How to get key IFRS numbers – Risk and IFRS
(a) Financial reporting under IFRSs is deeply connected with risk management. Entity which decides to adopt IFRSs should also ensure that it has a robust risk management (RM) system. This is for the reason that different IFRSs give references to the entity’s market and credit risk documented policy which helps determine if an asset has or has not been transferred.
(b) For example, an entity needs to determine under IFRS 9 that an asset has been transferred only when it has transferred substantially all of the risks and rewards of ownership of the asset. If substantially all the risks and rewards have been transferred, the asset is derecognised. If substantially all the risks and rewards have been retained, derecognition of the asset is precluded.
(c) Another example of risk is under IFRS 9 which requires gains and losses on financial liabilities designated as at FVTPL to be split into the amount of change in fair value attributable to changes in credit risk of the liability, presented in other comprehensive income, and the remaining amount presented in profit or loss.
2. Does Risk decide an IFRS value?
(a) The answer generally is a ‘yes’. First, the potential risk needs be identified qualitatively and quantitatively. But what is the meaning of risk? There is no one single definition of risk since different activities by humans and entities may be subject to different risks, qualitatively and quantitatively. In some cases, risk has been viewed as synonymous with uncertainty or volatility.
(b) How risk is quantified: Risk means quantifiable likelihood of loss. As risk is a future potential accident that may occur, risk could be quantified either based on past volatility in the returns or asset value multiplied by the numerical value of likelihood space computed from likelihood of the targeted outcome(s) divided by the sample space of likelihood (estimated total no. of outcomes) from an adverse event that may occur; or based on anticipated volatility in returns or asset value multiplied by the numerical value of probability space, arrived at as for likelihood.
In short, probability or likelihood of the accident occurring multiplied by expected loss in case of the accident, determines a risk value. You may apply the following formula to quantify risk:
Risk = (probability of the accident occurring) x (expected loss in case of the accident)
For example: if activity 1 may suffer an accident of A at a probability of 0.01 with a loss of 1000, the total risk is a loss of 10, since that loss is the product of 0.01 and 1000.
In case of there being several possible accidents, risk is the sum of the all risks for the different accidents, provided that the outcomes are comparable:
If activity 1 may suffer an accident of Y at a probability of 0.01 with a loss of 1000, and an accident of type Z at probability of 0.000 001 at a loss of 2 000 000, the total risk is a loss of $12, that is $10 from accident of types Y and $2 from accidents of type Z.
Risk = ∑ ((probability of the accident occurring) x (expected loss in case of the accident)
(c) How does then the degree of risk relevant to arrive at an IFRS value of say an asset or a liability? The greater the risk in holding an asset the lower will be its market value or discounted value (present value) in the form of a higher discount rate. The converse will be true for holding a liability, that is, the greater the risk the higher will be its market value or discounted value (present value) in the form of a lower discount rate. Thus, riskiness of an asset or a liability decides its IFRS value for recognition and disclosure. Of course, there are risk-free assets too but such assets have not been discussed in this tutorial.
(d) Remember that risk can be a market risk, credit risk or a liquidity risk etc. Risk is a potential event that may occur in future.
Market risk: The risk that the fair value or future cash flows of a financial instrument will fluctuate due to changes in market prices. Market risk comprises three types of risk: currency risk, interest rate risk and other price risk.
Market risk disclosure under IFRS 7: A sensitivity analysis (including methods and assumptions used) for each type of market risk exposed, showing impact on profit or loss and equity, or if a sensitivity analysis is prepared by an entity, showing inter dependencies between risk variables and it is used to manage financial risks, it can be used in place of the above sensitivity analysis.
Credit risk: The risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation.
Credit risk disclosure under IFRS 7:
- Maximum exposure to credit risk without taking into account collateral
- Collateral held as security and other credit enhancements
- Information of financial assets that are either past due (when a counter party has failed to make a payment when contractually due) or impaired
- Information about collateral and other credit enhancements obtained.
Liquidity risk: The risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities.
Liquidity risk disclosure under IFRS 7:
- Maturity analysis for financial liabilities that shows the remaining contractual maturities
- Time bands and increment are based on the entities’ judgement
- How liquidity risk is managed.
3. Difference between risk and exposure
(a) Terms risk and exposure have subtle differences in their meaning. Risk refers to the probability of loss while exposure is the possibility of loss, although they are often used interchangeably. Risk arises as a result of exposure. Put another way, financial risk is the probable variability of returns.
(b) Essentially, exposure is the entity’s potential for damages. Financially, exposure is the measure of the sensitivity of the value of the financial item, i.e. how much or how quickly can the value of the item change. Whereas, risk is a measure of variability of the value of the item, i.e. how probable or likely is it that the value of the item will change.
4. Risk adjustment in IFRS
(a) Remember that not all commercial transactions require a risk adjustment in IFRS reporting. For example, if a financial asset is held for trading under an entity’s business model, such an asset will be valued at FVTPL whilst if the same or another financial asset is held to collect the principle and interest cash flows, such an asset will be valued at amortized cost unless designated at FVTOCI to remove an accounting mismatch.
(b) An FVTPL valuation automatically takes care of the market risk element whilst the amortized cost financial asset will also consider credit risk whilst discounting the asset’s future cash flows by an appropriate risk-adjusted discount rate.
(c) It is at this juncture that the industry accountants and auditors should reach a consensus and record which are the risk elements that have been relevant and considered in an FVTPL and amortized cost valuation of a financial asset, financial liability and derivative instruments, for getting a proper IFRS value.
5. How risk adjustment is made to determine an IFRS value?
Risk type decides which rate to use in discounted cash flow analysis. Risk-free rate of return is linked with unsystematic risk or risk on an asset or a portfolio of assets which can be diversified.
