Chapter 1 (Tan&Lee)

8/12/2019 Chapter 1 (Tan&Lee)

1/51

Advanced Financial

Accounting: Chapter 1Risk Reporting

1Tan & Lee Chapter 1 2009


2/51


3/51

Content

1. Introduction2. Uncertainty, Risk and Exposure3. Risk Analysis and Measurement4. Risk Reporting5. Summary Metrics6. Conclusion7. Appendix 1A Relationship between Risk and

Value8. Appendix 1B IAS 14: Segment Reporting


1. Introduction


4/51

Introduction

Financial reporting has traditionally focused on the financialperformance and financial position of an enterprise

Scope of financial reporting has expanded to include the risks facedby business enterprises Some requirements on risk reporting mandated in accounting standards Other disclosures on risk are required by regulatory bodies in each

national jurisdiction

Firms challenge is balancing risks rather than eliminating risks

altogether

Thus the focus of business firms is not so much on risk reduction asit is on risk management.



5/51

Content

1. Introduction2. Uncertainty, Risk and Exposure3. Risk Analysis and Measurement4. Risk Reporting5. Summary Metrics6. Conclusions7. Appendix 1A Relationship between Risk and



2. Uncertainty, Risk and Exposure


6/51

Uncertainty, Risk and Exposure

The term uncertainty and risk are often used interchangeably,although they refer to different phenomena

Definition of uncertainty Possible states or occurrence/non-occurrence of future events Unpredictability of organizational and environmental variables that give

rise to risk (Miller, 1992)

Definition of risk: Probability loss or variability in outcome

Our view is that uncertainty give rise to risk



7/51


8/51


9/51

Content




3. Risk Analysis and Measurement


10/51

Risk Analysis and Measurement

Investors require information to analyze the risks affecting a firmsbusiness and assess the strategies and risk management policies

Two types of risk in finance theories:

1. Systematic risks (market risk)2. Unsystematic risks (firm-specific risk)

Better measurement of risk leads to better management

Accounting measures (e.g. contingency provisions) Accounting ratios (e.g. liquidity ratio, debt-equity ratio and interestcoverage ratio)

Non-accounting measures (summary metrics such as Value at Risk)



11/51

Content




4. Risk Reporting


12/51

Risk Reporting


Betterassessment

and managementof risk

Affects costof capital

Level playing

field

Enhancedmanagementaccountability

Better risk

management

Reasons firms should be more transparent in risk reporting


13/51

Risk Reporting

Markets

Firms businessstrategies

Uncertainty:Source /

determinationof risk

Risk:1. Downside

2. Volatility

Information:Method of

measuring andreporting on risks

Quantitative andqualitative

Cost of capital /firm value

Systematic ormarket risk

Unsystematic oridiosyncratic risk

Risk Management Strategies

Information:

Effect of risk management policies on strategies

Interaction between uncertainty, risk, information and value

Tan & Lee Chapter 1 13 2009


14/51

Risk Measurement and Reporting byBusiness Firms

Modes of risk reporting

ExamplesSegment reporting

Risk relating tofinancial instrumentsContingencies

Related partytransactions

ExamplesCredit ratings

Value at Risk

Sensitivity analysis

Bankruptcyprediction model

Examples

Discretionarydisclosures

Other regulatorydisclosures

Risk Reporting

Accounting-basedinformation Summary metrics

Descriptiveinformation



15/51

Accounting-based Measures of Risk


IAS 24 Related Party Disclosure

IAS 37 Provision, Contingent Liabilities and Contingent Assets

IFRS 8 Operating Segments

IAS 14 Segment Reporting (Appendix 1B)

IFRS 7 Financial Instruments: Disclosures

Standards that require information for risk assessment


16/51


17/51

IFRS 8: Operating Segments


Identifyoperatingsegment

Determinereportableoperatingsegment

Applymanagementdiscretion

Additionalsegments

Practicallimits

Steps for reporting operating segment


18/51






Additionalsegments

Practicallimits

IFRS 8 Paragraph 5 identifies the following characteristics of anoperating segment:1. Business component in an entity that earns revenue and incurs

expenses including start -up operations; 2. Subject to regular review by the entitys chief operating decision

maker; and3. Discrete financial information of the operating segment must be

available


19/51






Additionalsegments

Practicallimits

Once identified, an operating segment needs to be reported only if itmeets any of the following quantitative thresholds (IFRS 8:13)

