Advance Accounting - Chapter 1 (Tan_Lee)

Advanced Financial Accounting : Chapter 1

1. Advanced Financial Accounting: Chapter 1 Risk Reporting 1 Tan & Lee Chapter 1 © 2009

2. Learning Objectives Appreciate the broader economic context in which accounting information interacts with risks, valuation, and operating and financial strategies; Understand the interactions between uncertainty, risks, strategy, valuation and information; Compare the different modes of reporting – financial statement reporting, discretionary management disclosures and summary metrics; and Review an example of a financial risk metric 2 Tan & Lee Chapter 1 © 2009

3. Content Introduction Uncertainty, Risk and Exposure Risk Analysis and Measurement Risk Reporting Summary Metrics Conclusion Appendix 1A – Relationship between Risk and Value Appendix 1B – IAS 14: Segment Reporting 3 Tan & Lee Chapter 1 © 2009 1. Introduction

4. Introduction Financial reporting has traditionally focused on the financial performance and financial position of an enterprise Scope of financial reporting has expanded to include the risks faced by 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 as it is on risk management. 4 Tan & Lee Chapter 1 © 2009

5. Content Introduction Uncertainty, Risk and Exposure Risk Analysis and Measurement Risk Reporting Summary Metrics Conclusions Appendix 1A – Relationship between Risk and Value Appendix 1B – IAS 14: Segment Reporting 5 Tan & Lee Chapter 1 © 2009 2. Uncertainty, Risk and Exposure

6. 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 6 Tan & Lee Chapter 1 © 2009

7. Perspectives of Risk 7 Tan & Lee Chapter 1 © 2009 Perspectives of risk Probability of a loss One-tail perspective Downside risk Volatility risk Variability in outcome, both upside and downside Two-tailed perspective

8. Perspectives of Risk Risk exists only if there is exposure to the uncertainty Example of risk exposure: Firms with no debt have no direct exposure to interest rate risks But may be indirectly affected by interest rate volatility, as increase in interest rates increases cost of borrowing, which are passed on to the firms 8 Tan & Lee Chapter 1 © 2009

9. Content Introduction Uncertainty, Risk and Exposure Risk Analysis and Measurement Risk Reporting Summary Metrics Conclusion Appendix 1A – Relationship between Risk and Value Appendix 1B – IAS 14: Segment Reporting 9 Tan & Lee Chapter 1 © 2009 3. Risk Analysis and Measurement

10. Risk Analysis and Measurement Investors require information to analyze the risks affecting a firm’s business and assess the strategies and risk management policies Two types of risk in finance theories: Systematic risks (market risk) 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 interest coverage ratio) Non-accounting measures (summary metrics such as Value at Risk) 10 Tan & Lee Chapter 1 © 2009

11. Content Introduction Uncertainty, Risk and Exposure Risk Analysis and Measurement Risk Reporting Summary Metrics Conclusion Appendix 1A – Relationship between Risk and Value Appendix 1B – IAS 14: Segment Reporting 11 Tan & Lee Chapter 1 © 2009 4. Risk Reporting

12. Risk Reporting 12 Tan & Lee Chapter 1 © 2009 Better assessment and management of risk Affects cost of capital Level playing field Enhanced management accountability Better risk management Reasons firms should be more transparent in risk reporting

13. Risk Reporting Markets Firm’s business strategies Uncertainty: Source / determination of risk Risk: Downside Volatility Information: Method of measuring and reporting on risks Quantitative and qualitative Cost of capital / firm value Systematic or market risk Unsystematic or idiosyncratic 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. Risk Measurement and Reporting by Business Firms Modes of risk reporting Examples Segment reporting Risk relating to financial instruments Contingencies Related party transactions Examples Credit ratings Value at Risk Sensitivity analysis Bankruptcy prediction model Examples Discretionary disclosures Other regulatory disclosures Risk Reporting Accounting-based information Summary metrics Descriptive information 14 Tan & Lee Chapter 1 © 2009

