A. Background

The successive financial crises in different regions of the world over the past two decades have led to much reflection and analysis in various international bodies on ways to strengthen the international financial system. A special G-22 Working Group on Transparency and Accountability was formed in 1998 to focus particular attention on this topic, and it issued a comprehensive report.

A consensus has emerged that inadequate transparency by international organizations, national governmental units, and private sector entities was a contributing force to the serious financial disturbances that have plagued the global economy. The conclusion was reached that markets cannot function efficiently, and that they will continue to be highly vulnerable to instability, in the absence of adequate, reliable, and timely information from all quarters. Lack of accurate and timely information on economic and financial developments and policies, particularly in an environment of economic and financial weakness, aggravates the weakness and contributes to the emergence of crises situations.

From this discussion, the IMF produced the Code of Good Practices on Transparency in Monetary and Financial Policies. In addition, the Fund continues to develop its Special Data Dissemination Standards (SDDS) as another avenue for enhancing international transparency.

Specialist standard-setting bodies dealing with other financial sector-related areas (such as accounting, auditing, banking regulation and supervision, bankruptcy, corporate governance, insurance regulation, payment system and securities market regulation) are also active in developing standards relevant for a better functioning financial system. The focus of these standards typically is broader than transparency. However, transparency and disclosure practices are covered in these standards as well, and thus have relevance to the Fund’s Code of Good Practices on Transparency in Monetary and Financial Policies.

B. The Code —Its Underlying Rationale and Main Elements

What is meant by transparency? For purposes of the Code, transparency for central banks refers to an environment in which the objectives of monetary policy, its legal, institutional, and policy framework, monetary policy decisions and their rationale, data and information related to monetary policies, and the terms of central bank accountability are provided to the public on an understandable, accessible and timely basis. Thus, the code covers a much wider area than transparent accounting. However, transparency in accounting is the basis on which other elements rest.

The Code covers both monetary policies and financial policies (i.e., the policies related to the regulation, supervision, and oversight of banking, insurance, securities, payment systems, and deposit insurance). These two sets of policies are interrelated and often mutually reinforcing. The full benefits to be derived from good transparency practices in the monetary policy area cannot be achieved without complementary good transparency practices in the financial policy area, and vice versa. This section focuses on the part related to central banks.

The first part of the Code, “Good Transparency Practices for Monetary Policy by Central Banks,” is organized into four sections, each representing an aspect of transparency practices: (1) clarity of roles, responsibilities, and objectives of central banks; (2) the processes for formulating and reporting monetary policy decisions; (3) public availability of information on monetary policies; and (4) accountability and assurances of integrity by the central bank.

The design of transparency practices for central banks in the Code rests on two principles. First, monetary policies can be made more effective if the public knows and understands the goals and instruments of policy and if the authorities make a credible commitment to meeting them. Second, good governance calls for central banks to be accountable, particularly where monetary authorities are granted a high degree of autonomy. By publishing adequate information about its activities, the central bank can establish a mechanism for strengthening its credibility by matching its actions to its public statements. It is here that the transparency code and the accounting function intersect. Central bank accounting and reporting systems must be set up in such a way that the central bank provides the public with meaningful and transparent information.

Chairman Alan Greenspan of the U.S. Federal Reserve Board, at the Tercentenary Symposium of the Bank of England in 1994, reflected on the case for transparency for central banks in the following insightful manner:

.... if we are going to have independent central banks then implicit in that independence is accountability. You cannot in a democratic society have an institution which is fully or partly dissociated from the electoral process and which has powers that central banks inherently have. The question really amounts to how does one position the central bank with respect to the issue of disclosure and accountability—which are related questions.

The position that we [the Federal Reserve] take is that the burden of proof is against the central bank: that is, we have to demonstrate that either delayed disclosure or nondisclosure is a policy which is required for us to implement our statutory goals. We have struggled with this, and have concluded that we should make available to the electorate what it is we think, why we are doing what we are doing and in a general way under what conditions we would behave differently” (pp. 252-53, Forest Capie, Charles Goodhart, Stanley Fischer, and Norbert Schnadt, The Future of Central Banking, Cambridge University Press, 1994).

Transparency for central banks is not an end in itself, nor should transparency be considered as a substitute for pursuing sound policies. Transparency and sound policies should be seen as complements.

