q

- 20 . Chapter

RiskReportlng

o r o o

To understand Accounting, Tax and Legalissuesin Risk Management To have understanding about International Accounting standard(lAS) To haveunderstanding aboutlnternational Financial Reporting (IFRS) Standard To have understanding about Financial Accounting StandardBoard(SFAS)

lntroduction
Reporting Internal The information thatthe riskmanagement process is required to giveto the various levelsin theorganisation include; The Board of Directors
a a

To knowabout the mostsignificant risks facing the organisation To know the possibleeffectson shareholder value of deviations to expected performance ranges To ensure appropriate levels of awareness throughout theorganisation To knowhowtheorganisation willmanage a crisis To knowthe importance of stakeholder confidence in the organisation To know how to managecommunications with the investment community where applicable To assure thatthe riskmanagemeni process is working effectively To publish policy a clearriskmanagement philosophy covering riskmanagement and responsibilities To be awareof riskswhichfall intotheirarea of responsibility, the possible impacts these may have on other areasand ihe consequences other areas may have on them

a a

BusinessUnits "

*.

.Y

2 0 4 : F i n a n c i aR l iskManagement

To haveperformance indicators which allow them to monitor the keybusiness ano financial activities, progress towards objectives and identify developments which

require intervention (e.9. forecasts and budgets)

To have systems which cornmunicate variancesin budgets and forecastsar appropriate frequency to allowaction to be taken To reporl systematically and prompilyto seniormanagement any perceived new risksor failures of existing control measures Individuals
a a

To understand theiraccountability for individual risks To understanc.i how they can enable continuous improvement of risk management resDonse To understand that risk management and risk awarenessare a xey part o{ tne organisation's culture To reporl systematically and prompilyto seniormanagement any perceived new risksor failures of existing control measures

External Reporting A companyneeds tb reporlto its stakeholders on a regularbasis settingout its risk management policiesand the effectiveness in achievingits objectives. lncreasingly stakeholders look to organisations to provideevidence of effective' *unug"rent of the organisation's non-financial performance in suchareasas community affairs, humanrights, employment practices, health and safety and the environment. Goodcorporate governance requires thatcompanies adopta methodical approach to riskmanagement which: r Protects the interests of theirstakeholders ' Ensures that the Boardof Directors discharges its dutiesto directstrategy, build valueand monitor performance of theorganisation n Ensures thatmanagement controls are in place andareperlorming adequaiety The arrangements for the formal reporting of riskmanagement should be clearly statedand be available to the stakeholders. Theformal reporting sh-ould address: " '
a o

- particularly The control methods management responsibilities for riskmanagement The processes used to identifyrisks and how they are addressed bv the 4sk management systems The primary control systems in place to manage significant risks The monitoring and review system in place; anysignificant deficiencies uncovered by the system, or in the system itself, should Oeieported together withthe stepstaken to dealwiththem.

-t.

Risk Reporting : 205

Taxand Legal Accounting, lssuesin RiskManagement

Oneof the mainobjectives of accounting in riskmanagement is to provide truepicture to the regulators management, and the stakeholders. The traditional aCcounting is oone on

covering the events approach maytakeplace in future. Accounting riskarises whenthe datl is unreliable or manipulated and the decisions basedon such data results in unexpected losses.Company's accounts shouldreflectreal marketvalue,not the overestimated or profit underestimated figures. The management and employees mainconcern is maximizing profit throughaccounting juggleryas seen in case of Enron and Barringwhere the performance of employees is linked withprofit making.

basis whereas historical risk managomsnt emphasizos 0nrsal time and futuristic accounlino

Risk management approach on accounting on assetvaluation is different fromtraditional method of valuation basedon book valueor valueat cost.Risk management focuses on marketvalueof assetson record date basedon various marketparameters whichinfluence market valueof assets.Under the riskmanagement, accounts are prepared on the basis of marketvalueof assetsand liabilities to give true pictureof marketvalue of equityof the The marketvalueof equityof a company company. can not be derived from traditional accounting method. Only the marketvalueof assetsand liabilities give true inputto risk practices. management Incorrect accounting information may lead to wrongdecision for hedging and mismaiches. Manyof the banks and Fls havestarted preparing iheiraccounts on market valuebasisby marking all theirassets and liabilities to market and wheremarKet benchmark is available to valueassetsand liabilities marking to modelapproach adopted. The other very important issuein risk management based accounting is accounting of financial instrument i.e.derivative accounting. The lCAlhas issued AS 32 andAS 39 on the same regard. AS 32 dealswith Financial lnstrument Presentation and AS 39 dealswith Financial lnstrument Recognition and Measurement. Further, any changes in interest rates havean impact of changing thevalueof fixedrateassets and liabilities. However, accountinq does not capture suchan impact, but in long run ihe impactof the same may be seenii declining Nll of thebank.Hence, the needof riskbased accounting and auditis ielt. Treatment of tax differs fromcountry to country and the changes in tax lawsare an ongoing process. Mostof the banksand Fls having presence in various countries haveto makea smart tax management in order to avoidanyunforeseen tax liability or litigation arising outof non compliance of country's tax rules. The product and services in international market are customized on the basis of taxand legal prevailing framework in thatcountry. Sometimes the pricing of products and services are basedon country's tax rulesand legalenvironment. A smallchangein tax rulesor laws may impactprofitability of banks. The impactof rule changes maybe seenin Indian equity market for Fll and PE investors. Certain changes have beenmadein taxtreatment for theseentities for recognizing gain,whichhasresulted capital in lowerincome. The tax implication may alsoleadto litigation if ruleand law of landis not adhered to. Legalrisk implies that eitherthe contracts are not documented correcily or that thereare difficulties in theirlegalenforceability. Legalrisk oftenariseswhencounterparly losesmoneyin a transaction. This may be seenas in the firstquarter of 2008,manyof the corporates in India bookedheavy lossesin derivatives positionsuch as lClCl Bank, Haxaware and manyof the public products sectorbanks. The derivative weresoldto them by foreign banks andthe riskinvolved was notunderstood correctly by Indian counterparties. Manyof the banksare now facinglitigation from corporates, Corporates alleged that the