15. Accounting-based Measures of Risk 15 Tan & 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

16. IFRS 8: Operating Segments Key features of IFRS 8 Applies to enterprises whose equity or debt securities are traded in a public market or an over-the-counter market or are in the process of issuing equity or debt securities in the public securities market Segment information needs to be presented for consolidated financial statements only for groups Requires identification of the operating segment (both business and geographical segments) Uses internal reports regularly reviewed by the entity’s chief operating decision maker to determine operating segments Aggregation of identified operating segments if they demonstrate similar economic characteristics Uses qualitative criteria to determine reportable segments 16 Tan & Lee Chapter 1 © 2009

17. IFRS 8: Operating Segments Tan & Lee Chapter 1 © 2009 17 Identify operating segment Determine reportable operating segment Apply management discretion Additional segments Practical limits Steps for reporting operating segment

18. IFRS 8: Operating Segments Tan & Lee Chapter 1 © 2009 18 Identify operating segment Determine reportable operating segment Apply management discretion Additional segments Practical limits IFRS 8 Paragraph 5 identifies the following characteristics of an operating segment: Business component in an entity that earns revenue and incurs expenses including “start-up” operations; Subject to regular review by the entity’s chief operating decision maker; and Discrete financial information of the operating segment must be available

19. IFRS 8: Operating Segments Tan & Lee Chapter 1 © 2009 19 Identify operating segment Determine reportable operating segment Apply management discretion Additional segments Practical limits Once identified, an operating segment needs to be reported only if it meets any of the following quantitative thresholds (IFRS 8:13) Revenue test : revenue of the operating segment including intersegment sales is 10% or more of combined revenue 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 that reported a loss Asset test : assets of the operating segment are 10% or more of the combined assets of all operating segments

20. IFRS 8: Operating Segments Tan & Lee Chapter 1 © 2009 20 Identify operating segment Determine reportable operating segment Apply management discretion Additional segments Practical limits Operating segments that exhibits similar economic characteristics may be aggregated The economic characteristics include: The nature of the products and services; The nature of the production processes; Customer type or class; Methods of distribution; and Regulation governing that segment, for example, banking

21. IFRS 8: Operating Segments Tan & Lee Chapter 1 © 2009 21 Identify operating segment Determine reportable operating segment Apply management discretion Additional segments Practical limits However, IFRS 8 permits management to report an operating segment that does not meet any of the quantitative thresholds if management believes that information about the segment would be useful to users of the financial statements

22. IFRS 8: Operating Segments Tan & Lee Chapter 1 © 2009 22 Identify operating segment Determine reportable operating segment Apply management discretion Additional segments Practical limits If the total external revenue reported by operating segments constitutes less than 75% of the entity's revenue, additional reporting segments must be identified as reportable segments, even if they do not meet the quantitative thresholds specified above

23. IFRS 8: Operating Segments Tan & Lee Chapter 1 © 2009 23 IFRS 8 suggests a practical, but not precise limit of ten Identify operating segment Determine reportable operating segment Apply management discretion Additional segments Practical limits

24. IFRS 8: Operating Segments Tan & Lee Chapter 1 © 2009 24 Factors that determine the identification of reportable operating segments Segment assets Segment profit or loss, including detailed disclosures on revenue and expenses Segment liabilities Basis of measurement Reconciliations of segments’ revenue, profit or loss, assets, liabilities, and other material items to the reported amount Disclosures

25. IAS 24: Related Party Disclosures Overriding principle: an entity’s financial statements should contain disclosures 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-control Position as key management personnel Close family member of a related party Party in a post-employment benefit plan

26. IAS 24: Related Party Disclosures IAS 24 defines close family members as those who may be expected to influence, or be influenced by, that related party in their dealings with the entity Close family members may include: The related party’s domestic partner and children; Children of the related party’s domestic partner; and Dependants of the related party or the related party’s domestic partner Tan & Lee Chapter 1 © 2009 26