C. Transparency in Financial Statements of Central Banks

The annual report, including the annual financial statements, is a key for central banks to meet their accountability obligations. These statements reveal the results of the central bank’s functional activities on its balance sheet as well its use of the resources at its disposal. One does not need to look far to see examples of where the central bank’s financial reports have been used by opposition politicians to launch criticisms of both the government and central bank. As the ability to question performance is an essential component of accountability, those preparing annual financial statements carry the responsibility of presenting them so that they provide an accurate picture of the financial results of central bank operations in a manner that can be defended in terms of an internationally credible framework. Such presentation will direct criticism to appropriate areas, so reducing the possibility of the independence of the central bank being constrained and its operational effectiveness reduced.

Experience repeatedly shows that the best defense to criticism is through open and transparent disclosure, since this removes the risk of the hugely damaging consequences that occur when it is revealed that disclosures have been less than total. It is difficult to overstate the importance of the role of transparency in ensuring the maintenance of central bank independence and discharging its accountability obligations.

The importance of transparent reporting practices for central banks extends beyond narrow institutional interests because they make an important contribution to establishing the credibility of a nation’s financial system. As economies evolve and seek to establish their positions in the international market place, the national reporting framework becomes important to an expanded group of users. Central bank financial statements may be published or posted on the Internet where they can be read internationally. Opinions formed on the robustness of financial reporting frameworks from reading such documents contribute to judgments about the integrity and stability of the national financial system.

In the absence of a well-developed set of generally accepted accounting practices (GAAP) within a country, the published reports of authoritative institutions are used to determine what is best practice. By default, central bank disclosures make a material contribution to what is accepted as the nation’s GAAP, as commercial banks and other financial sector participants adopt them. Transparent central bank financial statements make it easier for bank supervisors to demand a similar level of disclosure from the commercial banks that they supervise. Transparent disclosures by commercial banks are an integral part of the process of establishing and maintaining a robust framework for the commercial banking system. In situations of emerging systems of GAAP, central banks have a valuable role to play in advancing the level of clarity and openness of disclosure.

For most transition economies, the accounting profession and the standard-setting framework in terms of market-based disclosures are still evolving. This can create potential problems for the production of internationally credible financial reports. Those who are not market participants and who have a conflict of interest, such as maximizing taxable revenue, may control standard setting. The section recognizes these tensions and seeks to enhance understanding of the conceptual framework upon which central banks base their reporting.

The basis of the section’s framework is the IFRS because these provide an agreed minimum conceptual framework for reporting. IFRS evolved from demands by the international marketplace and are gaining increasing acceptance as the foundation from which all national standards should evolve. Despite some issues for central banks, particularly in the treatment of price and foreign exchange revaluations of financial instruments, their international credibility provides a robust framework upon which to base and defend financial disclosures.

A. Introduction

This section provides an overview of issues associated in applying International Accounting Standard 1—Presentation of Financial Statements (IAS 1) and International Accounting Standard 30—Disclosures in the Financial Statements of Banks and Similar Financial Institutions (IAS 30) to central bank financial reporting. The issues discussed include:

• an overview of the external reporting model, types of information to be disclosed and the reasons it is required in market economies;

• the role and main components of financial statements including the fundamental concepts for preparing financial statements;

• users of central bank financial statements and their needs; and

• issues in applying aspects of IAS 1 and IAS 30 to each of the main components of the financial statements. This excludes the Statement of Cash Flows, which is subsequently discussed.⁷

This section should be considered in conjunction with the detailed requirements of IAS 1 and IAS 30. These detailed requirements are presented in Appendix I, which has been designed to assist with the preparation of central bank financial statements in accordance with IAS 1 and IAS 30.⁸

B. Overview of the External Reporting Model

Public and private sector entities are in business for a variety of reasons such as profit maximization or the achievement of outcomes that can benefit society. The business process will involve each entity entering various business arrangements and transacting with one another in the exchange and consumption of economic resources. These business transactions can range from relatively simple to extremely complex and can be completed in different countries with different laws governing the business arrangements and transactions.

