IFRS 7 Nature And Extent Financial Instruments Risks – FAQ | IFRS

IFRS 7 Nature and extent Financial instruments risks

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IFRS 7 Nature and extent Financial instruments risks provides the disclosure requirements regarding the nature and extent of risks arising from financial instruments to which the entity is exposed during the period.

The IFRS 7 backbone is summarised as follows:

  • Classes of Financial Instruments and Level of Disclosures1
  • Significance of financial instruments2
  • Nature and extent of risks arising from financial instruments
    • Qualitative disclosures
      1. the exposures to risk and how they arise;
      2. its objectives, policies and processes for managing the risk and the methods used to measure the risk; and
      3. any changes in 1. or 2. from the previous period.
    • Quantitative disclosures on types of risks, being:
      • Credit risk
        • Credit risk management practice
        • Expected credit losses quantifications and qualifications
        • Credit risk exposure
        • Collateral and other credit enhancements obtained
      • Liquidity risk
        • Maturity analysis of financial liabilities (derivatives and non-derivatives)
        • Liquidity risk management
      • Market risk consisting of currency risk, interest rate risk and other price risk
        • Sensitivity analysis
        • Other market risk disclosures

Disclosing Risk ‘Through the Eyes of Management’

The IFRS 7 disclosure requirements include both ‘qualitative’ narrative descriptions and specific ‘quantitative’ data about an entity’s exposure to risks arising from the use of financial instruments.

Companies must ‘provide information about the extent to which they are exposed to financial risks, based on information provided internally to the entity’s key management personnel’ – in other words, through the eyes of management.

The intentions in IFRS 7 are that the disclosures provided should depend on the extent of an entity’s use of financial instruments and the extent to which it assumes associated risks. Entities with many financial instruments and related risks should provide more disclosure to communicate those risks to users of financial statements. Conversely, entities with few financial instruments and related risks may provide less extensive disclosure.

IFRS 7 specifies disclosures about risk exposures applicable to all entities. These disclosures provide a common benchmark for financial statement users when comparing risk exposures across different entities and are expected to be relatively easy for entities to prepare. Entities with more developed risk management systems would provide more detailed information.

Qualitative risk disclosures

In conjunction with the quantitative disclosures, qualitative disclosures of the following are required:

  • The exposures to risk and how they arise;
  • Objectives, policies and processes for managing the risks and the methods used to measure the risks; and
  • Any changes from the previous reporting period in both items above

Quantitative disclosures shall comprise of data about its exposure to that risk (including concentration of risk) at end of the reporting period.

Implementing sensitivity analysis / Value at Risk model

The requirements are much more onerous and include disclosure of:

  • The exposures to risk and how they arise;
  • The objectives, policies and processes for managing the risk and the methods used to measure the risk;
  • Summary quantitative data about the entity’s exposure to that risk at the reporting date. This disclosure shall be based on the information provided internally to key management personnel of the entity; and
  • Disclosures about the concentration of risks.

Quantitative risk disclosures

For each type of risk, disclosure of summary quantitative data, based on information provided internally to key management personnel, as well as any concentrations of risk. Financial risk disclosures include, but are not limited to, credit risk, liquidity risk and market risk.

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.

The minimum disclosures include information on financial assets:

  • The amount that best represents its maximum exposure to credit risk at the end of the reporting period without taking account of any collateral held or credit enhancements.
  • Description of collateral held as security and of other credit enhancements, and their financial effect in respect of the amount that best represents the maximum exposure to credit risk.
  • Information about the credit quality of financial assets that are neither past due nor impaired.
  • Aging analysis of financial assets that are past due but not impaired.
  • Analysis of financial assets individually determined to be impaired.

Liquidity risk

Liquidity risk is defined as the risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities.

An entity shall disclose:

  1. a maturity analysis for non-derivative financial liabilities (including issued financial guarantee contracts) that shows the remaining contractual maturities;
  2. a maturity analysis for derivative financial liabilities. The maturity analysis shall include the remaining contractual maturities for those derivative financial liabilities for which contractual maturities are essential for an understanding of the timing of the cash flows; and
  3. a description of how it manages the liquidity risk inherent in (a) and (b).

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. Market risk comprises three types of risk: currency risk, interest rate risk and other price risk.

Currency risk is defined as the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates.

Interest rate 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 interest rates.

Other price 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 (other than those arising from interest rate risk or currency risk), whether those changes are caused by factors specific to the individual financial instrument or its issuer, or factors affecting all similar financial instruments traded in the market.

An entity shall disclose:

  1. a sensitivity analysis for each type of market risk to which the entity is exposed at the end of the reporting period, showing how profit or loss and equity would have been affected by changes in the relevant risk variable that were reasonably possible at that date;
  2. the methods and assumptions used in preparing the sensitivity analysis; and
  3. changes from the previous period in the methods and assumptions used, and the reasons for such changes.

