Advanced Financial

Accounting: Chapter 1
Risk Reporting
1 Tan & Lee Chapter 1 2009
Learning Objectives
1. Appreciate the broader economic context in which
accounting information interacts with risks,
valuation, and operating and financial strategies;
2. Understand the interactions between uncertainty,
risks, strategy, valuation and information;
3. Compare the different modes of reporting
financial statement reporting, discretionary
management disclosures and summary metrics;
and
4. Review an example of a financial risk metric
2 Tan & Lee Chapter 1 2009
Content
1. Introduction
2. Uncertainty, Risk and Exposure
3. Risk Analysis and Measurement
4. Risk Reporting
5. Summary Metrics
6. Conclusion
7. Appendix 1A Relationship between Risk and
Value
8. Appendix 1B IAS 14: Segment Reporting
3 Tan & Lee Chapter 1 2009
1. Introduction
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
Content
1. Introduction
2. Uncertainty, Risk and Exposure
3. Risk Analysis and Measurement
4. Risk Reporting
5. Summary Metrics
6. Conclusions
7. Appendix 1A Relationship between Risk and
Value
8. Appendix 1B IAS 14: Segment Reporting
5 Tan & Lee Chapter 1 2009
2. Uncertainty, Risk and Exposure
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
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
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
Content
1. Introduction
2. Uncertainty, Risk and Exposure
3. Risk Analysis and Measurement
4. Risk Reporting
5. Summary Metrics
6. Conclusion
7. Appendix 1A Relationship between Risk and
Value
8. Appendix 1B IAS 14: Segment Reporting
9 Tan & Lee Chapter 1 2009
3. Risk Analysis and Measurement
Risk Analysis and Measurement
Investors require information to analyze the risks affecting a firms
business 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 interest
coverage ratio)
Non-accounting measures (summary metrics such as Value at Risk)
10 Tan & Lee Chapter 1 2009
Content
1. Introduction
2. Uncertainty, Risk and Exposure
3. Risk Analysis and Measurement
4. Risk Reporting
5. Summary Metrics
6. Conclusion
7. Appendix 1A Relationship between Risk and
Value
8. Appendix 1B IAS 14: Segment Reporting
11 Tan & Lee Chapter 1 2009
4. Risk Reporting
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
Risk Reporting
Markets
Firms business
strategies
Uncertainty:
Source /
determination
of risk
Risk:
1. Downside
2. 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
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
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
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 entitys 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
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
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:
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; and
3. Discrete financial information of the operating segment must be
available

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)
1. Revenue test: revenue of the operating segment including
intersegment 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 that
reported a loss
3. Asset test: assets of the operating segment are 10% or more of the
combined assets of all operating segments

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:
1. The nature of the products and services;
2. The nature of the production processes;
3. Customer type or class;
4. Methods of distribution; and
5. Regulation governing that segment, for example, banking

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

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

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
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
IAS 24: Related Party Disclosures
Overriding principle: an entitys 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
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 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
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
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 entitys parent and the
ultimate controlling party
Compensation of key management
personnel
Arms length terms Tan & Lee Chapter 1 28
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
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
Content
1. Introduction
2. Uncertainty, Risk and Exposure
3. Risk Analysis and Measurement
4. Risk Reporting
5. Summary Metrics
6. Conclusion
7. Appendix 1A Relationship between Risk and
Value
8. Appendix 1B IAS 14: Segment Reporting
31 Tan & Lee Chapter 1 2009
5. Summary Metrics
Value at Risk
Probabilistic measure of the potential loss that could be incurred by
a 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 specified
time interval and a given confidence level
32 Tan & Lee Chapter 1 2009
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
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:
1) Historical simulation
2) Normal distribution
3) Monte Carlo simulation
Effects of risk factors on
individual values through
1) Asset valuation
model
2) Combination of
models
3) Use of judgment
Weights assigned
for individual assets
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
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
1. interest rates,
2. foreign exchange rates,
3. commodity prices, and
4. 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
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. 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
Content
1. Introduction
2. Uncertainty, Risk and Exposure
3. Risk Analysis and Measurement
4. Risk Reporting
5. Summary Metrics
6. Conclusion
7. Appendix 1A Relationship between Risk and
Value
8. Appendix 1B IAS 14: Segment Reporting
38 Tan & Lee Chapter 1 2009
6. Conclusion
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
Content
1. Introduction
2. Uncertainty, Risk and Exposure
3. Risk Analysis and Measurement
4. Risk Reporting
5. Summary Metrics
6. Conclusion
7. Appendix 1A Relationship between Risk and
Value
8. Appendix 1B IAS 14: Segment Reporting
40 Tan & Lee Chapter 1 2009
7. Appendix 1A Relationship between Risk and
Value
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
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
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 securitys return to movements of f
1
.


Content
1. Introduction
2. Uncertainty, Risk and Exposure
3. Risk Analysis and Measurement
4. Risk Reporting
5. Summary Metrics
6. Conclusion
7. Appendix 1A Relationship between Risk and
Value
8. Appendix 1B IAS 14: Segment Reporting
44 Tan & Lee Chapter 1 2009
8. Appendix 1B IAS 14: Segment Reporting
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
How does One Identify a Reportable
Segment?
Tan & Lee Chapter 1 2009 46
Risk and
return
characteristics
Organizational
Structure
Materiality
Thresholds
Non-
materiality
Thresholds
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
1. 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; and
5. If applicable, the nature of the
regulatory environment


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
1. Similarity of economic and
political conditions;
2. Relationships between
operations in different
geographical areas;
3. Proximities of operations;
4. Special risks associated with
operations in a particular area;
5. Exchange control regulations;
and
6. Underlying currency risks


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 enterprises organizational
structure and internal financial reporting
system is used as a starting point to
determine business segments and
geographical segments


How does One Identify a Reportable
Segment?
Risk and
return
characteristics
Organizational
Structure
Materiality
Thresholds
Non-
materiality
Thresholds
3 materiality thresholds:
1. 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
2. 10% test applies to three bases
i. Segment revenue is 10% or more of
total revenue, or
ii. Segment result, whether profit or
loss, is 10% or more of the combined
results of all segments
iii. Segment assets are 10% or more of
the total assets of all segments.
3. 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
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.