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Risks & Disclosure under IAS 32 and 39 & Long Term Loans and Advances

• Detailed study of IAS 32 and 39 is not included in this course. However, a general understanding of risks  discussed in these standards and their disclosures is necessary.

Financial Instruments

• Financial Instrument is an agreement that gives rise to both a Financial Asset of one entity and Financial Liability of another entity.
• Shares (equity instruments) are Financial Assets of the Investor and Financial Liability of the Investee Company.

• Other examples: Physical Assets:

• TFC,
• Loan Agreements,
• Trade Receivables / Payables.

• Following are specifically excluded from Financial Assets

• Physical Assets
• Prepaid Expenses

Different aspects of risks

• In undertaking transactions in financial instruments, an entity may assume or transfer to another party one or more of different types of financial risk as defined below. The disclosures required by the standard show the extent to which an entity is exposed to these different types of risk.

• Types of financial risk are

• Market risk
• Credit risk
• Liquidity risk
• Cash flow / interest rate risk

Types of Risks – Market Risks

• Currency Risk: is the risk that the value of the financial instrument will fluctuate due to changes in foreign exchange rates.
• Interest rate risk: is the risk that the value of the financial instrument will fluctuate due to changes in market interest rates.
• Price risk: is the risk that the value of the financial instrument will fluctuate due to changes in market prices whether those changes are caused by factors specific to the individual instrument or its issuer or factors affecting all securities traded in the market.

Types of Risks – Credit Risk

• Credit risk: The risk that one party to a financial instrument will fail to discharge an obligation and cause the

other party to incur a financial loss.
Types of Risks – Liquidity Risk
Liquidity Risk:

The risk that an entity will encounter difficulty in raising funds to meet commitments associated with financial instruments. Liquidity risk may result for an inability to sell a financial asset quickly at close to its fair value.
Types of Risks – Cash Flow Risk
Cash flow / interest rate risk:

The risk that future cash flows of a financial instrument will fluctuate because of changes in market interest rates. In the case of a floating rate debt instrument, for  example, such fluctuations result in a change in the effective interest rate of the financial instrument, usually without a corresponding change in its fair value.
Financial Instruments

• The standard does not prescribe the format or location for disclosure of information. A combination of narrative descriptions and specific quantified data should be given, as appropriate.
• The level of detail required is the matter of judgment. Where a large number of very similar financial instrument  transactions are undertaken, these may grouped together. Conversely, a single significant transaction may require full disclosure.
• Classes of instruments will be grouped together by management in a manner appropriate to the information to be disclosed.

Financial Instruments – Disclosure
• Information must be disclosed about the following:

• Risk management policies
• Terms, conditions and accounting policies
• Different risks involved
• Fair value of the asset or liability
• Material items of income, expenses from financial assets and liabilities.

Financial Instruments – Sample Narrative Disclosures
• Concentration of Credit Risk

• he credit risk represents the accounting loss that would be recognized at the reporting date if counter parties

(parties to the agreement) failed to perform as contracted.
Financial Instruments – Sample Disclosures

• The company does not have significant exposure to any individual customer. The company believes that it is not exposed to any major credit risk; however, any such possibility is mitigated by the application of credit limits to its customers and also obtaining collaterals. Financial Instruments – Sample Narrative Disclosures

Foreign Exchange Risk

• Foreign exchange risk arises mainly where receivables and payables exist due to sale and purchase transactions with foreign undertakings. Payables exposed to foreign exchange risks are identified as either “Creditors” or  “Bills payable” and receivables exposed to foreign exchange risks are identified as “Trade debts”. The transactions are however immaterial and do not pose a major risk.

Financial Instruments – Disclosure
One of the main purposes of IAS 32 is to provide full and useful disclosure relating to financial instruments.
“The purpose of the disclosures required by this standard is to provide information to enhance understanding of the significance of financial instruments to an entity’s financial position, performance and cash flows and assist in assessing the amounts, timing and certainty of future cash flows associated with those instruments.”
As well as specific monetary disclosures, narrative commentary by issuers is encouraged by the standard. This will enable users to understand management’s attitude to risk, whatever the current transactions involving financial instruments are at the period end.
Fair Value of Financial Instruments

• The carrying value of all financial assets and liabilities reflected in the financial statements approximates their fair values. Fair value is determined on the basis of objective evidence at each reporting date.

Liquidity Risk Management

• Liquidity risk reflects the company’s inability of raising funds to meet commitments. Management closely monitors the company’s liquidity and cash flow position. This includes maintenance of balance sheet liquidity ratios, debtors and creditors concentration both in terms of the overall funding mix and avoidance of undue reliance on large individual customers.

Recognition of Financial Instruments:

• IAS 39 Financial Instruments: Recognition and measurement establishes principles for recognizing and measuring financial assets and financial liabilities.

Scope:

• IAS 39 applies to all entities and to all type of financial instruments except those specifically excluded, as listed  below, for example most investments in subsidiaries, associates and Joint ventures.
• Notice that this is different from the recognition criteria in the Framework and in most other standards. Items are normally recognized when there is a probable inflow or outflow of resources and the item has a cost or value that can be measured reliably.

Example:

Initial Recognition.

• An entity has entered into two separate contracts:

a) A firm commitment (an order) to buy a specific quantity of iron

b) A forward contract to buy a specific quantity of iron at a specified price on a specified date.
Contract

(a) is a normal trading contract. The entity does not recognize a liability for the iron until the goods have actually been delivered. (Note that this contract is not a financial instrument because it involves a physical asset, rather than a financial asset.)
Contract

(b) is a financial instrument. Under IAS 39, the entity recognizes a financial liability (an obligation to deliver
cash) on the commitment date, rather than waiting for the closing date in which the exchange take place.
Note that planned future transactions, no matter how likely, are not assets and liabilities of an entity – the entity has not yet become a party to the contract.
De-recognition:

• De-recognition is the removal of a previously recognized financial instrument from an entity’s balance sheet.

An entity should de-recognize a financial asset when:
a) The contractual rights to the cash flows from the financial asset expires; or
b) It transfers substantially all the risks and rewards of ownership of the financial assets to another party.
An entity should de-recognize a financial liability when it is extinguished – i.e. when the obligation specified in the contract is discharged or cancelled or expires. It is possible for only one part of a financial asset or liability to be derecognized. For example if an entity holds a bond it has a right to two separate sets of cash flows: those relating to the principal and those relating to the interest. It could sell the right to receive the interest to another party while retaining the right to receive the principal. Long Term Loans and Advances
Disclosure Checklist

• Loans and advances must be shown separately.
• Distinguish between considered good and bad or doubtful
• Classification (line items on face)
• Loans and advances to related parties.
• Other loans and advances
• In case of loans and advances to related parties:
• Name
• Amount
• Particulars of collateral / security held
• In case of CEO, Directors and Executives, the purpose and reconciliation of opening and closing balance.
• The maximum aggregate amount of loans and advances outstanding (month-end basis)
• In other loans name of borrower with e repayment terms in case of material loans.
• Provisions if any.