1. Revenue test: revenue of the operating segment includingintersegment sales is 10% or more of combined revenue

2. Profit of loss test: 10% or more of the greater of (a) combined

reporting profit of all operating segments that did not report a loss,and (b) combined reported loss of all operating segments thatreported a loss

3. Asset test: assets of the operating segment are 10% or more of thecombined assets of all operating segments


20/51






Additionalsegments

Practicallimits

Operating segments that exhibits similar economic characteristicsmay be aggregated

The economic characteristics include:1. The nature of the products and services;

2. The nature of the production processes;3. Customer type or class;4. Methods of distribution; and5. Regulation governing that segment, for example, banking


21/51






Additionalsegments

Practicallimits

However, IFRS 8 permits management to report an operatingsegment that does not meet any of the quantitative thresholds ifmanagement believes that information about the segment wouldbe useful to users of the financial statements


22/51






Additionalsegments

Practicallimits

If the total external revenue reported by operating segmentsconstitutes less than 75% of the entity's revenue, additionalreporting segments must be identified as reportable segments,even if they do not meet the quantitative thresholds specifiedabove


23/51



IFRS 8 suggests a practical, but not precise limit of ten




Additionalsegments

Practicallimits


24/51



Factors that

determine theidentification ofreportable operating

segments

Segment assets

Segment profit or

loss, includingdetailed disclosureson revenue and

expenses

Segment liabilitiesBasis of

measurement

Reconciliations ofsegments revenue,

profit or loss, assets,liabilities, and othermaterial items to the

reported amount

Disclosures


25/51

IAS 24: Related Party Disclosures

Overriding principle: an entitys financial statements should containdisclosures to highlight the existence of related parties and transactions; and outstanding balances with such parties


Determination of related parties

Presence of control

Presence of significant influence

Presence of joint-controlPosition as key management personnel

Close family member of a related party

Party in a post-employment benefit plan


26/51


IAS 24 defines close family members as those who may beexpected to influence, or be influenced by, that related party in theirdealings with the entity

Close family members may include: The related partys domestic partner and children; Children of the related partys domestic partner; and Dependants of the related party or the related partys domestic partner



27/51


Key management personnel refer to those individuals who have theauthority and responsibility to directly or indirectly to plan, direct andcontrol the activities of the entity

IAS 23 considers non- executive directors as key managementpersonnel Key management personnel refer to those individuals who have the

authority and responsibility to directly or indirectly to plan, direct andcontrol the activities of the entity



28/51


29/51


30/51

IFRS 7: Financial Instruments: Disclosures

Tan & Lee Chapter 1 2009

Disclosures

Specific riskrelated to financial

instrument

Risk managementpolicies and

hedging activities

QualitativeInformation

QuantitativeInformation

Exposure toparticular risk

Risk management

Changes fromprevious period

Summary about exposure

Maximum exposure andaging analysisCollateral and creditenhancement

Maturity analysis

Sensitivity analysis

30


31/51

Content




5. Summary Metrics


32/51

Value at Risk

Probabilistic measure of the potential loss that could be incurred bya firms portfolio as a result of market risk

Risk is measured in terms of volatility of variables

interest rate; foreign exchange rate; stock market indices; prices of commodities.

Estimates the maximum loss that can be suffered on a portfolio(marked to market) under normal market conditions over specifiedtime interval and a given confidence level



33/51

Value at Risk

Information required to determine: Expected mean change in portfolio value defined as

Distribution of portfolio values Expected standard deviation

Expected portfolio value Current portfolio valueCurrent portfolio value

Mean

5%

Mean -1.65 (SD) 33Tan & Lee Chapter 1 2009


34/51

Value at Risk


VaR Framework

Distribution ofvalues of risk

factors

Distributionof values of

individual assets

Distributionof values of a

portfolio of assets

Derived from:1) Historical simulation

2) Normal distribution3) Monte Carlo simulation

Effects of risk factors onindividual values through

1) Asset valuationmodel

2) Combination ofmodels

3) Use of judgment

Weights assigned

for individual assets


35/51


36/51

Sensitivity Analysis

Sensitivity analysis is a method of measuring exposure to marketrisks

Sensitivity analysis measures the potential loss (or gain) in future earnings, fair values, or cash flows of market-sensitive

instruments resulting from hypothetical changes in1. interest rates,2. foreign exchange rates,3. commodity prices, and4. other market rates or prices

Shortcomings Does not provide information to level of probability of loss (or gain) Essentially a point of estimate and provides no information on the

variance of the distribution36 2009Tan & Lee Chapter 1


37/51

Multivariate Models

Models may use financial ratios to predict bankruptcy

Typically compare the profiles of actual bankrupt and non-bankruptfirms to determine a critical value of a financial attribute/ ratio (e.g.

debt-equity ratio) that clearly separate these firms

Weights are assigned to each attribute through a statistical processcalled multiple discriminant analysis (e.g. Altmans original Z -score )

Criticisms Generally lacks a conceptual underpinning Restricted to a sample of firms from a particular time period and industry



38/51


39/51

Conclusion

Issues that firms should consider with regards to risk reporting are What definition of risk should a firm adopt? Should it focus on risk of loss or volatility risk? Should sensitive information be disclosed? What roles does judgment play in risk reporting?