If the entity prepares a value-at-risk sensitivity analysis that reflects interdependencies between risk variables (e.g. interest rates and exchange rates) and uses it to manage financial risks, it may use such a sensitivity analysis. If so, the entity shall also disclose an explanation of the method used in preparing the analysis including the parameters and assumptions. An explanation of the objective of the method used and of limitations that may result in the information not fully reflecting the fair value shall be disclosed as well.

Example disclosures in the notes to the Financial Statements

Financial risk management

This note explains the group’s exposure to financial risks and how these risks could affect the group’s future financial performance. Current year profit and loss information has been included where relevant to add further context. IFRS 7 Nature and extent Financial instruments risks

IFRS references: IFRS 7 21A(a), IFRS 7 21C, IFRS 7 31, IFRS 7 32, IFRS 7 33

Risk

Exposure origin

Measurement basis

Management practice

Market risk

– Foreign exchange

Future commercial transactions

Cash flow forecasting

Foreign currency forwards and foreign currency options

Recognised financial assets and liabilities not denominated in FX-land currency units

Sensitivity analysis

– Interest rate

Long-term borrowings at variable rates

Sensitivity analysis

Interest rate swaps

– Security prices

Investments in equity securities

Sensitivity analysis

Portfolio diversification

Credit risk

Cash and cash equivalents, trade receivables, derivative financial instruments, debt investments and contract assets

Aging analysis

Credit ratings

Diversification of bank deposits, credit limits and letters of credit

Investment guidelines for debt investments

Liquidity risk

Borrowings and other liabilities

Rolling cash flow forecasts

Availability of committed credit lines and borrowing facilities

The group’s risk management is predominantly controlled by a central treasury department (group treasury) under policies approved by the board of directors. Group treasury identifies, evaluates and hedges financial risks in close co-operation with the group’s operating units. The board provides written principles for overall risk management, as well as policies covering specific areas, such as foreign exchange risk, interest rate risk, credit risk, use of derivative financial instruments and non-derivative financial instruments, and investment of excess liquidity. [IFRS7 33(b)] IFRS 7 Nature and extent Financial instruments risks

Note 12(b) Market risk IFRS 7 Nature and extent Financial instruments risks

IFRS References: IFRS 7 33, IFRS7 21C, IFRS 7 31, IFRS 7 34(c), IFRS 7 22A(c)

(i) Foreign exchange risk IFRS 7 Nature and extent Financial instruments risks

Exposure IFRS 7 Nature and extent Financial instruments risks

The group’s exposure to foreign currency risk at the end of the reporting period, expressed in FX-land currency units, was as follows:

Amounts in CU ‘000

31/12/19

31/12/18

USD

EUR

RMB

USD

EUR

RMB

Trade receivables

5,150

2,025

4,130

945

Bank loans

-18,765

-1,509

-8,250

Foreign currency forwards

-4,250

-5,130

– buy foreign currency (cash flow hedges)

11,519

10,613

– buy foreign currency (held for

trading)

12,073

11,422

Foreign currency options

10,000

8,000

The aggregate net foreign exchange gains/losses recognised in profit or loss were: IFRS 7 Nature and extent Financial instruments risks

IFRS References: IAS 21 52(a), IAS 23 6(e)

Amounts in CU ‘000

2019

2018

Net foreign exchange gain/(loss) included in other gains/(losses)

518

-259

Exchange losses on foreign currency borrowing included in finance costs

-1,122

-810

Total net foreign exchange (losses) recognised in profit before income tax for the period

-604

-1,069

Instruments used by the group IFRS 7 Nature and extent Financial instruments risks

The group operates internationally and is exposed to foreign exchange risk, primarily the US dollar. Foreign exchange risk arises from future commercial transactions and recognised assets and liabilities denominated in a currency that is not the functional currency of the relevant group entity. The risk is measured through a forecast of highly probable US dollar expenditures. The risk is hedged with the objective of minimising the volatility of the FX-land currency cost of highly probable forecast inventory purchases. [IFRS 7 33(b), IFRS 7 22A(a)] IFRS 7 Nature and extent Financial instruments risks

The group treasury’s risk management policy is to hedge between 65% and 80% of forecast US dollar cash flows for inventory purchases up to one quarter in advance, subject to a review of the cost of implementing each hedge. For the year ended 31 December 2019, approximately 80% of inventory purchases were hedged in respect of foreign currency risk. At 31 December 2019, 90% of forecasted US dollar inventory purchases during the first quarter of 2020 qualified as ‘highly probable’ forecast transactions for hedge accounting purposes (for 2018, approximately 85% of inventory purchases were hedged and 93% of the purchases qualified as ‘highly probable’ as at 31 December 2018). [IFRS 7 22A(b),(c)] IFRS 7 Nature and extent Financial instruments risks

The US dollar-denominated bank loans are expected to be repaid with receipts from US dollar denominated sales. The foreign currency exposure of these loans has therefore not been hedged.