Parties entering business arrangements will be concerned about the overall financial health of the entities with which they undertake business, including the ability of the entity to pay any amounts owing to them, whether the entity will continue to exist in the future, how successful the entity has been in generating profits, and the risks the entity has exposed itself to in various business undertakings. More specifically, external parties will seek information about an entity’s business transactions and performance in order to:

• make decisions about providing resources to, or doing business with, the entity;

• assess management’s stewardship of the resources entrusted to it;

• assess the entity’s current and potential ability to generate profits and cash flows; and

• assess the entity’s compliance with laws and business contracts to the extent that these affect the outcomes the entity is seeking to achieve.

External parties will generally obtain the above information from the entity’s annual report, which includes general-purpose financial statements. General-purpose financial statements are intended to provide information to users who are not in a position to demand tailored financial reports to meet their specific information needs. This reflects that some users are unable to extract relevant and timely information from their business partners in order to make decisions. Hence, they must rely on the information contained in the financial statements as their major source of financial information to assist them in their decision making. Users that have specific custodial or transaction monitoring requirements are usually able to contract for their specific information purposes as part of the business contract. An example of a specific financial information need is a commercial bank that can require a party to a loan agreement to provide specific information before the loan is provided.

The need for general-purpose financial statements is well recognized internationally. For example, most countries require public companies to publish regular financial statements as a condition of company registration. This is to ensure that information is provided:

• that is useful to present and potential investors, creditors, and other users in making rational investment, credit, and similar decisions;

• to help current and potential investors, creditors, and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest; the proceeds from the sale, redemption, or maturity of securities or loans; the entity’s capital transactions and other factors that affect liquidity;

• about the economic resources of an entity, the claims to those resources, and the effects of transactions, events, and circumstances that change resources and claims to those resources;

• about an entity’s financial performance given by measures of earnings and its components in order to help in assessing the prospects of an entity;

• about how management has discharged its responsibility to shareholders for the stewardship of the entity’s resources; and

• that is useful to management in making decisions in the interest of shareholders.

In addition, it is important to consider the connection between developments in financial markets and the consequences for financial reporting. It is generally accepted that, in an efficient market, security and share prices impound all publicly available information. Lack of timely and accurate information can distort prices and heighten uncertainty. This in turn can lead to increases in financial contracting costs as capital providers and capital users try to protect themselves against information uncertainties. It can also lead to costly litigation after the fact, if it may be alleged that vital information was missing or presented an inaccurate picture of the state of the entity’s affairs. In summary, information uncertainties can increase the cost of capital to an entity.

To reduce the likelihood of information uncertainties arising, common frameworks for financial reporting have been developed to facilitate the provision of consistent and reliable financial information. IFRS are accepted as the global standard for financial reporting that provides financial information to meet the diverse needs of general users who cannot require the business entity to provide specific information. IFRS are standards and interpretations adopted by the International Accounting Standards Board and comprise:

• International Financial Reporting Standards;

• International Accounting Standards; and

• Interpretations originated by the International Financial Reporting Interpretation Committee or the former Standing Interpretation Committee.

Users of financial statements generally expect compliance with IFRS, and this is likely to assist entities to avoid the information uncertainties that can otherwise increase the cost of capital.

C. The Role and Components of Financial Statements

IAS 1 describes financial statements as a structured financial representation of the financial position and financial performance of an entity. The objective is to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions. Financial statements also show the results of management’s stewardship of the resources entrusted to it. To meet this objective, financial statements provide information about an entity’s:

• assets;

• liabilities;

• equity;

• income and expenses, including gains and losses;

• other changes in equity; and

• cash flows.

This information, along with other information in the notes to financial statements, assists users to predict the entity’s future cash flows and in particular the timing and certainty of the generation of cash and cash equivalents.

IAS 1 explains that a complete set of financial statements includes:

• accounting policies;

• a balance sheet;

• an income statement;

• a statement showing either all changes in equity or changes in equity other than those arising from transactions with equity holders acting in the capacity of equity holders;

• a cash flow statement; and

• explanatory notes.

These financial statement components interrelate because they reflect different aspects of the same transactions or other events. Although each component provides information that is different from the others, none is likely to serve only a single purpose or provide all the information needs for all users. Hence, the information contained in the notes to the accounts is of equal importance as the major statements such as the balance sheet and income statement.