2 0 6 : F i n a n c i a tR i s k M a n a g e m e n t

are notavailable, as banks'ur"no, the litigation beingfacedby themout oi derivative deals. Nowwe will discuss various accounting standards evolved overthe yearsand are related to the accounting and drscrosure of derivaiive products in brief. The standards discussed below are the brief extractof these standards howeverfor the requirements referencemust be made to International_Accounting standaros (lAS), International FinancialReportingstandards (IFRS) unJ Finun.ial n"ccounting standard Board(FASB) Statements

was nosuch requirrrrni. ir'.r* ismore inherent risk involvgfl in thecountor dorivativg contfacts thatarecustomised to suit the requiremenrs of the counterparty' The exactdetails of suinqparties j[r"lo.,nJ

products were not a-sper Indianmarketand they were not explained the featuresof the derivative products',soT! of the corporates even'alleged that the derivative products were sold tothem even when there

International Accountin g Standards

IAS 32 FinancialInstruments: presentation The objective of this standard is to establish principles for presenting financial instruments as liabilities or equity and for offsettinq financial assets and'financial-liabilities. lt applies to the classification of financial instrumeits, from ttre perspective of the issuer, into financial assets, financialIiabilities and equity instruments;' ttre ciassification of reiated interest, dividends' lossesand gains;and thetircumstances in whichfinancial assets and financial liabilities shouldbe off!et. The principles in this Standard 'assets complement principles the for recognising%nd measuring financial and financial liabilities in IFRS g Financial Instruments, and for disclJsing informition aboutthem in IFRS 7 Financial Instruments: Disclosures' The issuer o{ J financialinstrument shall classifythe instrument, or: its component pads,on initial recognition as a financjal tiaoitity, a financial assetor an equrty instrument in accordance with the substanceof tre coirractualarrangement and the definitions of a financial liability, a financial assetanJ in equitvinstrument. The issuer of a non-derivative financial instrument shallevaluate the terms of the financial instrument to determine whether it contains botha liability. and uqriiy romponent. such components .un shallbe classified separately as financial tiaoitities, tinanciitLssers or equity instruments. A financial instrument any contract that givesriseto a financial assetof one entityand a is financial liab)lity or equityinstrument of another entitv. A financial assetis any assetthat is: (a)cash; (b) an equityinstrument of another entity; (c) a contractual right to receive cashor another financiar assetfromanother entitv: or o to exchange financiarassets or financiarriabirities with another entity under conditions thatare potentially favourable to the entitv (d)a contract thatwillor maybe settled in theentity's ownequity instruments and is: o

RiskReporting:2O7

' o

a non-derivative for whichthe entityis or may be obligedto receive a variable number of the entity,s ownequity instruments; or a derivative thatwill or maybe settled otherthanby the exchange of a fixedamount of cash or another financial assetfor a fixed numberof the entity,s ;.-;ilt; instruments.

A financial liabitity is anyliability thatis: (a)a contractual obligation o o to deliver cashor another financiar asset to another entity; or

to exchangefinancialassets or financialliabilities with another entrty uncjr:, conditions thatare potentiaily unfavourabre to the entity (b)a contract thatwillor maybe settled in theentity's ownequity instruments andis: o a non-derivative for whichtheentity is or maybe obliged to celiver a.variable numbeiof the entity's ownequityinstruments; or o a derivative thatwill or maybe settled otherthanby the exchange of a fixedamount of cash or another financial assetfor a fixed numberof ttre"entitfs'o*n equity instruments.

An equityinstrument is any contract that evidences a residual interest in the assetscf an entityafterdeducting all of its liabilities. A financial instrument may require the entityto deliver cashor another financial asset, or otherwise to setileit in sucfra *iv fl.rui it wouldL;c a financial liability in the eventof the occurrence or non-occurrence of unceftain futir: events(or on the outcome of uncertain circumstances) that are beyondthe control of both the issuerand the holderof the instrument, such as a changein a stockmarketindex, consumer priceindex, interest rateor taxation requirements, or the issuer,s future revenue. net incomeor debt-to-equity ratio.The issuerof such an instrument does not have unconditional right to avoid delivering cashor another financiat asset(orotherwise to settie r, in sucha waythatit would be a financial liability). Therefore, it is a financial liability of the issuer untess: (a) the partof the contingent settlement provision that couldrequire setilement in cash or another financial asset(orothenvise in sucha way thatit wouldbe a financial liability) is n o tg e n u i n e ; (b) the issuer can be required to settle the obligation in cashor another financial asset(or otheirwise to settleit in sucha waythat it wouldbe a financiat liability) onlyin the eventof liquidation of the issuer; or (c)the instrument hasall the features whena derivative financial instrument givesone p a choice overhow it is settled (egthe issuer or the holder can choose setilement ne. cashor by exchanging shares for cash), it is a financlal assetor a financial liability unless all of thesettlement alternatives wouldresult in it being an equity instrument. lf an entity reacquires its own equity instruments, thoseinstruments ('treasury shares,) shall be deducted from equity'No gain or loss shall be recognised in profitor loss on the

