In the midst of audit season, with financial statements being scrutinised by auditors and boards of directors before being finalised, it is timely to consider the issues affecting the quality of those financial statements. IAASA (the Irish Auditing and Accounting Supervisory Authority) have had some interesting comments to make on fund financial statements over the last few years. While their remit in terms of the funds industry mostly relates to closed ended funds (as a result of the EU Transparency Directive), many of the points made in their reports and observation documents are relevant for a wider range of fund types.

In advance of the 31 December 2013 year end, IAASA published “Observations on Selected Financial Reporting Issues:   Issuers financial years ending on or after 31 December 2013". In this document, they focus on recent and recurring financial reporting issues, and also some expectations for financial statements with 31 December 2013 year ends. A number of the issues raised relate specifically to funds.


Quality of Fair Value and Risk Disclosures by debt issuers/special purpose vehicles

The IAASA observations document refers to previous reviews of fund and debt issuers financial statements and notes while there have been improvements, they are largely limited to issuers who have been reviewed by IAASA. The quality of these disclosures remains low in general. The problems are typically:

  • Boilerplate disclosures
  • Minimum disclosures in the notes
  • Lacking issuer specific information
  • Similar disclosures repeated each year even if circumstances have changed

Suggestions made by IAASA for improvement are:

  • Early engagement in the planning process with investment managers and pricing vendors
  • Deeper consideration of the main drivers of risk

General Disclosures in financial statements

This one comes up again and again. How many times have we seen a couple of throwaway sentences, drafted by an auditor, director or manager carried through financial statements for multiple funds for several years, to the point where it becomes meaningless. IAASA comments that some disclosures are too boilerplate, not issuer specific and provided limited if any useful information to readers. In annual observations documents over the last few years the following disclosures in particular have been highlighted:

  • Off balance sheet items: qualitative disclosures
  • Risks and uncertainties
  • Financial instruments: Risk disclosures
  • Sensitivity analysis (other price risk, interest rate risk and foreign currency risk)
  • Going concern
  • Directors reports, Management reports and audit committee reports

Financial Reporting Changes

Helpfully, the observations document highlights the accounting standard changes expected to have the most impact on 2013 year ends. Attention is specifically drawn to IFRS 13 and the amendments to IFRS 7.

IFRS 13: Fair Value Measurement

IFRS 13 is effective for financial reporting periods beginning on or after 1 January 2013. It’s been a long road for funds financial reporting since IAS 39, but we are required to consider again how funds measure and disclose fair value. IFRS 13 provides a single definition of fair value, a framework for measuring fair value and requires specific disclosures. It’s important to remember that IFRS 13 applies not just to financial instruments, but also to other assets, liabilities and equity instruments.

 Fair value is defined as an exit price, i.e. the price an asset can be sold at or a liability transferred at. The fair value hierarchy, which we are familiar with from IFRS 7 for financial instruments, is extended to all assets and liabilities. (With Level 1 being quoted prices, Level 2 being observable inputs and level 3 being unobservable inputs).


Some of the potential pitfalls in implementing IFRS 13 may be:


IFRS 13: Valuation of Liabilities: Impact of Own Credit Risk

Careful consideration should be given to valuation of liabilities, in particular noting that the impact of the entity’s own credit risk on the valuation must be taken into account. The subtle difference here compared to previous guidance is that the fair value of a liability is the amount at which the liability could be transferred to another market participant. i.e. the liability would still be outstanding. (Rather than valuing the liability at the amount it could be settled with the counterparty at, in which case the liability would be extinguished).


  As the liability would therefore remain a liability of the valuing entity, the fair value of the liability is affected by non performance risk, including the credit risk of the valuing entity itself. Specifically in terms of derivative liabilities, credit or debit value adjustments for credit risk will need to be reflected in valuations. It is significant that changes in the credit risk of the entity must be assessed and reflected in arriving at the fair value of its liabilities.