The group uses a combination of foreign currency options and foreign currency forwards to hedge its exposure to foreign currency risk. Under the group’s policy, the critical terms of the forwards and options must align with the hedged items. [IFRS 7 22B(a)] IFRS 7 Nature and extent Financial instruments risks

The group only designates the spot component of foreign currency forwards in hedge relationships. The spot component is determined with reference to relevant spot market exchange rates. The differential between the contracted forward rate and the spot market exchange rate is defined as the forward points. It is discounted, where material. [IFRS 9 6.5.16] IFRS 7 Nature and extent Financial instruments risks

The intrinsic value of foreign currency options is determined with reference to the relevant spot market exchange rate. The differential between the contracted strike rate and the discounted spot market exchange rate is defined as the time value. It is discounted, where material. [IFRS 9 6.5.15]

The changes in the forward element of the foreign currency forwards and the time value of the options that relate to hedged items are deferred in the costs of hedging reserve. [IAS 1 117, IFRS 7 21] IFRS 7 Nature and extent Financial instruments risks

The group also entered into foreign currency forwards in relation to projected purchases for the next 12 months that do not qualify as ‘highly probable’ forecast transactions and hence do not satisfy the requirements for hedge accounting (economic hedges). The foreign currency forwards are subject to the same risk management policies as all other derivative contracts. However, they are accounted for as held for trading, with gains (losses) recognised in profit or loss. [IFRS 7 7, IFRS 7 21]

Hedge of net investment in foreign entity IFRS 7 Nature and extent Financial instruments risks

In 2019, Reporting Entity Plc has entered into a bank loan amounting to CU1,699,000 which is denominated in Chinese renminbi (RMB) and which was taken out to fund an additional equity investment in the Chinese subsidiary. The forward rate of the loan has been designated as a hedge of the net investment in this subsidiary. There was no ineffectiveness to be recorded from net investments in foreign entity hedges. [IFRS 7 22A]

Effects of hedge accounting on the financial position and performance IFRS 7 Nature and extent Financial instruments risks

The effects of the foreign currency-related hedging instruments on the group’s financial position and performance are as follows:

IFRS References: IFRS 7 24A, IFRS 7 23B, IFRS 7 22B, IFRS 7 24B IFRS 7 Nature and extent Financial instruments risks

* The foreign currency forwards and options are denominated in the same currency as the highly probable future inventory purchases (US$), therefore the hedge ratio is 1:1. [IFRS 7 22B(c)]

IFRS References: IFRS 7 24A, IFRS 7 23B, IFRS 7 22B, IFRS 7 24B

* The foreign currency forwards and options are denominated in the same currency as the highly probable future inventory purchases (US$), therefore the hedge ratio is 1:1. [IFRS 7 22B(c)]

IFRS References: IFRS 7 24A, IFRS 7 23B, IFRS 7 22B, IFRS 7 24B

Sensitivity IFRS 7 Nature and extent Financial instruments risks

As shown in the table on page 122 above, the group is primarily exposed to changes in US/CU exchange rates. The sensitivity of profit or loss to changes in the exchange rates arises mainly from US dollar-denominated financial instruments and the impact on other components of equity arises from foreign forward exchange contracts designated as cash flow hedges. [IFRS 7 40(a),(b),(c)]

Amounts in CU ‘000

Impact on post-tax profit

Impact on other components of equity

2019

2018

2019

2018

USD/CU exchange rate – increase 9% (2018 – 10%) *

-1,494

-1,004

-806

-743

USD/CU exchange rate – decrease 9% (2018 – 10%) *

1,223

822

660

608

* Holding all other variables constant IFRS 7 Nature and extent Financial instruments risks

Profit is more sensitive to movements in the FX-land currency unit/US dollar exchange rates in 2019 than 2018 because of the increased amount of US dollar denominated borrowings. Equity is more sensitive to movements in the FX-land currency unit/US dollar exchange rates in 2019 than 2018 because of the increased amount of foreign currency forwards. The group’s exposure to other foreign exchange movements is not material.

