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05/11/2015 - Jens Kock, Director Consulting Hanse Orga Group

Reporting financial instruments under IFRS

Practical “How To” guide for those whose time is precious

The pace with which international financial reporting standards (IFRS) are being developed and amended is staggering for preparers and users of financial information alike. This blog article is an extract from our whitepaper on this topic and provides a short, high level and practical overview of the current reporting requirements for financial instruments in annual financial statements (AFS) under IFRS, as well as an overview as to how Hanse Orga’s FinanceSuite solution is ideally positioned to assist companies in gathering and reporting this information.

This document assumes that you are, on a high level, familiar with reading a set of accounts.

What are financial instruments?
A financial instrument is either a financial asset (e.g. cash, equity investments, loans, receivables, derivatives) or a financial liability (e.g. borrowings, derivatives) – or a hybrid instrument that is a combination of both (e.g. a loan to a customer that is linked to an interest rate swap derivative).
Technically, a financial instrument is “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.”

Why should you bother about properly considering these?
Without knowing where financial instruments are disclosed, how these are valued and for which reason they are valued as such you will not be able to properly assess a company’s financial position and future prospects. For example:

  • The fixed-rate loan book of a bank (financial asset) may be measured at amortized cost or at fair value. Fair value is dependent largely on market interest rates. Thus, if interest rates increase, the fair value of the loan book will decrease, which may not be reflected as such in the financial statements; or
  • The bank loan that a manufacturing company holds is normally measured at amortized cost. However the company may – at initial recognition – elect to show this loan at fair value instead. Not knowing this implication will result in a skewed view of the company’s liabilities, e.g. in a take-over or merger situation; or
  • Derivatives, e.g. forward exchange contracts, are always measured at fair value. Without understanding the underlying valuation model you will not be sensitized as to the impact that any market movement of the underlying variables (exchange rates in this case) has on the balance sheet of the company. Valuation models in turn depend on the marketability of derivatives.

Where is the financial instruments disclosure “hidden” in a set of IFRS AFS?
You should look out for information pertaining to financial instruments at the following sections in a company’s set of IFRS AFS:

The accounting policies
Yes, though this is a highly technical and boring section you should nevertheless start your read here, as this chapter will provide you with very important insights,  for example relating to the type of financial instruments a company has and the valuation elections a company has adopted, to name but a few. 

The statement of financial position and the notes thereto
Information on financial instruments is mostly contained in the notes to the statement of financial position. Be on the lookout for valuable information in the note “other financial assets”, in advances for a banking environment, borrowings and in the notes “other financial liabilities”.

The statement of profit or loss and other comprehensive income
This statement comprises two main sections for the purposes of this analysis:
In the profit and loss bit you will find gains and losses resulting from financial instruments that affect the company’s EBITDA and net profit figure. Be specifically on the lookout for large gains and losses vis-à-vis the prior year end ensure that you understand the reasons for these. Consider whether these are due to once-off effects or whether they are sustainable.

Of even more interest though is the “other comprehensive income” section. In here you will find fair value movements of financial instruments that are not reported in the company’s EBITDA or profit figure but which go directly into equity, thereby “bypassing” the current year’s results calculation. Examples may be:

  • Exchange differences when translating foreign subsidiaries to the company’s reporting currency
  • Fair value movements on hedging instruments that are considered effective hedges.

While there are good reasons for not including these items in profit or loss, careful consideration of these is of course crucial, especially when valuing a company.

Statement of changes in equity

While technically these are not financial instruments, please be on the lookout for any movements in share capital and the reasons for these.

Statement of cash flows
Be alert to all cash flows arising from financial instruments. Assess whether these appear reasonable and whether any significant fluctuation from the prior year make sense. For example, you should keep an eye on interest received and paid, payments made to acquire financial assets, amounts advanced to subsidiaries, payments for debt issue costs, proceeds from borrowings and dividends received from subsidiaries.

The financial instruments note
Towards the end of a set of IFRS financial statements you will normally find a separate note containing certain prescribed additional disclosure on financial instruments. Alternatively, this disclosure may be distributed over the other financial instruments notes.

Some of this disclosure is extremely useful in assessing the risks and potential included in the company’s financial instruments, for example the disclosures on capital management and on categories of financial instruments. Moreover, the descriptive section on financial risk management contains extensive and detailed information on how the treasury department manages the various types of risks affecting the company. Value-at-Risk analyses, sensitivity analyses and hedges are useful sources of information to name but a few.

In summary
Financial instruments disclosure is ever evolving and constantly changing under IFRS. As a result, the understandability of financial statements – which are typically significantly impacted by financial instruments – is severely impacted over time by ever changing measurement and disclosure “goal posts.”
By focusing on the types of disclosures that are required for financial instruments as set out above, you should be in a position to quickly assess the key risks and rewards that the reporting group or company is exposed to.

However, the garbage-in-garbage-out principle applies to financial instruments disclosure as well: any set of accounts is just as good as its preparers and – even more critical – as good as the underlying financial systems that are in operation to collate the required information.

With Hanse Orga’s FinanceSuite solution, and soon with the new FS2 release, companies are ideally placed to accurately gather and track critical information on financial instruments, such as:

  • Every incoming and outgoing cash flow across complex SAP and non-SAP systems that is reportable in many different dimensions and drill-downs
  • Accurate forecasts liquidity forecasts based on actual and planned cash flows
  • Better control over liquidity and outgoing payments and better reporting capabilities
  • Extensive treasury reporting capabilities that are of critical importance for a proper, in-depth understanding of the risks and rewards inherent in financial instruments

For more detailed and comprehensive information on how to best manage financial instruments, download our free whitepaper "Reporting Financial Instruments under IFRS" here.

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