In addition, IAS 1 outlines fundamental concepts for account preparation including:

• Going concern. The assumption that the business will continue to operate into the future (i.e., the business will not be liquidated or cease trading).

• Accrual basis. Transactions are recognized as they occur and reported in the periods to which they relate. This recognizes that some cash outlays will benefit several future periods—for example, the purchase of an asset will provide benefits to future reporting periods and the costs of the asset are allocated to each period through capitalization and depreciation of the asset.

• Consistency. Presentation and classification of items in financial statements should be consistent between periods. Where the presentations or classifications are changed, the comparative information should be changed to reflect the new basis.

• Materiality. Each material item should be presented in the financial statements and immaterial items should be aggregated. It is important to recognize that materiality encompasses both materialities by amount and materiality by nature. For example, entering a low-value transaction may have extremely important risk consequences for the entity that are important to disclose to the users of the financial statements. In this context, information is material if nondisclosure is likely to influence the economic decisions of the financial statement users.

D. Users of Central Bank Financial Statements and Their Needs

To understand the specific objectives of central bank financial statements it is necessary to consider the users of the central bank financial statements and what information they require. For a central bank, the users include:

• The central bank stakeholders, including taxpayers and government. Stakeholders may be concerned with the central bank stewardship of public monies. Because central banks use public money, they have a responsibility to display an appropriate level of care in managing these funds and using resources efficiently to perform their functions. In particular, these users may wish to assess the accountability of management when deciding whether to reappoint or replace them. Given the increasing independence being granted to central banks, governments may use financial statements as a major means of applying central banks’ accountability. Financial statements may also provide the basis for calculating the annual dividend to be paid to government.

• Commercial banks. Many central banks prescribe the external reporting requirements of commercial banks. Commercial banks may look to the central bank for examples of appropriate and best practice financial statement disclosure.

• External suppliers and lenders. The central bank may purchase goods and services, or borrow funds, from other domestic and international suppliers who are interested in the ability of the central bank to meet their obligations as they fall due.

• Credit rating agencies and financial markets. The relative position of the central bank may provide information to credit rating agencies and financial markets on the resources of the central bank and the ability of the central bank to be effective in meeting its stated policy objectives. This may affect the overall credit rating of the country or risk premium demanded by international financial markets. For example, specific information may be sought on foreign reserves and the ability of the central bank to meet exchange rate objectives.

• Purchasers of central bank services. Central banks may provide certain services such as payment system mechanisms. Customers of these services will be interested in the extent to which the central bank provides these services on commercial terms and the level of profit generated by such services.

The needs of these users can generally be met by providing information on the:

• economic resources under control of the central bank;

• legal and economic obligations of the central bank;

• inflows and increases in economic resources and consumption or declines in economic resources of the central bank;

• cost information on central bank operations;

• future risks to the maintenance of the resources of the central bank;

• potential obligations and resources not yet measured by the central bank and why;

• level of transactions with parties related to the central bank including unconsolidated subsidiaries; and

• methods used to portray and measure the actual economic resources.

This information will generally be provided through various components of the central bank financial statements.

E. Accounting Policies

Accounting policies allow the users of central bank financial statements to understand how the economic resources of the central bank have been measured and portrayed in the financial statements. In particular, the accounting policies should describe the measurement basis used in preparing the financial statements and disclose each specific accounting policy that is necessary for a proper understanding of the financial statements.

It is suggested that the accounting policies should be the first component of the financial statements to be presented. This recognizes that the accounting policies will determine how the financial statements measure and portray the position and performance of the central bank. On this basis, they can be considered as the “window” through which the financial statements portray and interpret the actual events and transactions of the central bank.

In deciding whether a specific accounting policy should be disclosed, consideration should be given to whether disclosure would assist users in understanding the way in which transactions and events are reflected in the reported performance and financial position. For example, it is important to understand the basis on which assets are valued and how both realized and unrealized gains and losses are treated in the income statement and balance sheet.

An objective for preparers of central bank financial statements is to select accounting policies so that the financial statements comply with the requirements of IFRS. Where there is no specific requirement, accounting policies should ensure that the financial statements provide information that is relevant to the decision-making needs of users and are reliable in that they:

• faithfully represent the results and financial position of the central bank;

• reflect the economic substance of events and transactions;

• are neutral (that is, free from bias);

• are prudent; and

• are complete in all material respects.