27. IAS 24: Related Party Disclosures Key management personnel refer to those individuals who have the authority and responsibility to directly or indirectly to plan, direct and control the activities of the entity IAS 23 considers non-executive directors as “key management personnel” Key management personnel refer to those individuals who have the authority and responsibility to directly or indirectly to plan, direct and control the activities of the entity Tan & Lee Chapter 1 © 2009 27

28. IAS 24: Related Party Disclosures Nature of the related party relationship Where control exists Even if no transactions exist Disclosures Related party relationships Information required to understand potential effect of relationships Information about the transactions Outstanding balances Relationships between parents and subsidiaries Name of the entity’s parent and the ultimate controlling party Compensation of key management personnel Arm’s length” terms Tan & Lee Chapter 1 28

29. IAS 37: Provisions, Contingent Liabilities and Contingent Assets Information provided alerts the user to the possibility of a loss occurring in some period as a result of some past event(s) Contingencies are characterized by a lack of a reliable estimate of the future loss 29 Tan & Lee Chapter 1 © 2009 Note disclosure required Make provision Liability recognized on balance sheet Probability of loss Probable Possible, but not probable or remote

30. IFRS 7: Financial Instruments: Disclosures Tan & Lee Chapter 1 © 2009 Disclosures Specific risk related to financial instrument Risk management policies and hedging activities Qualitative Information Quantitative Information Exposure to particular risk Risk management Changes from previous period Summary about exposure Maximum exposure and aging analysis Collateral and credit enhancement Maturity analysis Sensitivity analysis 30

31. Content Introduction Uncertainty, Risk and Exposure Risk Analysis and Measurement Risk Reporting Summary Metrics Conclusion Appendix 1A – Relationship between Risk and Value Appendix 1B – IAS 14: Segment Reporting 31 Tan & Lee Chapter 1 © 2009 5. Summary Metrics

32. Value at Risk Probabilistic measure of the potential loss that could be incurred by a firm’s 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 specified time interval and a given confidence level 32 Tan & Lee Chapter 1 © 2009

33. 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 value Current portfolio value Mean 5% Mean -1.65 (SD) 33 Tan & Lee Chapter 1 © 2009

34. Value at Risk Tan & Lee Chapter 1 © 2009 34 VaR Framework Distribution of values of risk factors Distribution of values of individual assets Distribution of values of a portfolio of assets Derived from: Historical simulation Normal distribution Monte Carlo simulation Effects of risk factors on individual values through Asset valuation model Combination of models Use of judgment Weights assigned for individual assets

35. Value at Risk Variants of VaR Uses among non-financial institutions is less common because the bulk of their assets are carried at historical cost and are used for productive purposes rather than trading Other terms like earnings at risk and cash flow at risk, are often used A Note of Caution Regarding VaR Use of a highly aggregated measure results in a loss of critical information that is necessary to evaluate risks. Different methodologies and different assumptions relating to time horizon and confidence level can result in highly different VaR estimates Does not address extreme market conditions Tan & Lee Chapter 1 © 2009 35

36. Sensitivity Analysis Sensitivity analysis is a method of measuring exposure to market risks Sensitivity analysis measures the potential loss (or gain) in future earnings, fair values, or cash flows of market-sensitive instruments resulting from hypothetical changes in interest rates, foreign exchange rates, commodity prices, and 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 distribution 36 © 2009 Tan & Lee Chapter 1

37. Multivariate Models Models may use financial ratios to predict bankruptcy Typically compare the profiles of actual bankrupt and non-bankrupt firms 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 process called multiple discriminant analysis (e.g. Altman’s 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

38. Content Introduction Uncertainty, Risk and Exposure Risk Analysis and Measurement Risk Reporting Summary Metrics Conclusion Appendix 1A – Relationship between Risk and Value Appendix 1B – IAS 14: Segment Reporting 38 Tan & Lee Chapter 1 © 2009 6. Conclusion

39. 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 adverse outcomes 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 losses as to avoid a misleading impression Disclosure of sensitive information has its costs and benefits Management judgment is integrated in risk disclosures 39 Tan & Lee Chapter 1 © 2009

