Malta: Know Your IFRS ‘ABC’: Q Is For ‘Qualitative’ Disclosures For Financial Risk

Last Updated: 13 June 2014
Article by Fabio Axisa

Many of us became accountants for a reason – we prefer numbers to words. So it is not surprising that qualitative disclosures are less popular with preparers of financial statements. Following the financial crisis, many blamed the accounting rules for the lack of sufficient warning. But disclosure of the financial risks of the entity, as required by IFRS 7, should have given some sign of what was to come.

Let's focus on the qualitative aspects of disclosure. IFRS 7 is a perfect opportunity for management to 'tell their story' about exposure to financial risks. But management can be reluctant to say more than the 'bare minimum' or reveal more than what their competitors might say. The regulators are starting to catch on. ESMA referenced IFRS 7 disclosures in their 2013 enforcement priorities emphasising the need to include better qualitative and quantitative disclosures about financial risks.

IFRS 7 in a nutshell

What is the objective of IFRS 7?

IFRS 7 applies to financial and non-financial institutions and is divided into two distinct sections. The first section covers quantitative disclosures about the numbers in the balance sheet and the income statement. The second focuses on risk disclosures which reflect the way management perceives measures and manages the risks.

It requires both qualitative and quantitative disclosures and explains that 'providing qualitative disclosures in the context of quantitative disclosures enables users to link related disclosures and form an overall picture of the nature and extent of risks arising from financial instruments.'

What has changed recently?

IFRS 7 has been amended several times over the years to improve disclosures about the entity's exposure to financial instruments. The latest two amendments relate to transfers of financial assets (applicable 1 July 2011) and offsetting financial assets and financial liabilities (applicable 1 January 2013).

Many of the fair value disclosure requirements previously included in IFRS 7 have been transferred to IFRS 13. But disclosures of all other types of financial risk remain in IFRS 7. These disclosures are more relevant now than ever as the financial markets become more complex and exposure to risk continues to increase.

What qualitative disclosures are required?

IFRS 7 focuses on risks associated with financial instruments such as credit risk (risk of suffering a loss related to a financial asset), liquidity risk (risk of not meeting financial obligations as they are due) and market risk (including currency, interest rate and price risk). For each type of risk, an entity should disclose:

  • the exposures to risk and how they arise;
  • objectives, policies and processes for managing the risk and the methods used to measure the risk; and
  • any changes to the above from the previous period.

IFRS 7 requires disclosure about the exposure to risks and how the entity has mitigated such risks. For example, an entity might disclose the policies around monitoring credit risk and investing in financial assets of a certain credit quality.

It might discuss the collateral enhancements to ensure collateral is sufficient to cover any loss. For liquidity risk, an entity should discuss the funds available to cover short and long term debt obligations. The entity might also economically hedge exposure to market risk even if it is not formally electing to apply hedge accounting. Qualitative disclosures should be included to comply with the spirit of IFRS 7.

Keep in mind there are more disclosure requirements about the entity's capital structure captured in IAS 1. This includes what an entity considers capital and its objectives, policies and processes for managing capital.

Frequently asked questions

Let's look at some common questions in practice around the application of IFRS 7:

Capital risk disclosures

Q: Are disclosures relating to 'externally imposed capital requirements' in IAS 1 only relevant for regulated entities?

A: The scope of 'externally imposed capital requirements' is broad and includes not only solvency ratios established by insurance or banking regulators, but also capital requirements/limits established by other bodies and through certain contractual relationships.

'Net' versus 'gross' risk

Q: An entity invests in a foreign currency bond maturing in one year and simultaneously enters into an FX forward contract with a corresponding maturity to offset the foreign currency risk. Is the materiality of the foreign currency risk on the bond assessed with or without the FX forward contract?

A: The materiality of the foreign currency risk on the bond is assessed without the FX forward contract. The bond and the FX forward are dissimilar items (per IAS 1), therefore the materiality assessment of the foreign currency risk is performed without considering the FX forward. If it is the risk that is material, the relevant qualitative disclosures are required.

The sensitivity analysis, however, is based on the net FX exposure, that is, after offsetting the foreign currency bond against the FX forward contract.

The same approach would apply for the assessment of credit risk, liquidity risk and other market risk.

Liquidity risk

Q: An entity has appropriately disclosed a liquidity table. What else is required?

A: The liquidity table provides helpful quantitative information but does not provide a full picture of how any entity manages liquidity risk. For example, it excludes information about how the maturity analysis links to funding requirements or how the entity manages borrowing against assets such as money market funds or unused facilities. ESMA¹ specifically encouraged issuers 'to make sufficiently clear and explicit the relationship between different disclosures related to liquidity risk and funding.'

Entities with more than one business

Q: How should an entity with two distinct operations (for example, a retail division and a bank division) present the risk disclosures if management monitors each division separately?

A: They should present the disclosures based on the management reporting separately for the bank and retail business, if that is the way management monitors the financial risks.

Footnote

1. ESMA European Securities and Markets Authority PUBLIC STATEMENT European common enforcement priorities for 2013 financial statements November 2013

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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