In connection to maximum credit risk disclosure, IFRS requires reporting the amount that best represents a company’s maximum exposure to credit risk. For a financial asset, this amount is typically the gross carrying amount, net of any offset in accordance with IFRS rules, and of any impairment losses recognized in line with rules outlined in IAS 39. Activities that give rise to credit risk, and associated maximum exposure to credit risk include, but are not limited to:
● Granting loans and receivables to customers
● Placing deposits with other entities
● Entering into derivatives contracts, such as foreign exchange instruments and interest rate swaps
● Dealing in credit derivatives, and so on.
When the resulting asset is measured at fair value, the maximum exposure to credit risk will equal the carrying amount in the entity’s financial report. Amounts disclosed in maturity analysisare contractual undiscounted cash flows. Examples are different financial obligations, prices specified in forward agreements to pur- chase financial assets, streams of floating rate swaps, and the like.
There is a counterpart of minimum disclosures based on one of the assumptions underpinning IFRS: that because companies view and manage risk in different ways, standard financial disclosures reflecting how an entity manages risks are unlikely to be comparable between different firms. Indeed, some disclosures might even convey little or no information about the risks the entity has assumed.
To overcome the limitations outlined in the preceding paragraph, IASB has spec- ified minimum disclosurerequirements concerning risk exposures, able to prov- ide a common benchmark for financial statements. The aim is to have statements understandable by users when they are comparing assumed risk across different entities. Three groups of exposure are targeted by minimum disclosures:
● Credit risk
● Market risk, and
● Operational risk.
For instance, in connection to credit risk the company should disclose the fair value of collateral pledged as security, and other credit enhancements. Another vital piece of information to be reported regards credit quality of assets that are neither past due nor impaired. This approach:
● Gives a good insight into the credit risk of assets, and
● Helps users of financial statements appreciate whether such assets are more or less likely to become impaired in the future.
IFRS requires separate disclosure of financial assets that are past due to impair- ment, a move designed to provide users with information about financial assets with the greater credit risk. Also required is an analysis of the age of financial assets that are past due as at reporting date, but not yet impaired.
Useful information called for by the new accounting rules concerns, as well, the status of collateral and other credit enhancements which have been obtained.
Apart from the insight this provides in terms of expected risk, such references are useful because they reveal important data about:
● The frequency of leaning activities, and
● The entity’s ability to obtain and dispose of collateral obtained.
In connection to market risk, IFRS calls for disclosure of a sensitivity analysis for each type of exposure associated with market variables. Sensitivity analysis should take place for all types of market risk, and it should be done in a way that
is easy to calculate and understand. This type of information can be most help- ful not only to third parties but also to the company’s own management:
● As a compass for its decisions, and
● As an indicator of how the entity manages its market risk(s).
Among market risks to which a financial company may be exposed are: residual value risk, as in the case of writing residual value guarantees, and prepayment risk. For instance, a bank having fixed rate prepayable loan assets may find that as interest rates decrease, loan prepayments increase because borrowers refi- nance their debt at a lower rate of interest. This has happened massively in the United States in the early years of the 21st century, because of rock-bottom inter- est rates.
IASB acknowledged that a simple sensitivity analysis that shows a change in one variable has limitations, such as failure to reveal nonlinearities in sensitivities, or disclose the effects of interdependencies between variables. For this reason IFRS requires additional disclosure when the sensitivity analysis is unrepresentative of risk inherent in a financial instrument.
While IASB is doing a good job in establishing modern, sound, and fair interna- tional accounting standards, some of the authorities who should see to it that it is fully implemented and complied with take a hand in watering down IFRS implementation and its impact. This is typically done through amendments to the draft of the IFRS discussion paper which came into effect following political pressures. As an example, the initial statement that:
This Standard contains requirements for the presentation of financial instru- ments and identifies the information that should be disclosed about them.
has been replaced by:
The objective of this Standard is to establish principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and finan- cial liabilities.
The new version has, however, retained the original definition that the new international accounting standard applies to the classification of:
● Financial instruments, from the perspective of the issuer of financial assets, financial liabilities and equity instruments
● Interest, dividends, losses, and gains related to business activities
● Circumstances in which financial assets and financial liabilities should be offset.
Some entities, particularly in the banking industry, have criticized IASB for not following the Basel II standard in expected loss (EL) which is Basel II’s IRB approaches for corporate, sovereign, and bank exposures, as well as for retail exposures. This is the cost components of a loan covered by provisioning in financial statements.
IFRS, however, does not address itself only to the banking industry, and more- over the exposure algorithm continues to evolve. Originally, the amount of EL was calculated as the product of:
● Probability to default (PD)
● Loss given default (LGD)
● Exposure at default (EAD).
But after the Basel Committee’s Madrid meeting of October 2003, this EL equa- tion went out of the window, precisely at the insistence of these same commer- cial banks which said that they accounted anyway for EL through classical provisioning. Since then, the equation has been modified for stress testing, and is used in computing unexpected losses (UL):
ULSPD • SLGD • SEAD
where, respectively, SPD, SLGD, SEAD, stand for stress PD, stress LGD, and stress EAD. Given this change, IASB could not have used the EL formula even if it wanted to. And it did not need to use it either, since IASB is an independent standards body. Beyond this, it is not a good idea to interlink standards formu- las, because this leads to a very inflexible system.
Incurred loss under IAS 39 is covered through provisions that are based on objec- tive and evident observations. For financial assets that are valued at amortized cost, like loans and receivables, as well as for held-to-maturity financial instru- ments, the provision requirement for defaultable instruments is computed as the difference between:
● The asset’s carrying amount, and
● Present value of estimated cash flows discounted at the financial asset’s original effective interest rate.
Financial assets in the available-for-sale category are measured at fair value, as the difference between historical cost and current fair value, resulting in a shift from capital into the profit and loss account. In the IFRS accounting system, defaults are calculated across the residual maturity of the loan portfolio, with an assessment of potential default threat based primarily on objective observations at time of valuation.