IFRS promotes transparency, practically at par with US GAAP, but greater than any of its predecessor national accounting systems. ‘Sunshine is the best disin- fectant,’ said Dr Louis Brandeis, US Supreme Court Justice. ‘Sunshine’ means transparency and transparency can give investors a much better understanding of risk and return which characterizes their financial assets. Some experts expect that this will help to lower the risk premium, reducing the cost of equity capital.
Other experts, however, disagree as to the end result.
● One of the opinions I heard in my research is that there will be a positive impact on the cost of capital only if the additional volatility is already priced in by investors.
● Another opinion made reference to a prognostication of positive impact if, and only if, investors think they have greater insight into the business whose equity they purchase.
● Still others, however, say there will be no impact on the cost of capital if the additional volatility is already priced in by investors. Differences in opinions is what makes the market.
On the other hand, three contradictory opinions do not lead to a conclusion.
Where most experts agree is that the introduction of the new IFRS rules will cer- tainly raiserisk awareness and sensitivity. As a result, management will need to promote a stronger risk culture inside the firm, as well as an awareness amongst shareholders, employees, clients and other stakeholders that risk has its price.
In my opinion, increased transparency will see to it that companies will face growing pressure to produce more detailed risk reports, which are comprehen- sive as well as comprehensible to their readers. These analytical risk reports should be both quantitative and qualitative, including:
● Cash flow sensitivity, and
● Analyses of risk concentration.
For instance, there should be increased focus on credit risk exposure in the after- math of more stringent impairment rules. This is altogether positive, particularly at a time when creative accounting practices, restatements of earnings, revela- tions of accounting fraud, and other corporate scandals have undermined public confidence in financial reporting.
Greater transparency is not only welcomed by investors, but also by rating agen- cies, equity analysts, and regulators, who want accounting standards to reflect more accurately the economic and financial nature of the business. Only those who have something to hide resist transparency. But those who resist trans- parency are the few trying to misguide the many.
As far as corporate governance is concerned, transparency in financial statement and a properly functioning internal control correlate. IFRS specifies that an entity’s internal organizational and management structure, as well as its system of internal financial reporting to the board of directors and chief executive offi- cer, will normally be the basis for:
● Identifying the predominant source and nature of risks, and
● Pin-pointing differing rates of return facing the entity in its current operations.
The board, CEO, and executive vice-presidents need properly functioning inter- nal control channels.9 They may also be assisted by on-line datamining and knowledge artifacts instrumental in determining which type of risk gets out of established control limits, and where this happens. The impact of these factors on the entity’s financial reporting content and structure is self-evident.
A good example where the internal control reporting structure finds fruitful application is liquidity risk. Beyond credit risk and market risk, IFRS require disclosure of maturity analysis for financial liabilities, that show the remaining earliest contractual maturity, and therefore case outflow. Such information tar- gets the risk that the entity:
● Will encounter difficulty in meeting commitments associated with finan- cial liabilities, and
● Will likely be confronted with liquidity problems that might turn into insolvency.
Liquidity risk arises because the entity could be required to pay its liabilities on their earliest contractual maturity date. If it has failed to properly match cash
inflows and outflows, it may have to employ fire brigade approaches. Because, however, a contractual maturity analysis does not necessarily reveal the expected maturityof outstanding liabilities, IFRS requires a description of how the liquidity risk portrayed by contractual maturityanalysis is managed. Such a description should include disclosure of factors like:
● Expected maturity dates of liabilities, and
● Assets held by the company to mitigate liquidity risk.
IFRS further calls for the company to describe how it manages liquidity risk inherent in maturity analysis of financial liabilities. This is an example of the quantitative and qualitative aspects of financial reporting, of which we spoke in preceding sections.
Under IFRS rules, liquidity risk is essentially a mismatch risk to be studied through contractual maturity analysis for financial liabilities. The new account- ing discipline allows an entity to use its judgment to determine an appropriate number of time bands. For instance, not later than one month, or not later than one year. Such time bands must, however, be realistic, reflecting the case(s) where an entity has to pay a due amount or to receive a payment.
Another important but rather obscure issue addressed by IFRS is synthetic instruments. On this subject bankers cannot quite agree on a unique definition.
According to the International Accounting Standards Board, a synthetic instru- ment is a financial instrument acquired and held to emulate the characteristics of another instrument. Such is the case of a floating rate long-term debt com- bined with an interest rate swap that involves:
● Receiving floating payments, and
● Making fixed payments synthesizing a fixed rate long-term debt.
But in the research I did for a book on ‘wealth management’,10commercial and investment bankers gave me different definitions of synthetic instruments, and some were at a loss to find one because of too many new terms coming up at the same time.
Following the IASB definition, IFRS specifies that each of the individual finan- cial products that together constitute a synthetic instrument represents a con- tractual right or obligation with its own terms and conditions. The complexity
arises from the fact that though part of an integrative product marketed and inventoried in its own right:
● Each individual part may be transferred or settled separately, and
● Each is exposed to risks that may differ from the risks to which other finan- cial instruments in the same lot are exposed.
Therefore, when one of the financial products entering into a synthetic instru- ment is an asset, while another is a liability, these two are notoffset. As a result, they should be presented on an entity’s balance sheet on a net basis, unless they meet specific criteria outlined by the international accounting standard, which might permit offsetting.
Moreover, according to the rules of IFRS, financial disclosure of concentrations of risk should include a description of the shared characteristic that identifies each concentration. Examples are industry distribution of a portfolio of loans, and geographic distribution of counterparties to trading, loans or other deals.
Such counterparties may comprise individual countries, groups of countries or regions within countries – or, alternatively, physical or legal entities.
Notice as well that when quantitative information at the reporting date is unrep- resentative of the entity’s exposure to risk during the period, IFRS requires fur- ther information to be provided such as highest, lowest, and average amount of exposure. An example given by IASB is that if a company has a large exposure to a particular currency but at year-end unwinds the position, it can disclose a graph that shows the exposures at various times during the period in reference, including the highest, lowest, and average exposures.