, property, equipment, and inventory). Accounting recognition of such assets depends on the recognition criteria in IFRS and not the conditions of the transaction and/or local law. 

HSBC Holdings plc  Annual Report and Accounts 2006, p196 HSBC includes the following disclosure in the Management the Management of Risk  section  section that precedes the financial statements. Note the statement in the note that this information is audited in its annual report. IFRS 7 does not require the risk disclosures to be included in the primary financial statements and, accordingly, this information is incorporated in the audited financial statements by reference:

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Liquidity risk IFRS 7 requires a maturity analysis for financial liabilities to be presented showing their remaining contractual maturities, and a description of how the company manages those liquidity risks. In practice, most companies manage liquidity risk based not on contractual cash flows but on expected maturities. This is especially true for banks where a large proportion of current accounts that are, in theory, repayable on demand can be expected to remain in place. If this is the case, then the company may wish to provide a separate maturity analysis based on e xpecte  xpected d maturity dates, possibly both for financial assets and liabilities, along with the limits or other measures used by the company to manage its liquidity exposures. However, such an analysis will not remove the need to produce the contractual liability analysis required by the Standard.

 Contractual maturity analysis for financial liabilities liabilities IAS 30 requires banks to disclose contractual maturity information about both financial assets and financial liabilities. IFRS 7 is less prescriptive and does not require disclosure of contractual maturities of financial assets. A company may nevertheless decide to present such information in order to provide a complete view of the company’s contractual commitments. The Application Guidance on the contractual maturity analysis is one of the most problematic sections of IFRS 7. According to this guidance:

 

•

•

Financial liabilities must be disclosed by their contractual maturity, based on undiscounted  cash  cash flows.  Note that if they are undiscounted, then the table is unlikely to reconcile reconcile easily to information recorded in the balance sheet and, also, is unlikely to be information which is routinely prepared for management purposes.  purposes. 

 

For derivatives, the contractual amounts to be disclosed should be the gross cash flows to be paid. Hence, a currency swap will need to be grossed up to show the gross amounts payable, while an interest rate swap would be shown net. In order to show the true liquidity profile, most companies will wish also to disclose amounts receivable that are related to the gross cash outflows. Disclosure  practices may well vary. For For example, some companies have omitted omitted derivatives from the contractual contractual liability disclosure using the argument that such instruments form part of a trading portfolio and are short-term in nature.  nature. 

 

It is unclear how to treat perpetual instruments. Since the cash flows are required to be shown undiscounted, the cash flows are potentially infinite. Most companies will probably wish to deal with such instruments using narrative disclosure.  disclosure. 

 

Financial instruments that give the creditor an option as to when amounts are paid should be analysed according to their earliest date on which the can be required to pay, without considering the probability of the option being exercised.  exercised. 

 

The analysis should include guarantees and commitments. commitments.  

•

•

•

It should be noted that IFRS 4 permits insurance companies to disclose the liquidity analysis of recognised insurance liabilities based on the estimated timing of the net cash outflows from the contracts rather than on their contractual maturities as required by IFRS 7.

 

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Novartis Annual Report 2006, p.183 and 185  Novartis discloses the contractual maturities maturities of its financial assets, as as well as the contractual maturities for financial liabilities in the notes to the financial statements. This disclosure is supplemented by a discussion of how the company manages its liquidity risk, also located in the notes to the financial statements:

Description of how liquidity risk inherent in financial liabilities is managed Factors mentioned in the Implementation Guidance that the “company might consider” in describing how it manages its liquidity risks include whether the company:

 

expects some liabilities may be paid later than the earliest contractual due date

   

has undrawn loan commitments that are not expected to be drawn

•

     

has committed borrowing facilities which it could use to help provide liquidity

•

holds deposits at central banks that it can use to meet liquidity needs

•

   

has diverse funding sources

•

has significant concentration of liquidity risk in either its assets or its funding sources.

• •

•

•

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holds financial assets for which there is a liquid market and are, therefore, readily saleable to meet liquidity needs

holds financial assets which are not traded in a liquid market, but which can be expected to generate cash inflows that will be available to meet cash outflows on liabilities

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HSBC Holdings plc Annual Report and Accounts 2006, p.213-214 HSBC includes both the qualitative discussion of the process used to manage liquidity risk and the required liquidity analysis of financial liabilities in the financial review section of its annual report:

 

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Market risk Market risk is defined as “the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices” and includes interest rate risk, foreign currency risk and “other price risks”, such as equity and commodity risk. All financial instruments are subject to market risk; however, the required market risk quantitative disclosures are restricted to the sensitivity of profit or loss and equity to changes in market risks. The disclosures, therefore, focus on accounting ( accounting  (as as opposed to economic)) sensitivity and exclude, for example, interest rate risk arising on fixed rate financial assets held economic to maturity or loans and receivables. Companies may also provide disclosures about such items but, arguably, they would need to be shown separately. There are two ways in which market risk sensitivity may be disclosed:

  a separate sensitivity analysis for each type of market risk to which the company is exposed at the

•

reporting date, based on changes in the risk variable that are considered “reasonably possible” at that date; or

  an analysis such as Value at Risk (VaR) that takes into account the interdependencies between market

•

risk variables, if this method is used by the company to manage its financial risks. All sensitivity analyses should take account of the effects of hedges but, as the amounts to be disclosed are the expected effect on profit or loss or equity, the Standard implies that the accounting treatment of the hedges needs to be taken into account in the analysis.