l-

2Og I Financial Risk Management

settre on a netbasis, or to rearis" [?]J?:"l$r3,i):"'to ; ;;

fromequity, be accounted nrioi unvrerated for "qrity income iax'benetit. A financial assetand a financial liability shailbe offset and.the statement net amount of financiar presented position in the wrrrrl"ro onrywhen, an entity: (a)c,rrenflyhas a regaily enforceabre righito set offthe recognised arnounts; and

;h;ii'fr" reJognisea dividends, oi,.u.trv rosses. , andsains,"rrtins Interest, i; ; i;;.;;ui-,i!i,rrrnt or a componenr financial liabilitvsharr rhat ne"iecog;'i"l;" is a income oi profit horders of an equity or ross. Distributions instrumeit.r,"rr to "*p*-n.".in t" o"oii"joviil related ollecuy.to incometax benefit' equrry, net of rttntutiion costsof un any "ll,^, transaction as a deduction shat

purcha'se' sale'issueor cancellation of an entity's own instrurnents. shares maybe acquired such treasury .equity uiJ h;illy the entity'oi[u'o,n* group' members consideration or ir.,e '*or,,u. consoridated paid ot ieieived

J*,i" theriabirity

illi;;:""eded

IAS 39 Financiar Instruments: Recognition and Measurement The lnternational-Accounting standardsBoard has decided Instruments: 'in"'ii., Recognition rAS 39 Financial un-drtrrulir"r"nt over a perioo to reprace dealingwith crassiiication or timb. instalment, ;";';;;rement of financiar -ruqi,'irements Financial Inslrumentsin assets,was issued as ,FRS rtrou"r["i, 2009. Tl-r" 9 measurement for crassification of financial riabirities and oiiinuncialassetsand riabirities addedto rFRs 9 in october;'il. and derecognition were and will becomeob.so.lete.for A.'"..onruqr"nce, paftsof rAS39 are beingsuperseded annrari"riors dgi;;il 5il'oi utt., 1 January application was permitted 20is and earrier in ,01o.-ri! ,"r"ining re;uireri'ents bv r,i*";;.i;;il;"; rffisb:i;"'il"j[ of rAS39 continuein effect

;;;p;;;,rAS sginiG ""p""t,

lmpairment and uncottectibility of financiar assetsmeasured at amortised cost

'tosies (excluding future creoit asset's originaleffectivei;i"fuiir'rut"r.'l""not been incuirlo) discounted at irre financiar t"i.'1i",h" recognition)' rate computedat initial The carrying amount of "ri".ti"r"i"ierest thl assetshalr be ,.ou""o of an atowance direcryor account. The;";;i;; use *,. tor. ;fi;;gnrsed "ither profit through in or ross. Hedging A hedging relationship qualifies for hedqe accounting underparagraphs if, all of tl.re tottowing B9-102,if and onty ionoition.a;; ;;;:t' (a) At the inception designation hedging rerationship l"g,gu, rhere,^is -o^i^th: and documentation ano _p,ir1, of the t6e' ;;;il'r risk managJr"nt objecriveand stiategy ror

:''J:i[,!!i*x?l*T,"f ,rff n:L:J'.*;1iH$fl:':ffi iil::.il,:l'Jffii::;t"; f between 'n" ;,""i."li,i,il,jlj,l[ili h:1itrilf:jnh:;f

fl.:ltjtJ,r*l""i.;".s

ar theendof each. reportins period whether rhere is anyobjective

[,,nT,,ff;i,l?.:;1f,,?t

R i s k R e p o r t i n g: 2 0 9

ttows atiributable to thehedged risk. (b)The nedgeis e199ct9! to be highly effective in achieving offsetting changes in fairvatue or cashflowsattributable to the hedged risk,consistentf with ftre"originiilidocumenteo riskmanagement strategy for thatpa-rticurar rreoging ieiationsrrip. (c) For cashflow hedges, a forecast transaction that is the subject of the hedgemust be highlyprobable and must present an exposure to variations in cash flowstnat could ultimately affectprofitor loss. (d)The effectivenes.s of the hedgecan be reliably measured, i.e.,the fair valueor cashflows of the hedgeditem that are attributable to'the ;;og"o risk and the fair vatueof the hedging instrument canbe reliably measured. (e)The hedge it ut::":gd on an ongoing basisanddetermined actually to haveoeenhighly effective throughout thefinanciat-repdrting prrioJ. ioi *r-'i"r.r the hedgewas designated. Hedging relationships are of threetypes: (a) Fair value hedge: A hedgeof the exposure to changesin fair value of a recognised assetor liability or an unrecognised firmcommitmeni, Ji an ioentified porlion of suchan asset'liability or firmcommitment, thatis attributable to a parlicular risk and could affect profitor loss. (b) cash flow hedge: A hedge of the exposure to variabirity in cash flows thal (i) is attributable to a particular riik associated with a recogniseo asset;li"b;;ty (suchas atl or some futureinterest payments on variablerate d"ebt; or a highly probable "y' ")' v'vvqu forecast transaction and(ii)could profit affect or loss. (c) Hedgeof a net investmenfin a foreign operation as defined in rAS21. lf a fair valuehedgemeetsthe conditions paragraph in BB duringthe period, it shallbe accounted for as follows: (a) the gainor lossfrom remeasuring the hedging instrument at fair value(fora derivative hedging instrume.nt). glt!" foreign" currency component of its carrying amount measured