Specific issues to consider in disclosing accounting policies include:

• Financial instruments. Financial instruments comprise a significant proportion of a central bank’s economic resources and account for a significant amount of the overall financial performance. Financial instruments can be subject to various measurement practices (such as historic cost or market value) or may not even be recorded within the financial statements (i.e., they are off balance sheet). Consideration should be given to including detailed disclosure in the accounting policies of the way in which these financial instruments are accounted for, including the measurement base used and how they are recognized in the financial statements. The detailed disclosure is important to understanding how profit is measured and any implications that measurement may have for dividend calculation purposes. In addition, disclosure may provide an appropriate example for commercial bank disclosure because information on financial instrument recognition and measurement is an integral part to understanding the profitability and health of commercial banks.

• Changes in accounting policies. Accounting policies should also include an explanation on whether or not there have been changes made in any specific accounting policies. Where changes have been made, the reason should be disclosed, and the impact on the current and prior periods should be explained.

• Disclosure of supplementary information. The accounting policies are an appropriate location for disclosing other nonfinancial information required by IFRS, including the entity’s name, legal status, the reporting group, whether the financial statements comply with IFRS, and whether the fundamental accounting assumptions such as accrual accounting and going concern have been applied.

F. Balance Sheet

The balance sheet reflects the economic resources under the control of the central bank and the legal and economic obligations of the central bank. This provides information on the financial structure, liquidity and solvency of the central bank.

The application of IAS 1 and IAS 30 to central bank balance sheets raises several issues including disclosure:

• of current and long-term categories of assets and liabilities versus disclosure in broad order of liquidity;

• in the face of the balance sheet or notes to accounts; and

• of equity and reserves.

G. Income Statement

The income statement provides information concerning the performance of the central bank and, in particular, its profitability. This information can assist understanding how economic resources have been increased and consumed by the central bank. In addition, central banks may charge for the provision of certain services (such as banking services to the public sector and government). Profit information allows users to understand the extent to which the profit generated from these activities is excessive or comparable to the profits generated by commercial suppliers of similar services.

However, the disclosure of central bank profit is usually an inappropriate measure of central bank performance. This is relevant where central bank profit arises largely from the consequences of implementing monetary policy and from the monopoly issue of circulating currency. The profit generated in these circumstances will arise usually as a consequence of the monetary policy actions of the central bank. The central bank may influence interest rates in order to achieve inflation objectives, and the profit the central bank earns as a consequence of the monetary policy actions is secondary to achieving the inflation objectives. A better measure of performance in these circumstances is information that explains the inflation objectives and the success of the central bank in meeting the inflation objectives. The more important financial information is the operating costs the central bank has incurred in achieving these inflation objectives.

The disclosure of cost information is usually a better indicator of financial performance because it demonstrates whether the central bank has been efficient in achieving its policy objectives. For example, has central bank spending been appropriate given the policy objectives? Disclosure of cost information allows users to review the central bank stewardship of public resources. This disclosure of cost information can be used to demonstrate that the central bank has been efficient and responsible in using public resources. This can enhance the central bank’s credibility and reduce the potential for political interference. Hence, the disclosure of central bank cost information can contribute to obtaining and preserving greater central bank independence.

Consideration can be given to complementing the traditional income statement with a statement that discloses financial performance by reference to the material business operations of the central bank. This approach can refer to the “outputs” or goods and services that the central bank produces and may satisfy the functional presentation requirements suggested by IAS 1, but is not a specific requirement of IAS 1 or IAS 30. The RBNZ presents two income statements, one in the traditional fashion and one by reference to the outputs of the RBNZ. These statements include performance relative to budget and explain any significant budget variances to enhance transparency.

IAS 1 and IAS 30 prescribe certain information to be included on the face of the income statement or in the notes to the accounts. The IAS 30 classifications are more appropriate to central bank circumstances, since the IAS 1 approach is the more traditional approach designed for businesses that make and sell physical goods. The IAS 1 approach uses a “gross profit” concept where information is provided on income generated by sales of goods less the cost of purchasing or making those goods. The net of this income and cost is the “gross profit” of the entity that is available to meet operating costs before profit is calculated.