 Sensitivity analysis IFRS 7 does not prescribe the format in which a sensitivity analysis should be presented, although exposures to risks from significantly different economic environments should not be combined. For example, (1) a company that trades financial instruments might disclose sensitivity information separately for financial instruments held for trading and for those not held for trading, and (2) exposure to market risks in hyperinflationary economies might be disclosed separately from exposure to the same market risks arising in economies with low inflation rates. Companies with significant non-financial commodity contracts may wish to present a sensitivity analysis  both for contracts that are recognised in the financial financial statements (ie, those within the scope of IIAS AS 39) and those that are not recognised, in order to provide a complete picture of the company’s exposure to commodity price risk. The Application Guidance indicates that it is possible to use different sensitivity methodologies for different classes of financial instruments or business segments. For example, a bank with insurance operations might manage its risks related to the two businesses differently and may wish to present its sensitivity analysis in accordance with the manner in which it manages the risks. The Implementation Guidance identifies two types of interest rate sensitivity. These are the effects of changes in interest rates on:

  fixed rate financial assets and liabilities; and   variable rate financial assets and liabilities.

•

•

The first of these measures the impact on profit or loss for the year (for items recorded at fair value through  profit or loss) and on equity (for available-for-sale available-for-sale securities and financial instruments instruments used as cash flow hedges and net investment hedges) that would arise from a reasonably possible change in interest rates at the balance sheet date on financial instruments held at the period end. The second of these measures the change in interest income or expense over the period of a year attributable to a reasonably possible change in interest rates, based on the floating rate assets and liabilities held at the balance sheet date. The Application Guidance makes it clear that the sensitivity analysis should show the effects of changes that are reasonably possible over the period until the company will next present its risk disclosures, ie usuallycurrently the next year. test should exclude or ‘worst case’rate scenarios or ‘stressvarying tests’. Banks use a The widesensitivity range of assumptions for theirremote non-trading interest risk sensitivity, from 0.01% to 1%.

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The foreign currency risk sensitivity information required by IFRS 7 is limited to the risks that arise on financial instruments denominated in currencies other than the functional currency in which they are measured. As a result, there is no requirement in IFRS 7 to provide quantitative disclosures of the currency risks posed by overseas net investments (and so revalued on consolidation through equity). Similarly, there is no requirement to provide disclosures about hedges of overseas net investments.

VaR and similar models If the company uses a method such as VaR analysis that reflects interdependencies between risk variables it must explain the method used in preparing the sensitivity analysis and the parameters and assumptions underlying the data provided. This will usually include:

   

•

•

the period over which positions are expected to be held (and so the modelled losses incurred) the confidence level at which the calculation is made, ie the percentage number of days in which losses are expected to be less than the disclosed VaR.

We would also expect companies to provide sufficient narrative information to explain what these  parameters mean and how they should be interpreted. interpreted. When VaR is used, there is no reference in IFRS 7 to “reasonably possible changes” – the assumptions are left to the company to select, based on those it uses to measure its risks for management purposes. Banks currently use a wide variety of assumptions, for example one bank may use a 95% confidence level and a one-day holding period, while another bank may use a 99% confidence level and a ten-day holding  period. Such differences in assumptions assumptions will make it difficult for reade readers rs to compare the risk profiles of different institutions. If a methodology such as VaR is used, then the company also needs to disclose the limitations of the method, which might include:

  the measure is a point-in-time calculation, reflecting positions as recorded at that date, which do not

•

necessarily reflect the risk positions held at any other time

  that VaR is a statistical estimation and therefore it is possible that there could be, in any period, a

•

greater number of days in which losses could exceed the calculated VaR than implied by the confidence level

  that although losses are not expected to exceed the calculated VaR on, say, 95% of occasions, on the

•

other 5% of occasions losses will be greater and might be substantially greater than the calculated VaR. Most companies that use VaR make reference to their use of stress testing to help manage losses arising from lower frequency, higher magnitude movements in market prices than those modelled using u sing VaR. As there is no requirement to disclose stress test sensitivities, these companies do not normally quantify the losses expected to arise in stress circumstances. Whatever form of sensitivity analysis is presented, if the sensitivities based on year end positions are not representative of the risks managed during the year, the company must provide further disclosure to show the level of risk that would be a better indicator. For example, a company may disclose maximum, minimum, and/or average amounts in addition to the required year-end amount.

 

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Deutsche Telekom 2006 Financial Review, p.186-187 Deutsche Telekom provides a sensitivity analysis in the notes to the financial statements to illustrate the impact on profit or loss and equity of changes in currency rates. The following is an excerpt that describes the risk and the impact on the financial statements:

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Novartis Annual Report 2006, p.184  Novartis uses a VaR model model to measure the impact of the mar market ket risk relating to its financial instruments instruments and includes the average, maximum, and minimum VaR, along with the year-end amounts:

 

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If you would like to discuss financial instruments in more detail, please contact your regular Ernst & Young representativee or one of the people below: representativ Michiel van der Lof

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