include identification of the hedging instrument, the hedged item ortransaction, the nature of the rirr, nling nJgeo and how the entitv will assess tl: he.dgjng instruqglll'g effectiveness in offsetting tho sxp0suf6 to changes in the hedged item'slaii value or casrr

undedaking the hedge.That documentation shall

ll ;rtirit:1ffi:,:n'o*

21(ior i nonoerivative rreosing rinstrumenu lrrarr berecognised

(b) the gain or loss on the hedgeditern attributable to the hedgedrisk shalladjustthe carrying amount of the hedged itemand be recognised in proritor loss,Thisappties if the hedgeditemis otherwise measured at cost.Rec6gnition oi tt'.}" gainor lossattributable to the hedgedrisk in profit or loss appliesif the"heJg"d il q itur , rv,,r r .vclildu o q is an availabte-for-sale financial assgt. lf a cash flow hedgemeetsthe conditions in paragraph BB duringthe period, it shallbe accounted for as follows: (a) the portionof the gain or loss on the hedging instrument that is determined to be an effective hedge(seeparagraph BB)shallbe recognised in othercomprehensive income: and

210 ; Financial Risk Management

tt' 'iililtJl?||f porlion ofthegain orloss onthehedging instrument sha,berecognised in

(b) the ineffective porlion shalr be recognrsed in profitor

a foreign it^1t^:t:l 0perdtidn, ili$iln a hedge rs accounted foras parlof tnenetlnvJst,ilrnt ofa monerary item rhar cashflowhedges: 1*." IAS21),shallbJ accounted for similarly to (a) the porlion of the oainor losson,n" n?1n:lg_instrument effective thatis determined hedge lsei paragraph to be an BB) ir,uir'0.recognised in oit,r.. comprehensive income;
ross.

a, net investme.nl in

Internationaf Financial Reporting Standards

IFRS7 Financial fnstruments: Disclosures The objectiveof this ,;g?r,; enrities statements ro provide thatenable disclosures in theirfrnanciat :?"fi:ilie (a) the significance of financiarinstruments performance; for the entity's financiar and position and (b) the natureand extent of risksarisingfrom fjnanc,u, exposed ,T:rlrT:nts,to which the during t3: g?,.r"9 entity is

allentities' incrudins entities rhat have rew rinanciar insrruments (esa iXlifilrrTo'f;"1" pavabre) are accounts. uno tr'ro.ut?#ifl"#il1? ,.u.*iuuol"-'alo a..ornts ,;stru.ments whose (ega rinan"ci"Tl'.,ii]i,"n assets inJiiuoiriti";;;" fi;;.ilii:iil,rl'ii:f".,' most oi

overview of theentity's useof tinaitiailnstruments anotil'exposures to risks theycreate.

iii,l"r"-":1?iiiJilH;ily:#s in te rn a r rv to th e

manages those period, io* theentity risks' ";;';i;r" Thequalitative !10 oroescriLl-run"gur"nt,s irr. irp"itins irscro:rres "no objeciives, poricies rrre quani,r.;il;,grsc-rgsureg

dx"[ ,?,#::g "Tj:L.. l"rry; l,.5;#:,d:l "tii ji:.:I S,rm:S "r".r,

p,.ouiJ" inrormarion

i ,jjriiil:,,?x"',!T{lii[t*n**#ilil#F,"j**
i;;;:fii;'ffix';i:1ts,343'iJ;,ff:n1;;au'F1,.fi:iii,#;;,;:x?3" ,iabi,ities in rRs sz
IFRS9 Financial fnstruments

fr#

t:ili".'#? ri n a n c ia I in st j,u ru m ffi J:tr''ffi e n t,a ."' ne n tity ".. or I 5,

rne starement or rinanciuLporition. in"",o:::lfr". i"tii,irdi!:irlnnXf?ffiji:,ilj:.;?

#:nil"j:i$'Jiilffi jll:iff ff"il:Jll*," l;"?,:,J?x,;il?Jl';,?Jg',?li;"1,1 ."A.*o'u

R i s k R e p o r t i n g: 2 1 1

Subsequent measurement of financial assets

measured classification at fair varue. is madeat the iir"lhl'tinanciar ur..ii. iniiiurry recognised, entity namery becomes whenthe a parlyto the contractuar provisions of the instrument. Debtinstruments

IFRS e divides at finanoiar assets in, scope - those measured H^Tl^qrrjenjrv classifications of rAS 3einto two at-.amortised cost and lf, those

two cond*ions can be measured atamor.tised fi3i:JI.]HA:TJH cost iiii,i'r;tl,.,i:11?,1''n

Bustnessmodel test: The objective of the entity's business moderis to hordthe financial asset to collectthe contractual cash flows (rathl; ihu-nto ru sett sell "'*" the tnstrumen Ine instrument contractualmaturityto prior to its rearise itsfaiivarue.r.,ungurj. cash flow characteristics test: The contractual terms of the financiala$set give rise on rlows it'ut J," soletv puv'uni."or measured at fairvaluethrough profit or loss(Fvrpl).