However, the application of the IAS 30 approach should be tailored to the specific circumstances of the central bank. The IAS 30 approach primarily facilitates analysis of profitability from a commercial bank perspective. In particular, the approach has been designed to allow analysis of commercial banks’ interest rate margin (i.e., the margin earned through the lending and borrowing money in the banking process), trading activities, and fee income. These profit categories are usually not as relevant to central bank circumstances given the nonprofit objectives of central banks.

H. Changes in Equity and Reserves

This statement explains the changes in the central bank’s equity and reserves, including distributions to stakeholders, increases of equity (by way of retained earnings or contributions by stakeholders), and changes in various reserves.

I. Explanatory Notes to the Accounts

The financial statements also contain notes, supplementary schedules, and other information that is relevant to the needs of users. This will include information concerning future risks to the maintenance of the resources of the central bank, potential obligations and resources not recognized in the financial statements of the central bank, and the reasons why these potential obligations are not recognized.

Information that is not included on the face of the balance sheet or income statement should be included in the notes to the accounts. Each item on the face of the balance sheet should be cross-referenced to any related information in the notes.

IAS 30 contains specific disclosures to be included in the notes to the accounts. The specific disclosures include:

• Contingencies and commitments (IAS 30, para. 26). This is to report any obligations not recognized in the financial statements and provides information concerning off balance sheet transactions, potential obligations that may affect liquidity and solvency, and potential losses that are not recognized. The information is extremely important because it allows users to understand any potential obligations of the central bank that are not currently recognized in the financial statements. These potential obligations may affect future central bank finances and disclosure should be sufficiently comprehensive and detailed to allow financial statement users to assess the probability and impact of any potential obligations. For example, a central bank may have provided guarantees for third-party lending that could have a material impact on the central bank in the event of third-party default. Even if the probability of the guarantee being exercised was low, the financial statements should describe the nature and amount of the guarantee and the circumstances governing its exercise. This provides the central bank with some defense in the event that the guarantee was exercised, which substantially reduced a future dividend payment to government.

• Maturity analysis of assets and liabilities (IAS 30, para. 30). This information allows users to assess the ability of the entity to meet obligations as they fall due and understand the overall liquidity of the entity.

• Concentrations of assets and liabilities (IAS 30, para. 40). Disclosure of significant concentrations by geography and industry assists users to assess the degree of exposure the entity has to any one sector. This is important to understand the risks the organization may face if a particular region/country or industry experiences financial difficulties.

• Significant net foreign currency exposures (IAS 30 para. 40). There is a requirement to disclose significant net foreign currency exposures to provide information regarding the degree of foreign currency risk the entity faces. A significant net foreign currency concentration exposes an entity to the risk arising from changes in foreign currency rates. Central banks may have significant net foreign currency exposures arising from the management of foreign reserves.

• Losses on loans and advances (IAS 30, para. 43). This allows users to assess the effectiveness of the entity in managing and providing for loan losses and in recovering outstanding loans to customers.

• General banking risks (IAS 30, para. 50). This information provides users with an understanding of items such as general provisions for loan losses.

• Assets pledged as security (IAS 30, para. 53). Banks will often pledge assets as collateral for borrowing money. A common example is repurchase agreements, where money is advanced to external parties after an entity passes legal title of the assets (usually marketable securities) to the counterparty. The purpose of this disclosure is to allow readers to determine the value of assets available to creditors and the ability of the entity to dispose of assets to meet liquidity requirements.

A. Introduction

This section discusses issues for central banks in applying IAS 32—Financial Instruments: Disclosure and Presentation (IAS 32).¹⁰ In addition, the section considers the broader issue of appropriate financial instrument risk disclosures for central banks, including:

• the importance of financial instrument risk disclosures, including an overview of key risks associated with financial instruments;

• qualitative disclosures, including disclosure of risk management policies and the nature and extent of activities;

• quantitative risk disclosures, including interest rate risk, foreign currency risk, credit risk, liquidity risk, and fair values; and

• offsetting financial assets and liabilities in balance sheet presentation.

The RBNZ’s 2002–2003 financial statements, included as Appendix II, are used as a case study for various disclosures. However, it should be noted that:

• The RBNZ’s financial statements are prepared in accordance with the requirements of New Zealand accounting standards. New Zealand accounting standards and disclosures reflect requirements considered appropriate to the New Zealand legal and economic situation and are not necessarily the same as the requirements of IAS.

