Upload
david-s-photowork
View
225
Download
0
Embed Size (px)
Citation preview
8/12/2019 Chapter 1 (Tan&Lee)
1/51
Advanced Financial
Accounting: Chapter 1Risk Reporting
1Tan & Lee Chapter 1 2009
8/12/2019 Chapter 1 (Tan&Lee)
2/51
8/12/2019 Chapter 1 (Tan&Lee)
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
3Tan & Lee Chapter 1 2009
1. Introduction
8/12/2019 Chapter 1 (Tan&Lee)
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.
4Tan & Lee Chapter 1 2009
8/12/2019 Chapter 1 (Tan&Lee)
5/51
Content
1. Introduction2. Uncertainty, Risk and Exposure3. Risk Analysis and Measurement4. Risk Reporting5. Summary Metrics6. Conclusions7. Appendix 1A Relationship between Risk and
Value8. Appendix 1B IAS 14: Segment Reporting
5Tan & Lee Chapter 1 2009
2. Uncertainty, Risk and Exposure
8/12/2019 Chapter 1 (Tan&Lee)
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
6Tan & Lee Chapter 1 2009
8/12/2019 Chapter 1 (Tan&Lee)
7/51
8/12/2019 Chapter 1 (Tan&Lee)
8/51
8/12/2019 Chapter 1 (Tan&Lee)
9/51
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
9Tan & Lee Chapter 1 2009
3. Risk Analysis and Measurement
8/12/2019 Chapter 1 (Tan&Lee)
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)
10Tan & Lee Chapter 1 2009
8/12/2019 Chapter 1 (Tan&Lee)
11/51
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
11Tan & Lee Chapter 1 2009
4. Risk Reporting
8/12/2019 Chapter 1 (Tan&Lee)
12/51
Risk Reporting
12Tan & Lee Chapter 1 2009
Betterassessment
and managementof risk
Affects costof capital
Level playing
field
Enhancedmanagementaccountability
Better risk
management
Reasons firms should be more transparent in risk reporting
8/12/2019 Chapter 1 (Tan&Lee)
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
8/12/2019 Chapter 1 (Tan&Lee)
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
14Tan & Lee Chapter 1 2009
8/12/2019 Chapter 1 (Tan&Lee)
15/51
Accounting-based Measures of Risk
15Tan & Lee Chapter 1 2009
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
8/12/2019 Chapter 1 (Tan&Lee)
16/51
8/12/2019 Chapter 1 (Tan&Lee)
17/51
IFRS 8: Operating Segments
Tan & Lee Chapter 1 2009 17
Identifyoperatingsegment
Determinereportableoperatingsegment
Applymanagementdiscretion
Additionalsegments
Practicallimits
Steps for reporting operating segment
8/12/2019 Chapter 1 (Tan&Lee)
18/51
IFRS 8: Operating Segments
Tan & Lee Chapter 1 2009 18
Identifyoperatingsegment
Determinereportableoperatingsegment
Applymanagementdiscretion
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
8/12/2019 Chapter 1 (Tan&Lee)
19/51
IFRS 8: Operating Segments
Tan & Lee Chapter 1 2009 19
Identifyoperatingsegment
Determinereportableoperatingsegment
Applymanagementdiscretion
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
8/12/2019 Chapter 1 (Tan&Lee)
20/51
IFRS 8: Operating Segments
Tan & Lee Chapter 1 2009 20
Identifyoperatingsegment
Determinereportableoperatingsegment
Applymanagementdiscretion
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
8/12/2019 Chapter 1 (Tan&Lee)
21/51
IFRS 8: Operating Segments
Tan & Lee Chapter 1 2009 21
Identifyoperatingsegment
Determinereportableoperatingsegment
Applymanagementdiscretion
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
8/12/2019 Chapter 1 (Tan&Lee)
22/51
IFRS 8: Operating Segments
Tan & Lee Chapter 1 2009 22
Identifyoperatingsegment
Determinereportableoperatingsegment
Applymanagementdiscretion
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
8/12/2019 Chapter 1 (Tan&Lee)
23/51
IFRS 8: Operating Segments
Tan & Lee Chapter 1 2009 23
IFRS 8 suggests a practical, but not precise limit of ten
Identifyoperatingsegment
Determinereportableoperatingsegment
Applymanagementdiscretion
Additionalsegments
Practicallimits
8/12/2019 Chapter 1 (Tan&Lee)
24/51
IFRS 8: Operating Segments
Tan & Lee Chapter 1 2009 24