40. Content Introduction Uncertainty, Risk and Exposure Risk Analysis and Measurement Risk Reporting Summary Metrics Conclusion Appendix 1A – Relationship between Risk and Value Appendix 1B – IAS 14: Segment Reporting 40 Tan & Lee Chapter 1 © 2009 7. Appendix 1A – Relationship between Risk and Value

41. Appendix 1A: Relationship between Risk and Value 41 Tan & Lee Chapter 1 © 2009 Effects of risk on equity value Result in higher cost of capital or returns expected by investors Gives rise to variability in predicted future net earnings. Greater information asymmetry and a likelihood of a higher variance

42. 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 as follows: 42 Tan & Lee Chapter 1 © 2009

43. 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 to market factors are included, in addition to a market index, as explanatory variables of the cost of capital. Hence, financial reporting must provide sufficient information to enable external constituents to evaluate the sensitivities of firms to changes in market factors. 43 Tan & Lee Chapter 1 © 2009  R = R f +  1 f 1 +  2 f 2 + ….. n f 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) and  1 = sensitivity of the security’s return to movements of f 1 .

44. Content Introduction Uncertainty, Risk and Exposure Risk Analysis and Measurement Risk Reporting Summary Metrics Conclusion Appendix 1A – Relationship between Risk and Value Appendix 1B – IAS 14: Segment Reporting 44 Tan & Lee Chapter 1 © 2009 8. Appendix 1B – IAS 14: Segment Reporting

45. Appendix 1B: IAS 14: Segment Reporting Presentation of disaggregated financial information by business or geographical segments Provides useful insights into the risk profile of the firm, and indications 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 and enterprises that are in the process of issuing equity or debt securities in the public securities market Segment information needs to be presented for consolidated financial statements only for groups Requires identification of more dominant segment types for primary reporting format 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. How does One Identify a Reportable Segment? Tan & Lee Chapter 1 © 2009 46 Risk and return characteristics Organizational Structure Materiality Thresholds Non- materiality Thresholds

47. How does One Identify a Reportable Segment? Tan & Lee Chapter 1 © 2009 47 Risk and return characteristics Organizational Structure Materiality Thresholds Non- materiality Thresholds By lines of business Nature of the products or services; Nature of the production process; Types or class of customers for the products or services; Methods used to distribute the products or to provide the service; and If applicable, the nature of the regulatory environment

48. How does One Identify a Reportable Segment? Tan & Lee Chapter 1 © 2009 48 Risk and return characteristics Organizational Structure Materiality Thresholds Non- materiality Thresholds By geographical segmentation Similarity of economic and political conditions; Relationships between operations in different geographical areas; Proximities of operations; Special risks associated with operations in a particular area; Exchange control regulations; and Underlying currency risks

49. How does One Identify a Reportable Segment? Tan & Lee Chapter 1 © 2009 49 Risk and return characteristics Organizational Structure Materiality Thresholds Non- materiality Thresholds By organizational structure The enterprise’s organizational structure and internal financial reporting system is used as a starting point to determine business segments and geographical segments

50. How does One Identify a Reportable Segment? Risk and return characteristics Organizational Structure Materiality Thresholds Non- materiality Thresholds 3 materiality thresholds: 50% test – more than 50% of the segment revenue must be from sales to external customers. If this condition is met, proceed to next test 10% test – applies to three bases Segment revenue is 10% or more of total revenue, or Segment result, whether profit or loss, is 10% or more of the combined results of all segments Segment assets are 10% or more of the total assets of all segments. 75% test – combined total revenue of reportable segment from sale to external customers should be 75% or more of consolidated or entity revenue. Tan & Lee Chapter 1 © 2009 50

51. How does One Identify a Reportable Segment? Tan & Lee Chapter 1 © 2009 51 Risk and return characteristics Organizational Structure Materiality Thresholds Non- materiality Thresholds Non-materiality thresholds Judgment or internal reporting structure may also used to determine economically significant segments as reportable segments.