;ffi3ffii"lilnJiln:"'h
Fairvalueoption

principar anJlii",.urt onrhe

All other debtinstruments mustbe

Even if an instrument meetsthe two amorlised cost tests, g designate a financial assetas m"a.ur"o at FVTpf it'oorg IFRS containsan optionto so eliminates reouces a measurement or recognition,.^i.rl_rl.t";ci"'lsometimes or significanily 'accounting referred ro as an mismatch') ftratwouto"lir,"*ir" arisefrom measuring recognising assetsor riabilities thegains or andlosses on ifr", on different basis.

rhe avairabre-ror-sare nid:;"fl:,.ili lff^'S'3g?E'":i:,-flillll,i,.i and herd-to-maturity

Equityinstruments All equity investments in scope of IFRS9 areto be measured at fairvarue financiar in thestarement position, wfn,,varuei..;hurg;;lcogniseo of in p.tiio,. ross,exceptfor those equity

,other lil:il1:il'.l3',yff[n?:ii:lf;i *:,.r*"*-;fl:l';"'nes in comprerrensiv

'Other comprehensive income, option

i]i'n,i'"i#orehensive ill'f[?;:il["ft'1"flffiru:;1,;# income (Fvrocr) XiH;,g:['*

lf an equity investment is not

heldfor trading, an entity can makean irrevocable erection at

I
L

212 I Financial R.isk Management

Measurement guidance

wnen rFRsg contains cosrmaybe the besr for a, T*jy. investments, guidance egtimaG c_ 9n ; _, ol ui fair rall value valug fopiesentaiive ahdalso ahd of fair when
varue. it mightnot b e Subsequent measurement of financial liabilities amoftised cost'Financiai (pvrpl) ano liabiritie. r.r.rifor trading financial ur, ,.u'.Y9lf:t'l-:.t-,:ss liabilities at FVTPi' arerneasurto ind all other ut umoirsed costLrr wvot unress lressIne th";Yl:! latr value optionis applied.

Despite thefairvarue.requirement

f#"'"i'",il:ii".i+:9ii!ii;,TtrilHllf ,iabi,ities under ,AS 3e ,ff1:l,fl,inancia,

Fair varue option

IFRSg contains an option to designate a financial liability as measured at FVTpLif:

or significanily .:o eliminates 1o^,1.9 reducesa measur rnconsistency (sometimu, ir"t"ii;,,," as anrr.orntin!";ilillJ,; otnerwise arise; ;?t#ji:i or liabitiries tosses or rdcognising rde'glinr"";no ",' "",i.' ", "',i"#,#T'#'*1.X.; o the liability-js.parl or a group of financial riabirities liabilities or financial thatis,manug; uni its. assets andfinanciar performan." i.-Juurrated on u iiir'iuruu basis, witha oicum"nteo in n:t il;#ilnt ,x?:ilXffi" o.r

"or entity mayonlytransfer to protii toss, tnecumut-ai;;;," or ross the within "or,',T.t"rreo Derecognition of financial assets
The basicpremisefor the derecognition model11tfnS 9 (carried determine whether the assetunder over from IAS 39) is to consioeration tor derecognition is:

?iri,3#;F:ru'[*i:Hf''ffi dilff !ffi tiidi""3'*:fr:'i?,il,r,

sha, bepresented fftll"il,*lnfl::t' in recosnition varue oittrJ in,n"pi"iii;:ffi':T;:i,n[",.::J:e rurr apgunt orchanse inthe rair inJo'e worid ,,."ui" ffllnlefen.iu" inother o,,s3iJ[[:t:l'13.?fi,t1. loiritv..,.o'i?l.n

A financial liability,which does not meet any of these criteria, at FVTPLwhen ii tont*nt may stiil be desrgnated g;T:i,""i onu o,.more embeoleo as oerivatives that wourdrequire IFRSI requires ouilt,3nd losses on financiar riabirilies or lossto be spliiintotne designated at fairvarue amouni;; .;;"g" in tn" through profit iuiiul-r#that is attrioutaolJ the creditrisk of the riab.ility, to crranges il;;;;1:: in comprehensive otcrrange-in ?-r";;ri.o", income, inJtui,. and varue "i,,,9, which ortn"iiJoirity

investment stratesy, isprovided and i;i';;ii;;n thar 'ununurJr?3:?:Jff"fl'ouo oi.[ t"'ir."entity,s key

R i s k R e p o r t i n g: 2 1 3

o o o c

an assetin its entirety, or sPeci{ically identified cashflowsfroman asset(ora group of similar financial assets), 0r (prorata)shareof the cashflowsfrom an asset(or a groupof a fullyproportionate financial similar assets), or a fully proportionate (pro rata)shareof specifically identified cash flows from a financial asset(ora'group of similar financial assets).

