IFRS 7 – Financial Instruments: Disclosures
Why is there a need for extensive disclosures regarding financial instruments?
Many entities operating across various industries are exposed to a wide range of risks due to holding financial instruments. This is true both for financial institutions and for entities in other sectors. Existing financial instruments include relatively simple ones such as trade receivables, loans or bonds, alongside more complex instruments, such as derivatives or structured instruments. The different risks involved in holding and issuing various financial instruments created a need to improve transparency by including information in the financial statements that enables users to understand the extent and nature of the risks to which companies are exposed arising from financial instruments. The importance of this information was underscored by the sub-prime crisis that began in the second half of 2007, which in some cases revealed exposures from complex financial instruments whose effects on the financial position and results of operations of various companies were highly significant.
How does the complexity of accounting for financial instruments affect disclosure requirements?
Beyond the economic risks inherent in financial instruments, another aspect closely tied to disclosures about financial instruments is the very complexity of the accounting for them. This complexity includes, among other things: different measurement bases, offsetting financial assets and financial liabilities, impairment for expected credit losses, hedge accounting and the derecognition of financial assets and financial liabilities, which in some situations may create off-balance-sheet exposures. Consequently, a further aim of the disclosure requirements under IFRS Accounting Standards (in addition to clarifying the risks involved) is to improve transparency regarding the accounting applied to such instruments.
What is the purpose and scope of IFRS 7?
IFRS 7 sets out the disclosure requirements in the financial statements for financial instruments. The Standard forms the third, complementary link to the principles for recognition, measurement and presentation contained in IFRS 9 Financial Instruments and IAS 32 Financial Instruments: Presentation. In a nutshell, the guiding principle of the Standard is to require disclosure in the notes of information that will enable users of financial statements to assess the significance of financial instruments for the reporting entity’s financial position and performance. In addition, the information is required to enable users to assess the nature and extent of risks arising from the various financial instruments to which the reporting entity was exposed during the reporting period, as well as how the entity manages those risks.
What practical considerations affect the scope, level of detail, and application of IFRS 7 disclosures?
The Standard’s disclosure requirements are extensive and they include qualitative as well as quantitative disclosures. To apply the disclosure requirements, financial instruments must be grouped appropriately and information shall be provided by category. Indeed, the Standard does not distinguish between the nature of the activities of different reporting entities applying it. Notably, the Standard originally replaced IAS 30, which addressed only financial institutions. In contrast, the scope of IFRS 7 is not limited to financial institutions. Thus, the Standard applies to both, financial statements of financial institutions such as banks or insurance companies, typically holding large and complex positions in financial instruments, as well as to financial statements of non-financial reporting entities such as industrial or commercial companies, which are generally exposed to less complex financial instruments such as trade payables or receivables. Indeed, the breadth of disclosure required will likely be greater for financial institutions than for entities with relatively low exposure to financial instruments. However, one implementation challenge stems from the lack of clear guidance in the Standard as to the extent of disclosures and the required level of detail for different financial instruments or entities in different industries. In practice, the Standard includes, on the one hand, lists of wide-ranging disclosure requirements and, on the other hand, requires the reporting entity to exercise judgment in determining the necessary level of detail and whether additional explanations are needed beyond those prescribed. Accordingly, it is likely that the structure of the notes concerning financial instruments will need to be tailored to the extent and nature of the existing exposures to financial instruments. Thus, a reporting entity shall determine the types of segmentations, groupings, accompanying qualitative explanations and the need for additional qualitative and quantitative disclosures required under the circumstances to achieve the purpose of the Standard.
How does materiality affect disclosure requirements under IFRS 7?
Due to concerns that the financial statements could become overly voluminous, the Standard emphasises materiality, including reference to IFRS 18 Presentation of Financial Statements. IFRS 18 states that specific disclosure requirements in a Standard or Interpretation need not be applied if the information required is not material. This general principle also applies to the disclosure items required by IFRS 7.
To which financial statements does IFRS 7 apply?
The Standard applies to annual financial statements or to interim financial statements presented in full format. In addition, IAS 34 Interim Financial Reporting also prescribes certain disclosure items relevant to financial instruments that shall be included in interim financial statements.