IFRS 7 risk disclosures for Investment Funds: key areas of audit focus

Investment funds are, by their nature, heavily exposed to financial instruments. Financial instruments, by definition, refer to contractual arrangements between two parties that give rise to a financial asset on one end and a financial liability on another. While IFRS 9 determines how these instruments are classified and measured, IFRS 7 requires disclosures that enable investors to understand the significance of those instruments and the risks arising from them. For auditors, these disclosures are often an area of heightened scrutiny because they rely on information that originates from portfolio management, risk management, administrators, custodians and valuation processes.

Although the disclosure requirements may appear extensive, their underlying objective is to provide the users of the financial statements with relevant and meaningful information regarding the nature and extent of risks arising from financial instruments. These risks typically include:

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Credit risk

Credit risk is defined as the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation. For investment funds, credit risk commonly arises from exposures to custodians, prime brokers, banks and issuers of debt securities. However, the significance of credit risk will vary depending on the nature and investment strategy of the fund. For example, a fund investing in bonds or money market fund may have substantial exposure to credit risk, whereas an equity fund may primarily face credit risk through cash deposits and counterparties involved in settlement and custody arrangements.

In terms of managing this risk, the investment fund must consider acting in the best interest of its investors. This should also be done in line with terms stipulated within the Offering Documentation. Some examples of effective credit risk management include:

• Cash and cash equivalents:
  
  • Spreading cash balances across a number of approved banks
  • Setting a maximum percentage of net assets that may be held with any one institution
  • Reviewing bank credit ratings on a regular basis

• Debt securities
  
  • Investing only in securities that meet minimum credit ratings
  • Monitoring credit rating downgrades
  • Requiring specific approval before acquiring unrated instruments

Where the fund has significant exposure to a custodian or prime broker, practical risk management procedures may include periodic due diligence on the service provider, review of regulatory capital or credit information where available, confirmation that assets are appropriately segregated from the service provider’s own assets, and monitoring whether any material amounts are held as unsecured cash balances.

From an audit perspective, when auditing these disclosures, auditors typically focus on:

• Completeness of credit risk exposure
• Concentrations of credit risk
• Accuracy of quantitative information
• Consistency with third-party confirmations
• Credit quality
• Consistency with prospectus and offering documentation

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Liquidity risk

Liquidity risk refers to the risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities. The key consideration in an investment fund is whether the fund can meet redemption requests and other liabilities as they fall due, without adversely affecting the value of the remaining portfolio.

When it comes to managing such a risk, the investment fund can adopt the following measures:

• Monitoring the liquidity profile of the portfolio, including assessing how quickly investments can be sold without significantly impacting market prices
• Matching redemption terms to the liquidity of underlying assets, ensuring that redemption frequencies are appropriate for the types of investments held
• Maintaining a portion of the portfolio in cash or highly liquid instruments to meet anticipated redemption requests
• Using borrowing facilities or overdraft arrangements to address short-term liquidity needs where permitted by the fund's constitutional documents
• Applying redemption notice periods, requiring investors to provide advance notice before redeeming shares

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When auditing the liquidity risk disclosures of an investment fund, auditors typically focus on:

• Completeness and accuracy of contractual maturity analysis for financial liabilities
• Post year-end redemption activity, especially where substantial redemptions may provide evidence of heightened liquidity risk at the reporting date.
• Consistency between the financial statements and offering documentation
• Alignment between the liquidity of underlying investments and investor redemption terms, particularly where the fund invests in less liquid assets.

Liquidity risk becomes more significant from an audit point of view, where investors can redeem their shares faster than the fund can sell its investments. For example, a fund may offer monthly redemptions but invest in assets such as private equity, private debt or real estate that could take months to realise. Auditors will therefore assess whether the financial statements adequately explain how the fund manages this mismatch and its ability to meet redemption requests when they fall due.

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Market risk

Market risk refers to the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. For most investment funds, market risk is the most significant financial risk because the value of the fund's investments is directly affected by movements in financial markets and can cause the value of the fund's investments, and ultimately its Net Asset Value (NAV), to increase or decrease.

The three main components of market risk are:

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Price risk

Price risk is the risk that the value of an investment will fluctuate due to changes in market prices. For many investment funds, particularly equity funds, this is the most significant market risk.

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Interest rate risk

Interest rate risk is the risk that changes in interest rates will affect the value of financial instruments. Such a risk arises as there is generally an inverse relationship between bond prices and interest rates. Should interest rates increase, bond values typically decrease and vice-versa. This is because existing bonds become more or less attractive compared to newly issued bonds.

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Foreign exchange risk

Foreign exchange risk arises when investments or cash balances are denominated in a currency different from the fund's functional currency.

Users generally expect to understand not only the existence of these risks, but also the potential impact that changes in market variables may have on the fund’s performance and net asset value. Accordingly, sensitivity analyses often form an important component of the market risk disclosures.

Typical audit procedures covering market risk would typically include:

• Ensuring whether all positions subject to these 3 risks have been identified
• Assessing the reasonableness of the assumptions used in the sensitivity analysis
• Consistency between disclosures and the underlying investment holdings
• Verifying the accuracy of the associated calculations

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Concentrations of risk

IFRS 7 does not treat concentrations of risk as a separate risk category. Rather, it requires entities to disclose concentrations where they are relevant to understanding the nature and extent of risks arising from financial instruments.

A concentration of risk arises when a number of financial instruments share similar characteristics and are affected similarly by changes in economic or other conditions.

For an investment fund, concentrations may arise from:

• A particular issuer
• A single counterparty
• A geographic region
• An industry sector

From an audit perspective, concentration risk disclosures should enable users to identify areas in which the fund may be particularly exposed to adverse developments affecting a specific market, industry, issuer or counterparty.

The adequacy of these disclosures is therefore considered in the context of the fund’s investment strategy, portfolio composition and risk management practices.

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Conclusion

Effective risk disclosures are not achieved solely through compliance with a checklist. In the context of investment funds, such disclosures should provide a coherent and entity-specific explanation of the risks arising from the portfolio, how those risks are managed, and how they may affect investors.

From an auditor’s perspective, the most effective disclosures are those that are tailored to the fund’s specific circumstances, clearly describe significant risk exposures and provide users with meaningful insight into the risks associated with the fund’s investment strategy. These disclosures not only support compliance with IFRS 7, but also enhance the transparency, relevance and overall usefulness of the financial statements.