Oncethe assetunder consideration for derecognition has beendetermined, an assessment is madeas to whether the assethas beentransferred, and if so, whether thetransfer of that is subsequently asset eligible for derecognition. An assetis transferred if either the entityhastransferred thre contractual rights to receive the cashflows,or the entityhas retained the contractual rightsto receive the cashflowsf romthe asset,but has assumeda contractual obligation to pass those cash flows under an thatmeeis arrangement thefollowing three conditions: o the entity has no obligation to payamounts to the eventual recipient unless it collects equivalent amounts on the original asset

G the entityis prohibited from sellingor pledging the original asset (other.than as security to the eventual recipient) r theentity hasan obligation to remit thosecashflowswithout material delay

Once an entityhas determined that the asset has been transferred, it then determines whether or not it has transferred all the riskssubstantially and rewards of ownership of the asset. lf substantially all the risks and rewardshave been transferred, the asset is derecognised. lf substantially all the risks and rewards havebeenretained, derecognition of theassetis precluded. lf the entity has neither retained nor transferred substantially all of the risksand rewards of the asset, thenthe entity mustassess whether it hasrelinquished control of the assetor not. lf the entity doesnotcontrol the assetthenderecognition is appropriate; however if the entity has retained control of the asset,then the entitycontinues to recognise the assetto the extent to which it hasa continuing involvement in theasset. Derecognition of financial liabilities A financial liability shouldbe removed from the balance sheetwhen,and only when,it is extinguished, that is, whenthe obligation specified in the contract is eitherdischarged or cancelled or expires. Where therehas beenan exchange between an existing borrower and lender of debtinstruments withsubstantially different terms, or therehas beena substantial modification of the termsof an existing financial liability, thistransaction is accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. A gainor lossfromextinguishment of the original is recognised in financial liability profit or loss.

2 1 4 ; F i n a n c i a lR i s k M a n a g e m e n t

Derivatives

:!irfl:llJl["",ilfu3'"itJir:
Embeddedderivatives

'All derivatives' incruding those rinked equity investmentsr aremgasursd Yalug' valuo Onangs 1: :::,y:,.q at lair arO rOcOgnisod in proiir o, ror, ,nrrr. theentity has erected to rreat iistrurient inaccoroin.u

*nr'rAS 3d, ir-*r,tr, case the

insurance conti".,., contracts ;:::i""J,,:r":Hffii,!ifl;lili'.g contiacts, for the purchase

Reclassification For financial assets'reclassification is required. between FVTPLand amortised versa'if and onlv if the entity cost,or vice s ousinessmodel oo;ective tor its frnanciar its previous assetschanges mooel assessment so wouldno,long.er ippiv. ti recrassirication is appropriate, it

An embedded derivative. is a component of a hybridcontract that arso incrudes derivative host'withthe effectih; r;;" a nonor tne casr,iro*. oit a way similar to a stand-alone varyin derivative. " "on.,oi*i-inr,irn.,"n, n oerivativ, tt-,"t is attachedto a financial instrument but is contractualty transieraore inolpenolniry different counterparty, or has a is not un'rrnn"jieO Oeriuatiull.Ori,u of that instrument, i.purate financial insrrument. The embedded derivative concept of rAS39 has beenincrud.d i, r;;;; hosts that are not assets *iir'rir," u onryto itr"' ,.op" of the standard.consequenily, "oo derivatives that underIAS 39 *orio'nu"r-b:gn."pult"li emoedded uccounted for at FVTpLbecause they were not closelyrelated toh" inanciatnost asili*o *itt no longerbe separated, lnstead'the contractual cash no*s ot'ir,efinanciar ; assessed the asset in theirentirety, as a whole and is measureJ rvrpa if ;il";iii. ";;;i .urt., paymentsof principaland frows do not represent "i interest. ih" embedded o"iiuuiiu. conceptof rAS 39 is included in IFRS I now to tinanciiliiuoititi". 9!o continue.-io'appty and hostsnot w*hin the

IFRSg doesnot allowreclassification where: r the 'other comprehensive income, option has beenexercised for a financial asset, or .

does noi restate il3il"::r':1""fi['J.T:ll,? any 3:SJT;;il;i'il;'#'Ju#'lnentity

has exercised inany circumstance fora financial lll""lXi:lfrll,i,i,l,'"n been assets or

Financiar Accounting standards Boardstatements

FAS 133 : Accountingfor Derivative Instrunrents and HedglngActivities statement 133 (FAS-J33.or.SF-AS 133)establishes accounting -l,iriru,.n"nt" derivative instruments, and reporting standards for #u,l oerivaiive contractsand for hedging ^t"1"gi1J embedded in other activit'ies. rn_s tss t".rr"."", the hedge toors and noi the sort of risk that is bein-g titog"i.-FAs' iss o..rpier-ii."ri'with derivatives, no ma*er how

