CFA Institute: Financial instrument risk disclosures under IFRS 7

15 January 2013

CFA Institute has undertaken a study to examine the quality of existing financial instruments risk disclosures. The overall study evaluated credit, liquidity, and market risk disclosures and disclosures for derivatives and hedging activities under IFRS. The study specifically focuses on IFRS 7.

The CFA Institute's report, entitled 'User Perspectives on Financial Instrument Risk Disclosures Under IFRS, Volume 2, provides a user perspective on the disclosures of derivatives and hedging activities. It is an extension to Volume 1 which provided a user perspective on financial instrument credit, liquidity and market risk disclosures. In its approach, the study:

• reviews relevant literature on derivatives and hedging activities disclosures;
• obtains user feedback through user surveys and interviews; and
• reviews the quality of disclosures made in 2011 and 2010 annual reports of 30 IFRS-reporting companies and reviews in detail a case study of the disclosures of Lufthansa Airlines. The company review contextualises the user feedback obtained. As a result of reviewing company annual reports, some examples of both useful and less useful disclosures from these companies are highlighted.

Key Findings – A review of annual reports shows that the information content and presentation format of derivatives and hedging disclosures have room for significant improvement

Several shortcomings with derivatives and hedging activities disclosures were noted through the review of annual reports of IFRS-reporting companies. In general, the information content and presentation format of these disclosures shows room for significant improvement. Moreover, these disclosures tended to be inconsistent across the companies CFA Institute reviewed, and this can make it challenging for readers of financial reports to compare derivatives use, risk exposure, and risk management practices across companies. Some of the reviewed companies did not fully comply with mandated disclosures even when it seemed appropriate to do so. In addition, there was limited voluntary disclosure of useful information across the companies. Specific shortcomings include the following:

• derivatives and hedging disclosures could be better presented and more effectively integrated with other risk category disclosures;
• inadequate disclosure of underlying aggregate quantitative risk exposure and derivatives instruments;
• insufficient disclosure of derivatives use and hedging strategies;
• insufficient information related to the effects of hedging activities on the financial statements. This inadequacy was particularly pronounced with cash flow hedges. For example, one of the largest banks in the UK had significant cash flow hedge deferral to other comprehensive income (OCI) (i.e. >100 per cent of net income from an absolute magnitude perspective) in its 2011 annual report, but we could not readily find any disclosure on whether or not this bank had ineffectiveness on its cash flow hedges;
• limited scope of disclosure requirements contributes to incomplete reporting of risks and risk management activities.

The newly issued Volume 2 proposes general and specific recommendations for improving these risk disclosures, including:

• holistic disclosures that focus on communication and not ‘mere compliance’ should be provided. (Clear communication is especially important in relation to derivatives and hedging disclosures. As history has shown, investors can easily be blindsided regarding the purpose and loss potential of derivatives instruments due to uninformative disclosures.)
• Materiality assessment of derivatives should be based on loss potential of derivatives and not on reported fair values. (Derivatives instruments are inherently risky, highly leveraged financial instruments with significant potential for unexpected losses. Furthermore, derivative fair values represent current market values, not the upper bound of potential losses. Thus, it can be misleading to use the fair value of reported derivatives assets to judge materiality and thereby to reduce the quality of communication made by companies regarding their use of derivatives instruments. Instead, all companies that use derivatives and where there is potential for significant losses beyond the amount depicted by the fair value on the balance sheets should aim to provide holistic disclosures as recommended.)
• Improved presentation, location, and integration of derivatives and hedging disclosures with other key risk disclosures. (Centralised and tabular risk disclosures should be provided. In addition, derivatives and hedging disclosures should always be integrated with other risk disclosures in management’s discussion of use of derivatives. For example, hedging disclosures should be integrated with disclosures of quantitative risk exposures and market risk sensitivity analyses.)
• Improved quantitative risk exposure disclosure. (Comprehensive quantitative risk exposure information is required to assist users in understanding hedged and unhedged exposures. This disclosure should include an outline of both the economic exposure (e.g. foreign currency, interest rate, or commodity) both before and after hedging (e.g. effective post-hedging currency exposure).)
• Improved communication of derivatives use and hedging strategies. (Companies should adequately explain the nature and purpose of derivatives instruments used, making a clear distinction between accounting hedges, economic hedges and trading derivatives. When hedging, they should also explain their risk management policies, including the hedging objective and cost of hedging and link their descriptions of risk management to the disclosures of quantitative information. They should shed light on the hedging and risk transformation strategies, including those relating to complex hedging strategies such as: a) macro-hedging; b) synthetic exposures created due to netting or aggregation of hedging instruments and/or hedged items; and c) partial hedging of discrete risk categories.)
• Enhancement of disclosures related to effects of hedge activities on financial statements. (Disclosures related to the impact of both fair value and cash flow hedges on the financial statements need improvement. The disclosures of both fair value and cash flow hedges should:
  • outline the nature of the gains or losses, making it clear as to whether they relate to operating, investing, or financing activities;
  • include a roll forward of balance sheet amounts reflected in the financial statements; and
  • include an adequate explanation of any sources of ineffectiveness.
• For fair value hedges, the following enhancements should be made either on the face of the financial statements or within the notes:
  • disaggregation of carrying amounts of hedged items that are part of a hedging relationship (i.e. what is included in and what is excluded from the hedging relationship);
  • linked presentation that matches risk management pairs (i.e. hedging instrument and hedged item); and
  • disaggregation of the cumulative fair value adjustments of the hedged item and the hedging instrument.)

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