It comes as no surprise that IFRS rules reflect the International Accounting Standards Board’s belief that information about capital is useful for all compa- nies. This is evidenced by the fact that several entities now set internal capital requirements, and industry norms have been established for certain industries like banking and insurance.
The Basel Committee on Banking Supervision has upped regulatory capital requirements, linking them to the exposure assumed by the institution. The 1996
Market Risk Amendment obliged banks to account for market risk, over and above the 8% capital ratio for credit risk implied by the 1988 Capital Accord (Basel I).7Since its draft status of 1999, Basel II has introduced the:
● Process of internal ratings-based (IRB) calculation of capital requirements, and
● Associated notion of risk-based pricing.8
All this has had an effect. As ECB statistics show, banks are willingly increasing their capital reserves. The trend in Figure 3.1 is most welcome. For its part, the Insurance Advisory Steering Committee (IASC) has proposed, in its draft state- ment of principles, that capital disclosure requirements should be introduced for insurers. Solvency II, a new capital accord for insurers, is in the making. Other branches of industry seem to be moving in a similar way.
All this evidence had an impact on IASB when it concluded that the information about capital should be disclosed by all entities. Also that such disclosure should be set in the context of a discussion of the firm’s objectives, policies, and processes for managing capital. As Walter Wriston once said, information about capital is just as vital as capital itself.
A company may manage capital in a number of ways, and it may be subject to many different capital requirements. An example provided by IASB is that of a
AVERAGE
2000 2001 2003
14
7 10 12
9 8 11
2002 2004
13
INTER-QUARTILE RANGE MAX–MIN RANGE
Figure 3.1 Four-year trend (2000–2004) in capital ratio by big banks in Euroland (Source:European Central Bank, Financial Stability Review, June 2005)
conglomerate which includes entities that undertake both insurance and bank- ing activities, operating in different geographic regions.
● An aggregate disclosure of capital requirements, and of how capital is man- aged, must provide comprehensible information.
● If this is not achieved, then the financial statement distorts its user’s under- standing of the entity’s capital resources, and of its financial staying power.
In that case, IFRS states, the company must disclose information on its capital base separately. Some companies have objected to that clause, yet it is only normal that every entity shall disclose information that enables users of its financial statements to evaluate its capital as well as the adequacy of such capital. This must be done in no uncertain terms, and the way to do it is through fair value (more on this later).
IFRS specifies that every company shall also disclose qualitative information about its objectives, policies and processes for managing capital. Such information must include, but not be limited to, a description of what top management regards as cap- ital, its status, and its adequacy in relation to the firm’s assumed obligations. Also:
● How is it meeting its objectives for managing capital?
● When is it subject to externally imposed capital requirements?
● What is the nature of these requirements?
● How are these requirements incorporated into the management of capital?
Another qualitative input is the consequences of non-compliance ifand when the entity has not complied with capital targets set by externally imposed capi- tal requirements (usually by regulators) to which it is subject. It would be super- fluous to underline that this mainly qualitative information should be accompanied by quantitative data about capital targets set by management, including how well these targets are met.
IFRS rules on fair value require that for each class of financial assets and liabili- ties, a firm must disclose its worth in a way that permits it to be compared with the corresponding carrying amount in its balance sheet. For financial instruments such as short-term trade receivables and payables, when the carrying amount is a reasonable approximation of fair value, no other disclosure of value is required.
Fair value is volatile, and volatilityin fair value is primarily, but not exclusively, due to market risk. For instance, currency exchange risk arises on financial instruments that are denominated in a currency other than the functional cur- rency of the entity. Other examples of fluctuation in fair value are commodity
price risk and equity price risk. As with death and taxes, no firm and no investor can escape from volatility.
Volatility has always been embedded in the company’s assets. All IASB asks for is to disclose its after-effect. IFRS requires that in disclosing fair value, a com- pany must group financial assets and liabilities into classes. It can offset them only to the extent that their related carrying amounts are offset in the balance sheet. Moreover, an entity has to disclose in its financial statement:
● Method and assumptions applied in determining fair values of financial assets and financial liabilities, and
● Hypotheses which have been used, such as estimated prepayment rates, rates of projected credit losses, interest or discount rates, and so on.
Behind these requirements lies the need for every entity to disclose information that enables the stakeholders, who are using its financial statements, to evaluate the nature and extent of risks arising from financial instruments to which the firm has been, and continues being, exposed:
● During the period, and
● At reporting date of the financial statement.
And has already been brought to the reader’s attention, this quantitative presen- tation should be enhanced through qualitative disclosures for each risk arising from financial instruments. For instance, how this exposure arose; which meth- ods are used to measure the risk; which are the policies and processes for man- aging the risk; and whether there are any changes in the above references, from the previous reporting period.
As an example, it is not enough that in the trading portfolioassets and liabilities are recorded at fair value from time to time, without exact periodicity. As the reader will recall from Chapter 2, Luca Paciolo said the same thing in 1494. Fair value must be calculated at each balance sheet date, with changes recorded as trading income in the P&L statement or, correspondingly, as a trading loss. Key judgements affecting this accounting policy relate to how the bank determines fair value for each item in assets and liabilities. As cannot be repeated too often:
● Where liquid markets exist, fair value is based on quoted market prices.
● For complex or illiquid financial instruments, however, banks have to use projections, estimates, and models to determine fair value – a good approach being discounted cash flow.
There are, as well, judgmental factors such as the need for credit adjustments, liquidity adjustments, and other valuation adjustments affecting the reported fair value of different assets and liabilities in the portfolio. Because of these judg- mental factors, and risks embedded into assumptions being made, senior man- agement must make sure that:
● Hypotheses and estimates being used are reasonable, and
● They are supportable in the prevailing market environment.
In conclusion, qualification is a necessary supplement of quantification, and both qualification and quantification are often based on hypotheses. The range of assumptions being made, estimates being used, and number of different prod- ucts covered mean that it is not always possible to meaningfully quantify the impact of different market factors – both present and projected. Senior manage- ment should, however, always control that assumptions and estimates being made are reasonable and supportable by the market.