IFRS 13: Valuation techniques and unobservable inputs

Valuation techniques used to calculate fair value should minimise unobservable inputs and maximise observable inputs. The techniques should be appropriate in the circumstances and there must be sufficient data available to measure fair value.


Where there are significant levels of unobservable inputs used in recurring fair value measurements, the effect of the measurements on profit or loss or other comprehensive income must be disclosed. A reconciliation of opening and closing balances is required, including profits and losses recognised, purchases and sales, and transfers in and out.


There are also significant disclosure requirements in terms of sensitivity analysis. In particular, for financial assets and liabilities, the impact of a change in one or more unobservable inputs to reflect reasonably possible alternative assumptions must be disclosed, together with details of how that impact has been calculated. (If such a change in unobservable inputs would change fair value significantly).


IFRS 13 Bid/Ask or Mid pricing

Where an asset has a bid ask price spread, its fair value will be the price within that spread that most closely estimates fair value. The use of bid prices for asset positions and ask prices for liabilities is permitted, but not required. The use of mid market pricing or other market conventions are not precluded.


Careful consideration must be given before making a decision regarding the use of a bid, ask, or mid price, or indeed a price within the bid/ask spread. In some cases implementation of IFRS 13 will reduce the need for adjustments between the “dealing NAV” and the financial statements, where the valuation basis for the “dealing NAV” is deemed appropriate for use in the financial statements.


IFRS 13: Portfolio level valuation methodologies

IFRS 13 requires consideration to be given to the fair value of each class of asset or liability and specifically notes that a line item in the financial statements does not necessarily constitute a class. Further separation into classes may be required based on the characteristics of the assets and liabilities. So a high level decision to value the entire portfolio may not be appropriate in a lot of circumstances.

However, the exception allowing valuation of net positions with offsetting risks will be of interest for funds financial statements. The assets and liabilities in question must be managed on a net basis in terms of their exposure to market risk or to counterparty credit risk. Information on that net basis must also be reported to key management personnel in accordance with a documented risk management strategy. The group of assets and liabilities can be valued at the price of the net position, i.e. the price at which at net short position could be purchased or a net long position could be sold. The key point here is to ensure that the conditions regarding documentation and reporting have been met.


IFRS 13: Documentation and Disclosures

Disclosure requirements are fairly extensive. Bear in mind the IAASA points above regarding the poor quality of fair value and risk disclosures in some financial statements. Remember to disclose what has been valued, how it has been valued and why it has been valued in that way. Explain clearly all matters where judgement has been exercised and explain the source of all inputs. Help the user to understand the valuation.


Amendments to IFRS 7: Offsetting Financial Assets and Financial Liabilities

The amendments to IFRS 7 are effective for accounting periods on or after 1 January 2013 and require entities to evaluate the effect or potential effect of netting arrangements for financial assets and liabilities on its financial position. The disclosures are relevant for master netting agreements, derivative clearing agreements, global master repurchase agreements, global master securities lending agreements, and any related rights to collateral. Financial instruments included are derivatives, repurchase agreements, reverse repurchase agreements, securities borrowing and securities lending agreements.

 The nature of the offsetting agreements must be disclosed as well as the gross amounts, amounts set off and net amounts. Reconciliation to line items in the financial statements is also required. A separate table for financial assets and liabilities is required. Additional qualitative disclosures should be provided where necessary in order to explain the offsetting arrangements.

Care should be taken with the detail of these disclosures, especially for more complex funds. Assessment should be made of all arrangements which could fall under the IFRS 7 definitions and hence require both narrative and numerical disclosures.


In summary, conclusions can be drawn from previous years and pitfalls can be identified from assessing new accounting standards being implemented. Appropriate quality control and review of funds financial statements is more essential now than ever in order to produce compliant and meaningful financial statements.



About the author

Mary Keily is a Chartered Accountant with over twenty years experience in fund accounting, financial reporting and funds audits. She has both a deep knowledge of and practical experience of the issues involved in preparing fund financial statements.


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Date Added: 20 Mar 2014

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