(ii) Cash flow and fair value interest rate risk IFRS 7 Nature and extent Financial instruments risks

IFRS References: IFRS 7 21C, IFRS 7 22A(a), (b), IFRS 7 33(a),(b)

The group’s main interest rate risk arises from long-term borrowings with variable rates, which expose the group to cash flow interest rate risk. Group policy is to maintain at least 50% of its borrowings at fixed rate, using floating-to-fixed interest rate swaps to achieve this when necessary. Generally, the group enters into long-term borrowings at floating rates and swaps them into fixed rates that are lower than those available if the group borrowed at fixed rates directly. During 2019 and 2018, the group’s borrowings at variable rate were mainly denominated in FX-land currency units and US dollars.

The group’s borrowings and receivables are carried at amortised cost. The borrowings are periodically contractually repriced (see below) and to that extent are also exposed to the risk of future changes in market interest rates. IFRS 7 Nature and extent Financial instruments risks

The exposure of the group’s borrowings to interest rate changes and the contractual re-pricing dates of the borrowings at the end of the reporting period are as follows: [IFRS 7 22A(c), IFRS 7 34(a)]

An analysis by maturities is provided in note 12(d) below. The percentage of total loans shows the proportion of loans that are currently at variable rates in relation to the total amount of borrowings.

Instruments used by the group IFRS 7 Nature and extent Financial instruments risks

Swaps currently in place cover approximately 11% (2018 – 8%) of the variable loan principal outstanding. The fixed interest rates of the swaps range between 7.8% and 8.3% (2018 – 9.0% and 9.6%), and the variable rates of the loans are between 0.5% and 1.0% above the 90 day bank bill rate which, at the end of the reporting period, was 8.2% (2018 – 9.4%). [IFRS 7 22B(a), IFRS 7 23B]

The swap contracts require settlement of net interest receivable or payable every 90 days. The settlement dates coincide with the dates on which interest is payable on the underlying debt. [IFRS 7 22B(a)]

Effects of hedge accounting on the financial position and performance

IFRS References: IFRS 7 24A, IFRS 7 23B, IFRS 7 22B(c)

The effects of the interest rate swaps on the group’s financial position and performance are as follows:

Sensitivity IFRS 7 Nature and extent Financial instruments risks

Profit or loss is sensitive to higher/lower interest income from cash and cash equivalents as a result of changes in interest rates. Other components of equity change as a result of an increase/decrease in the fair value of the cash flow hedges of borrowings and the fair value of debt investments at fair value through other comprehensive income. [IFRS 7 40(a)]

Amounts in CU ‘000

Impact on post-tax profit

Impact on other components of equity

2019

2018

2019

2018

Interest rates – increase by 70 basis points (2018 – 60 bps) *

138

-18

-90

-16

Interest rates – decrease by 100 basis points (2018 – 80 bps) *

-127

96

129

22

* Holding all other variables constant

(iii) Price risk

IFRS References: IFRS 7 21C, IFRS 7 33

Exposure IFRS 7 Nature and extent Financial instruments risks

The group’s exposure to equity securities price risk arises from investments held by the group and classified in the balance sheet either as at fair value through other comprehensive income (FVOCI) (note 7(c)) or at fair value through profit or loss (FVPL) (note 7(d)). [IFRS 7 33(a)]

To manage its price risk arising from investments in equity securities, the group diversifies its portfolio. Diversification of the portfolio is done in accordance with the limits set by the group. [IFRS 7 33(b)]

The majority of the group’s equity investments are publicly traded and are included either in the FX-land Stock Exchange 200 Index or the NYSE International 100 Index.

Sensitivity IFRS 7 Nature and extent Financial instruments risks

The table below summarises the impact of increases/decreases of these two indexes on the group’s equity and post-tax profit for the period. The analysis is based on the assumption that the equity indexes had increased by 9% and 7% respectively or decreased by 6% and 5%, with all other variables held constant, and that all of the group’s equity instruments moved in line with the indexes. [IFRS 7 40(a),(b)]

Amounts in CU ‘000

Impact on post-tax profit

Impact on other components of equity

2019

2018

2019

2018

FX-land Stock Exchange 200 – increase 9% (2018 – 7.5%)

385

361

284

266

NYSE International 100 – increase 7% (2018 – 6.5%)

254

184

FX-land Stock Exchange 200 – decrease 6% (2018 – 4%)

-257

-193

-189

-177

NYSE International 100 – decrease 5% (2018 – 3.5%)

-182

-99

Post-tax profit for the period would increase/decrease as a result of gains/losses on equity securities classified as at FVPL. Other components of equity would increase/decrease as a result of gains/losses on equity securities classified as at FVOCI.

Amounts recognised in profit or loss and other comprehensive income IFRS 7 Nature and extent Financial instruments risks

The amounts recognised in profit or loss and other comprehensive income in relation to the various investments held by the group are disclosed in note 7.

Note 12(c) Credit risk3

IFRS 7 Nature and extent Financial instruments risks

See also: The IFRS Foundation

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