Cash risk premium rate is for systematic risk, that is, portion of risk in a portfolio that cannot be diversified away by holding a pool of individual assets and therefore commands a return, in excess of the risk-free-rate.
Risk can be taken into account either in the discount rate or in the possible cash flows, using the expected present value technique in fair value measurement. See the following diagram:
(a) In rout (b), the cash premium risk rate is applied first to reduce the expected cash flows of investment asset (expected returns plus investment amount) yielding certainty-equivalent cash flows. Cash risk premium is applied only for systematic or non- diversifiable or market risk because market participants are compensated only for bearing the systematic risk inherent in cash flows, for example, probability of adverse change in market value of riskier asset due to expected fall in its returns; expected fall in commodity prices or exchange rate.
(b) In rout (a), instead of adjusting systematic and unsystematic risk on expected cash flows of an investment project (asset) in a two-step approach, risk adjustment for systematic (market) risk and unsystematic risk (for no timing uncertainty and default risk to get your returns plus the principal value of your investment) is built in the discount rate itself in a one-step approach. That is, to the cash risk premium rate is added the risk-free discount rate and the total rate is directly applied on the expected cash flows to get the risk-adjusted estimated value of your investment project (expected returns plus investment amount).
(c) The theory behind discounting of expected cash flows by a discount rate is the existence of risk-free assets and riskier assets. Most risk and return models in finance start off with an asset that is defined as risk-free and use the expected return on that asset as the risk-free rate. An asset is risk-free, if we know the expected returns on it with certainty, that is actual return is always equal to the expected return.
Expected returns on risky investments are then measured relative to the risk-free rate, with the risk creating an expected risk premium that is added to the risk-free rate.
6. Risk Management and IFRS in alignment
In short, there isn’t any asset that is literally risk-free, as risk is limitless. However, heavy tail risk (like low frequency high severity risk –earthquake, market crash etc) are not retained but transferred due to permanent non-availability of enough risk capital and bankruptcy and are therefore not considered in IFRS, akin to the theory of risk management by exclusion from economic capital computation to meet future unexpected losses.
7. How to measure risk-free rate?
In most developed markets, where the government can be viewed as a default-free entity, at least when it comes to borrowing in local currency, the implications are simple.
- When doing investment analysis on longer term projects or valuation, risk-free rate should be the long term govt. bond rate.
- If the analysis is shorter term, short term govt. security rate can be used as the risk-free rate.
- Remember that a risk-free rate is used to come up with what the expected returns should be.
- Risk-free rate used to come up with expected returns should be measured consistently with how the cash flows are measured.
- Thus, if the cash flows are estimated in nominal U. S. dollar terms, the risk-free rate will be the U. S. Treasury bond rate.
- This also implies that it is not where a project or firm is domiciled that determines the choice of a risk-free rate, but the currency in which the cash flows on the project or firm are estimated.
- For example, Nestle can be valued using cash flows estimated in Swiss Francs, discounted back at an expected return estimated using a Swiss long term govt. bond rate or it can be valued in British Pounds with both the cash flows and risk-free rate being the British.
8. How the risk premium estimated?
Choice of a risk-free rate also has implications for how risk premiums are estimated.
- If, as is often the case, historical risk premiums are used, where the excess return earned by stocks over and above a govt. security rate over a past period is used as a risk premium.
- Remember that the govt. security chosen has to be the same one as that used for the risk-free rate.
- Thus, the historical risk premium used in the U. S. should be the excess return earned by stocks over treasury bonds, and not treasury bills, for purpose of long term analysis.
- You can first compute risk premium in amount and then convert it into a rate.
9. Example of unsystematic risk (risk-free rate)
As a result, the portion of risk that is unsystematic — or risk that can be diversified away — does not require additional compensation in terms of expected return.
For example, consider the case of an individual who buys 50 corporate bonds from a single company. The individual receives a certain yield based on the purchase price. However, if unexpected business risks lead to liquidity problems, the company might go bankrupt and default on its loans. In such a case, the investor will lose the entirety of the investment. Diversifiable risk example (risk-free rate)
Conversely, if the investor buys a single bond from 50 different corporations who have similar credit ratings, then one instance of insolvency will have a far less drastic effect on the investor’s portfolio. (Diversifiable risk example (risk-free rate)).
10. Example of systematic risk (risk premium rate)
Now, imagine that these 50 corporations are all given a lesser credit rating because of the risk of their overall market segment. In this case, the individual is still at risk to lose some or all of the initial investment.
This type of risk cannot be diversified away, and is referred to as systematic risk. This is the portion of risk that pays the risk premium, because the risk associated with this particular segment of the market is more tightly linked to the risk of the market as a whole.
This risk is present regardless of the amount of diversification undertaken by an investor.
11. Diversification theory in Risk Management
Diversification theory says that the only risk that earns a risk premium is that which cannot be diversified away, with the implication that investors require more compensation for extra risk.
By diversifying a portfolio of assets, an investor loses the chance to experience a return associated with having invested solely in a single asset with the highest return. On the other hand, the investor also avoids experiencing a return associated with having invested solely in the asset with the lowest return — sometimes even becoming a negative return.
Thus, the role of diversification is to narrow the range of possible outcomes.
Risk plays a vital role in determining the quality of an IFRS value as well as measuring and recognition of the IFRS value under an IFRS reporting, usually at fair value (forward looking indicator). In comparison, GAAPs hardly give due consideration to risk in measuring and recognition usually at entry price (historical cost), a backward looking indicator.
It is highly recommended that practitioners of IFRS should have near expert knowledge (if not at thorough-level) of the theory and practice of risk management, for a robust and proper application of IFRSs in their entities or clients, for market-consistent financial reporting.
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