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Principles of liquidity risk disclosures and reporting

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Liquidity risk occurs when an organisation encounters difficulty meeting obligations associated with financial liabilities settled by delivering cash or another financial asset. It simply means the risk that an organisation fails to meet its financial obligations.

There are numerous reasons why this situation could occur.

However, the most common scenario is from insufficient cash to settle obligations.

These obligations stem from contracts entered by an organisation that results in financial liabilities. Common examples of financial liabilities include debt instruments such as bank borrowings, trade payables, and lease liabilities to mention a few.

The management of liquidity risk is critical for every organisation because of its existential consequence on an entity’s going concern assumption.

Stakeholders such as investors, suppliers, and employees, to name a few are eager to understand the management of this risk because it impacts the ability of the organisation to fulfill its obligations to them.

These include short-term obligations like working capital commitments and longer-term obligations like bank borrowings.

The IFRS 7, Financial Instruments: Disclosures, is the global financial reporting standard that provides the disclosure requirements for liquidity risk.

There are two main aspects of liquidity risk disclosures an organisation should aim to cover for financial reporting.

The first is a maturity analysis for financial liabilities that shows the remaining contractual maturities and the second is a description of how it manages the liquidity risk inherent in its maturity analysis for financial liabilities.

The maturity analysis is a quantitative disclosure that provides a snapshot of when the financial liabilities held by an organisation are to mature.

In practice, organisations should apply judgement when preparing this analysis. It includes determining the appropriate number of time bands for classifying the maturity periods.

For example, organisations could choose to have bands that reflect financial liabilities maturing in less than one month, between one and three months, between three and 12 months, between one and five years and those after five years based on what is appropriate considering their circumstance.

In addition, organisations should allocate financial liabilities in the maturity analysis based on the earliest period the organisation can be required to pay or settle the obligation.

The cash flows used in the liquidity maturity analysis should be undiscounted. Undiscounted cash flows are cash flows not adjusted to incorporate the time value of money.

An organisation should describe how it manages the liquidity risk inherent in the items disclosed in the maturity analysis. For example, where asset and liability matching information is helpful to stakeholders, organisations should consider including an additional maturity analysis of financial assets held for managing liquidity risk.

For example, banks usually employ asset and liability matching strategies to manage liquidity risks. Similarly, in other industries, it is applied to confirm that short or long-term financing is matched with projects and sources of repayment with a comparable maturity.

Other factors organisations could consider when providing these disclosures include the availability of credit lines, deposits, and other liquid assets to meet liquidity needs.

In addition, the availability of diverse funding sources, significant concentrations of liquidity risk in either its assets or funding sources, internal control processes and contingency plans for managing liquidity risk, the existence of financial liabilities with unique terms such as an accelerated repayment following a downgrade of the organisation’s credit ratings among others.

Furthermore, organisations should explain the relationship between these qualitative and quantitative liquidity risk disclosures to enable stakeholders to evaluate the nature and extent of liquidity risk.

Comprehensive liquidity risk disclosures and reporting can help organisations communicate the resilience level of their balance sheet to withstand market shocks and disruptions.

Awodumila is an Associate Director at PwC Kenya. An author who writes and speaks widely on corporate reporting topics