R i s k R e p o r t i n g: 2 1 5

areused' FAS133is a compromise they on fairvalue accounting. FAS133offers hedgers (vs' tradersof derivatives) a halfwayhouse in the form or other Comprehensive
themin current income. lt is partof theincome statemenl, but notcurrent earnings. FAS 133 somecommon outlaws hedgepractices suchas marcoand portfolio neoging,"netting and synthetic accounting in its various incarnation. The resultis a mucn greater chancethat hedgemismatch will createvolatiie earnings' sometimes for 'good,r"u"ronr,ano often for reasons technical thatdo not necessarily reflect the economics 6t tre rreoging'reiationship, For example, timevaluein options mustbe marked to marketin incomein mostcases, so evenif the optionhedgeis perfectly effective at limiting the company's downside risk with respect to futurecashflows,the costof the hedge(whichusedto be amorlized in a straight linefashion) can become a source of undue votaiitity. U1d9r f4S 133 (in order to qualifyfor hedge accounting) treasuries can definethe relationship between a derivative and an exposure in one of thiee basicways: e Fair value hedges:Hedgesof exposures to the changesin value of a recognized assetor liability, or unrecognized firmcommitment. c Cashflow hedges: Hedgesof forecasted transactions, or the variability in the cash flowof a recognized asset or liability. e Netinvestment hedges: Hedges of the netinvestment in a foreign operation. While the accounting forthesehedge relationships mayvary: Fair valuehedges: The derivatives are marked to marketin earnings. The valueof the hedge willbe offset by changes in thevalue of the underlying exposure. C.9sh flow hedges: The derivatives are markedto marketand carriedat fair value.The porlion effective is recorded in OCl.The ineffective porlion goesintocurrentincome. Net investment hedges : The gain/losses in the hedgeare recorded in oCl, Consequenly, these hedgesare inconsistent with much of the new derivatives accounn:ng rule. For example, they allowtreasury to hedgethe 'net'exposure. trrey atsoallowcompa-nies to use nonderivatives (e'g'foreign currency borrowing) to covertheirinvestment risk. FAS 133defines derivatives as: A derivative instrument is a financialinstrument or other contractwith all three of the followin g characteristics: (a) lt has o ' oneor moreunderlying, and one or morenotional amounts (by any othername)or payment provisions or both. Thosetermsdetermine the amountof the settlement or setilements, and, in some cases,whether or not a setilement is required,

'park' (QQl), lpcome QQI ioa pla00 gains t0 and losses 0nh0dges until it istime torecognize

2 1 6 : F i n a n c i a lR i s k "ununurn"n*

(b) lt requires no initial netinvestment or an initiar net investment that

wourd .*o,.,ed :.:ffiJ?i.L",ld:1'; rohave a sim irar Xn:**;1#'ii,u,'iJo,,"o'"J!

is smarerthan

be se.,ed ner by ameans "'fi.':ffiJl.lTi1[l:,'# ourside ?sJilll:yl:gTsg,,y asset that puts the recipient substantially in a Jitterent
fromnet,.ttr.drojt"n iositionnot SFAS138:An amendment to SFAS133 SFAS138includes thefollowing fourmajor amendments: ' purchases and normalsales exception is expanded Jff#:imal to cerlaincommodity o o an interest ratehedgeis redefined. Recognized foreign currency_denominated assetsand liabilities a singlecross-currency may be hedged with compound heoge. The riskthatcan be hedged in

'

derivatives may bedesisnated il"1r::t$?$":il:XX'i.$?i:n"'o"nv ascash ,ow

Normalpurchases and NormalsalesExcel

ffr3,::nlx?,';.,it'"'""rrv,

i#,[ff ,'#,lErus!:utii*:11*,,'l j; i:rr;:;*d*ffi -t# 1.".1ii,fl3"3i;31il3J%J'ffi:i:ff:i

phvsicarrv ouiiue' ;16'1frTl,.ffi:i?

In theirnormal toT:" of business, companies -'"11i1'""i that

niiurar oir, "'*', 'ii.naserecrricity, sas,

consume or produce commodities often

in",.derivatives inJp,*."nt til:r".tl"JffiJ.,J,l:fi3ffi::fy",iJfl simirai risks; thererore,

InterestRate SFAS138soughtto^r9d1c-e the implementation confusion causedby the definition rate risk usedin sFAg rgs. of interest ih";lrn]'st'anoaro ii"orpon"nts of risk into interest rateriskand creditrisk'and ot""J"".i'rte concept "oroin"" of interest rate benchmarked rateriskto incrude the index, ir.rrling' the popurar1rgon interest r? rreoging ]h", rr;G;';;;', lnterbankoffer Rare) (London iate i'r..uL rtii"trv'd;;;iil:a,rso captures risk movements

FASBdecided contracts that permit butdo not require setilemenJ by derivery of a commodity

jire,ements :iil::[$?#::filT:.:j?,""rtrlimn1"j"f,:ni3;0,, risr< fonsist,,"?

undercertain conditions' SFAS 133allows interest rateswaps assumes to usea shortcut no ineffectiveness. method that The shortcut method J"".'"# strategy thatdesignates to a hedging the oencrrmart intereit rat;; i#'!9ooeo "|f1t,-,h?ry"ugr, rlemls stated riskwhenthe hedged at a different ino"*,tJ.r't u, ilr" pi,m, ,ul"l rn. basicdifference oetween

l
Risk Reporting t ZLT

wouldaffectthe assessment thoseindices and measurement of hedgeineffectiveness and possibly force moreitems intoquarlerly hedge effectiveness testing. SFAS'138has broadened the scopeof qualifying hedges. lt allowscompanies to hedge rateswith available interest derivatives products b-ased on LIBoR Hedgeetteciiveness witt increasebecausechanges in credit spreadswill not be considered u rorr.J oi ineffectiveness if hedgingwith a benchmark interest rate. lt has also complicated the accounting, however, forcing morefrequent effectiveness testing. Entities should evaluaie howtheyhedge interest rateriskanddetermine whether newpolities are required. Hedging of Foreign Currency Denominated ttems provision One important of SFAS138is thatit allows jointhedging of interest rateriskand exchange (FX risk one compound hedge), srns tga widens the lqleign net of quatified 11 FX hedges to include thefollowing: o Foreign currency-denominated (FD)assets or liabilities can be hedged in fair value or cash flow hedges.However, cash flow hedgesof recognized FCD assets or liabilities are.permitted onlywhenall the variability in the hJdgeditemi'functional currency equivalent cashflows is reduced to zero. Unrecognized FCD firm commitments can be hedgedin fair value or cash flow hedges.