In reporting risk, a firm has to decide whether to focus on adverseoutcomes or the possible variations in its earnings or cash flows

If a 2-tailed perspective of risk is adopted, investors should be

provided with information on the potential for gain as well as lossesas to avoid a misleading impression

Disclosure of sensitive information has its costs and benefits

Management judgment is integrated in risk disclosures39Tan & Lee Chapter 1 2009


40/51

Content




7. Appendix 1A Relationship between Risk andValue


41/51

Appendix 1A: Relationship between Riskand Value


Effects of riskon equity value

Result in highercost of capital or

returns expected byinvestors

Gives rise tovariability inpredicted futurenet earnings.

Greater informationasymmetry and alikelihood of ahigher variance


42/51

How is Cost of Equity Capital Determined?

The expected return of a company is the cost of equity capital

Using the Capital Asset Pricing Model, the expected return is asfollows:



43/51

How is Cost of Equity Capital Determined?

Using the Arbitrage Pricing Theory (APT) model, the expected return

Other models include the three-factor model, where size and book tomarket factors are included, in addition to a market index, asexplanatory variables of the cost of capital.

Hence, financial reporting must provide sufficient information toenable external constituents to evaluate the sensitivities of firms tochanges in market factors.


R = R f + 1f 1 + 2f 2 + .. nf n

where f 1 = Systematic risk factor 1 Risk free rate (i.e. risk premium

associated with a particular systematic risk factor, e.g. inflation) and1 = sensitivity of the securitys return to movements of f 1.


44/51

Content




8. Appendix 1B IAS 14: Segment Reporting


45/51

Appendix 1B: IAS 14: Segment Reporting

Presentation of disaggregated financial information by business orgeographical segments

Provides useful insights into the risk profile of the firm, andindications of the types of significant risk that a firm faces

Key features of IAS 14

Applies to enterprises whose equity or debt securities are publicly traded andenterprises that are in the process of issuing equity or debt securities in thepublic securities market

Segment information needs to be presented for consolidated financialstatements only for groups

Requires identification of more dominant segment types for primary reportingformat and the other for secondary segment information

Uses the internal reporting structure as a starting point to identify segments

Uses quantitative criteria as one of the bases to determine segments


46/51


47/51

How does One Identify a ReportableSegment?


Risk and

returncharacteristics

OrganizationalStructure

MaterialityThresholds

Non-

materialityThresholds

By lines of business1. Nature of the products or

services;2. Nature of the production

process;3. Types or class of customers for

the products or services;4. Methods used to distribute the

products or to provide the

service; and5. If applicable, the nature of the

regulatory environment


48/51



Risk and




Non-


By geographical segmentation1. Similarity of economic and

political conditions;2. Relationships between

operations in differentgeographical areas;

3. Proximities of operations;4. Special risks associated with

operations in a particular area;

5. Exchange control regulations;and

6. Underlying currency risks


49/51



Risk and




Non-

materialityThresholds By organizational structureThe enterprises organizationalstructure and internal financial reportingsystem is used as a starting point todetermine business segments andgeographical segments


50/51


Risk and




Non-


3 materiality thresholds:1. 50% test more than 50% of the

segment revenue must be from sales toexternal customers. If this condition ismet, proceed to next test

2. 10% test applies to three basesi. Segment revenue is 10% or more oftotal revenue, or

ii. Segment result, whether profit orloss, is 10% or more of the combinedresults of all segments

iii. Segment assets are 10% or more ofthe total assets of all segments.

3. 75% test combined total revenue ofreportable segment from sale to externalcustomers should be 75% or more ofconsolidated or entity revenue.



51/51


Risk and




Non-

materialityThresholds Non-materiality thresholdsJudgment or internal reporting structuremay also used to determine economicallysignificant segments as reportablesegments.

Documents

Chapter 1 (Tan&Lee)