The majority of accountants are already aware of the ‘fair-value’ treatment of derivatives required by modern accounting standards, particularly with the introduction of FRS 102 (mandatory for periods commencing on or after 1 January 2016).
This ‘fair-value’ treatment has been well understood by the banks for many years, however, the end users of derivative products (either corporate or non-sophisticated financial institutions) typically do not have the skills, knowledge or expertise to value or model the risks of their holdings of derivative instruments.
Many of these organisations will rely on their accountants to provide them with a basic level of information on these particular risks. However, in the majority of cases, businesses will need to acquire a deeper level of understanding in order to successfully manage the level of risk associated with the use of derivative products. Nasar Zamir, director at Congruent, reports.
Accountants and advisers representing such businesses would be well advised to partner with an independent risk advisory firm to provide valuable insight on this particular issue. For instance, an expert in financial risk would be able to assist in the eligibility and qualification criteria for an entity to apply hedge accounting. This reduces the volatility of earnings given that the new accounting standards require the ‘fair-value’ treatment of these financial instruments.
Hidden danger of secondary risk
In some cases, even though the principal or primary risks (for example market risks) may be understood by end users/clients, these instruments usually tend to exhibit additional or secondary risks. The real danger is that these risks are not often understood and this may have a significant financial impact on the business. Even for relatively ‘vanilla’ interest rate derivative products (for example an interest rate swap) the secondary or additional risks may suddenly manifest themselves due to credit deterioration of the counterparty as was experienced during the financial crisis. This can have serious consequences for a business if an independent expert is not on board to help mitigate such risks before they occur.
Understanding contingent risk
Contingent risks arise in derivative contracts as a result of some internal or external event affecting the hedged or hedging item, for example refinancing of a loan or default of the hedging counterparty. Many accountants and financial advisers are already aware that contingent risk is not well understood by smaller businesses. This was evidenced by the recent redress programme introduced by the FCA which instructed the major UK banks to compensate qualifying customers for mis-sold derivative contracts. This programme revealed that the main customer complaint was that the contingent risk or “break cost” inherent in these contracts was not adequately explained by the bank in question.
Therefore, accountants must ensure their clients acquire a better understanding of contingent risk and the likely impact on their businesses. Greater understanding will be achieved only with the help of a financial risk adviser who can explain the issues surrounding contingent risk (and their consequences) in a suitable level of detail.
As the majority of accountants are already aware, the FRS 102 accounting standards require businesses to provide a certain degree of disclosure in their financial statements including the new strategic report that details principal risks and uncertainties. This assists users in evaluating the connection between financial instruments and the final performance of the business. It also enables them to assess the nature of risks arising from the use of financial instruments and how the business seeks to mitigate them.
With regards to the nature and extent of risks arising from financial instruments, the disclosure requirements include qualitative and quantitative disclosures about exposures to each class of risk separately for credit risk, liquidity risk, and market risk including sensitivity analyses. With respect to sensitivity analyses the latest FRS 102 standard requires that for each market risk to which the business is exposed it should disclose what would be the effect on profit or loss and on equity for a change in the relevant risk variable.
Yet again, the analysis of these risks (particularly secondary risks and contingent risks) requires specialist technical assistance from financial modelling experts who can assist not only with the quantitative aspects but also with the qualitative description required for these disclosures.