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
8/12/2019 Chapter 1 (Tan&Lee)
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
Tan & Lee Chapter 1 2009 25
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
8/12/2019 Chapter 1 (Tan&Lee)
26/51
IAS 24: Related Party Disclosures
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
Tan & Lee Chapter 1 2009 26
8/12/2019 Chapter 1 (Tan&Lee)
27/51
IAS 24: Related Party Disclosures
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
Tan & Lee Chapter 1 2009 27
8/12/2019 Chapter 1 (Tan&Lee)
28/51
8/12/2019 Chapter 1 (Tan&Lee)
29/51
8/12/2019 Chapter 1 (Tan&Lee)
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
8/12/2019 Chapter 1 (Tan&Lee)
31/51
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
31Tan & Lee Chapter 1 2009
5. Summary Metrics
8/12/2019 Chapter 1 (Tan&Lee)
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
32Tan & Lee Chapter 1 2009
8/12/2019 Chapter 1 (Tan&Lee)
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
8/12/2019 Chapter 1 (Tan&Lee)
34/51
Value at Risk
Tan & Lee Chapter 1 2009 34
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
8/12/2019 Chapter 1 (Tan&Lee)
35/51
8/12/2019 Chapter 1 (Tan&Lee)
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
8/12/2019 Chapter 1 (Tan&Lee)
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
Tan & Lee Chapter 1 2009 37
8/12/2019 Chapter 1 (Tan&Lee)
38/51
8/12/2019 Chapter 1 (Tan&Lee)
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
8/12/2019 Chapter 1 (Tan&Lee)
40/51
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
40Tan & Lee Chapter 1 2009
7. Appendix 1A Relationship between Risk andValue
8/12/2019 Chapter 1 (Tan&Lee)
41/51
Appendix 1A: Relationship between Riskand Value
41Tan & Lee Chapter 1 2009
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
8/12/2019 Chapter 1 (Tan&Lee)
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:
42Tan & Lee Chapter 1 2009
8/12/2019 Chapter 1 (Tan&Lee)
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.
43Tan & Lee Chapter 1 2009
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.
8/12/2019 Chapter 1 (Tan&Lee)
44/51
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
44Tan & Lee Chapter 1 2009
8. Appendix 1B IAS 14: Segment Reporting
8/12/2019 Chapter 1 (Tan&Lee)
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
8/12/2019 Chapter 1 (Tan&Lee)
46/51
8/12/2019 Chapter 1 (Tan&Lee)
47/51
How does One Identify a ReportableSegment?
Tan & Lee Chapter 1 2009 47
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
8/12/2019 Chapter 1 (Tan&Lee)
48/51
How does One Identify a ReportableSegment?
Tan & Lee Chapter 1 2009 48
Risk and
returncharacteristics
OrganizationalStructure
MaterialityThresholds
Non-
materialityThresholds
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
8/12/2019 Chapter 1 (Tan&Lee)
49/51
How does One Identify a ReportableSegment?
Tan & Lee Chapter 1 2009 49
Risk and
returncharacteristics
OrganizationalStructure
MaterialityThresholds
Non-
materialityThresholds By organizational structureThe enterprises organizationalstructure and internal financial reportingsystem is used as a starting point todetermine business segments andgeographical segments
8/12/2019 Chapter 1 (Tan&Lee)
50/51
How does One Identify a ReportableSegment?
Risk and
returncharacteristics
OrganizationalStructure
MaterialityThresholds
Non-
materialityThresholds
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.
Tan & Lee Chapter 1 2009 50
8/12/2019 Chapter 1 (Tan&Lee)
51/51
How does One Identify a ReportableSegment?
Risk and
returncharacteristics
OrganizationalStructure
MaterialityThresholds
Non-
materialityThresholds Non-materiality thresholdsJudgment or internal reporting structuremay also used to determine economicallysignificant segments as reportablesegments.