'

Priorto SFAS138,hedgeaccounting for foreign currency risK exposures was limited to fair valuehedges of unrecognized FCDfirmcommitments, cashflowhedges of forecasted FCD transactions, andnetinvestments in FCDforeign operations. FCDitems (e.9., a fixed-rate bondin deutsche marks) aresubject to two underlying risks: faii value risk in terms of changesin Germaninteresi rates,and changesin itre FX rates (between the deutsche markand the U.S.dollar). Before SfnS 138,tie debtor woutdfirsl hedge the interest rateriskby locking in thecombined valueof the bondand swapat a fixe<., amount in marks witha swapin whichvariable interest was received and fixedinterest was paid.Then another derivative contract, such as a forward contract to hedgeagainstthe possible fallof the markagainst thedollar, would hedge thecombined FCDvalue for FX risk. UnderSFAS133,the FCDdebtwas remeasured (viathe income statement) basedon the prevailing spot rate of exchange and the derivesfive was markedto market(alsovia the incomestatement)' However, thesetwo adjustments rarelymatch,creating unintended earnings volatility. Under the SFAS 138 amendments, it is now possible to acquirea singlecompound derivative to hedgethe jointfair valueriskof interest rateand FX movements. One such derivative is a crosscurrency interest swap,whichwould receive a fixed interest rate in foreign currency and pay a variable interest ratein domestic currency. SFAS 138 permits theserecognized FCD assetsand liabilities to be designated as the hedgeditemsin fair valueor cashflowhedges. lncompany Exposures Multinational corporations enterintomanytransaetions with FX riskexposure. A centralized treasury centerthat assesses corporate-wide FX exposure and hedgesthe net exposure

2 1 g : F i n a n c i a lR i s k M a n a g e m e n t

H',tffirt-rt:ffiu''ut

offers significant cost savings over subsidiaries acquiring their own

ffJffJ:ffJflJl,tjtt"nt

SFAS 133discouraged hedge accounting by treasury centers because members it required of a consolidated individual o.r;;;;t.-, inoiuiorurtri."iiirg derivative parties' coniracts which nullifies wrth third Jhe,c6st tauintsbeneiits. ft. sFn's'!seamenoments intercompany arow derivatives certain thatareotfs'J tt,iro-pa,ry contracts to be designated ?l:lr",e:o in

s mi,, ion rrom aJapan i,i f ii'lii:.T:1il::',i:':':$'Jfl ese ilru'* :.J;,loy. mirrion uu'rth 0rinvenrory ttol, culrrn supprier ,,,*" .lliu"'#;jfi"r3rj:?T:rlJ[: y":illi co u, dh :i"?J:tr eds eits ri J#ii?1,?'o?,y.; s kby l; [w i3: s;;i ;,?#:",.u
cash ito*'h"osrs offoreisn.r*un.y risk in theconsoridated

Amendments to DIGGuidance SFAS 138 also amendsre.lated interpretatiolr-!r.,r..9 by the Derivatives Group (DlG)' lssue G3: oir.ontinruiion rmprementation of a cash flow hedge.5FAS accounting 138 amenosthe for discontinued cashtro* r'Jog"r uv ,.eqriring'il.ru, ,nu net derivative from a discontinuel:::l gainor ross d- r,'Jib-"be ,eportedin iccumurated income'unlessit is probable other com-prehensive thattt.,L%r*.urted transaction *irr not occurby the eno of the originariy specified timeperiod or within an additionar two montns.

Summary
Thereare various accounting issues are involved in accounting of derivative aboutfinancial products. instrument IAS32 talks presentatio. rns sg tJr.r-"o"riiinun"iur measurernent' instrument The procesLlj:pl3."irg recognition ""J and rns'ss g by IFRS i.-i, iil-,.ideration. directions on financial IFRS7 his oetaiteo instrument oisct6sure. -iJ,. stut"ln"ni rsi |FAS'133or sFAS 133) accountingand reportingttunoutot estabrishes derivativei"rlri.r"ni. including certain derivative

certain-prwisr:ons-or srns ffi'3"J^"."lHT:$*T"il;';;::iffili:"' r;l1i:'"Jh:Tff5i:i

KEYCONCEPTS
RBI SEBI EWRM ICAAP ALM Derivative Accounting

Review euestions
1

2.
?

Whatdo you understand by internal and external riskreporting? Writea shoft noteon IAS32 andIAS39. what are the various accounting, tax and regal issues invoived in riskmanagement?

RiskReporting : 219 4. S. 6, 7. B. 9. Whatarethe financial assets and liabilities as defined in IAS32? Define hedging as per IAS39. Howmanyhedging relationships havebeendefined in IAS39?Discuss, Writea short noteon IFRS7 and IFRS9. Writea shortnoteon SFAS 133and SFAS 138, Whatarethe amendments carried out in SFAS 133to bringSFAS 138?

References:
1. 2. www.ifrs.org http://www.iasplus.com