  • In addition, the RBNZ’s financial statements contain disclosure requirements required under International Financial Reporting Standards. However, the financial statements have not been prepared in accordance with the measurement and recognition requirements of IFRS. Therefore, the disclosures, which are specific to those measurement and recognition requirements, have not been made.

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B. Importance of Financial Instrument Risk Disclosures

During the early to mid-1990s, there was increasing recognition of the need for organizations to provide comprehensive information on the nature and extent of their exposure to financial risks. This was in part due to the dynamic nature of financial markets and the growing use and development of more complex financial instruments such as derivative financial instruments. An entity can substantially change its financial risks very quickly by entering into financial transactions including derivative instruments. For example, derivatives may be used to modify a particular financial risk, to reduce or even eliminate exposure to it. Alternatively, derivatives may be used as speculative tools to multiply the effects of changes in interest rates, foreign currency rates, or security prices.¹¹

In addition, there was an increase in the demand for information on financial risks and risk management systems because of financial market crises (such as the collapse of Barings Bank and the Asian financial crisis). A number of these financial market crises arose from the combination of poor risk management and complex financial instruments, combined with low or ineffective levels of disclosure. This raised the need for published information on the nature and extent of financial risk that an organization faced and the way in which these risks were managed and mitigated.

As previously discussed, relevant, reliable, and timely financial information is of crucial importance to the efficient operation of modern capital markets.¹² Information uncertainties can increase the cost of capital to an entity. Accounting standard setters have sought to reduce information uncertainties arising from involvement in financial instruments by developing specific standards (including IAS 32) that detail disclosure requirements for financial instruments. The importance of disclosure concerning financial instruments is reinforced by other international organizations. For example, a 1999 survey of trading and derivative disclosures published by the Basel Committee and International Organization of Securities Commissions (IOSCO). These two groups considered transparency of banks’ and securities firms’ activities and risks to be a key element of an effectively supervised financial system as follows:

Transparency, based on meaningful public disclosure, plays an important role in reinforcing the efforts of supervisors in encouraging sound risk management practices and fostering financial market stability.¹³

This report suggested that financial institutions should:

• Provide financial statement users with a clear picture of their trading and derivatives activities. They should disclose meaningful summary information, both qualitative and quantitative, on the scope and nature of their trading and derivatives activities and illustrate how these activities contribute to their earnings profile. They should also disclose information on the major risks associated with their trading and derivatives activities and their performance in managing these risks.

• Disclose information produced by their internal risk measurement and management systems on their risk exposures and their actual performance in managing these exposures. Linking public disclosure to internal risk management processes helps ensure that disclosure keeps pace with innovations in risk measurement and management techniques.

While these recommendations are for derivative instrument disclosures, they are equally relevant to disclosures concerning financial instruments in general.

The importance of disclosures concerning financial instruments is reflected in the requirements of IAS 32. The objective of IAS 32 is to enhance financial statement users’ understanding of the significance of financial instruments to an entity’s financial position, performance, and cash flows. IAS 32 requires the disclosure of information about the factors that affect the timing and certainty of an entity’s future cash flows relating to financial instruments and the accounting policies applied to those instruments.

In particular, IAS 32 requires disclosure of information about the nature and extent of an entity’s use of financial instruments, the business purpose they serve, the risks associated with them, and management policies for controlling those risks. This assists users to understand the risks associated with financial instruments, including market risk, credit risk, and liquidity risk. Each of these risk types is defined below:

• Market risk. IAS 32 identifies three types of market risk, as follows:

  • Currency risk is the risk that the value of a financial instrument will fluctuate because of changes in foreign exchange rates.

  • Fair value interest rate risk is the risk that the value of a financial instrument will fluctuate because of changes in market interest rates.

  • Price risk is the risk that the value of a financial instrument will fluctuate as a result of changes in market prices, whether those changes are caused by factors specific to the individual instrument or its issuer or factors affecting all instruments traded in the market.

• Credit risk. The risk that one party to a financial instrument will fail to discharge an obligation and cause the other party to incur a financial loss.

• Liquidity risk. The risk that an entity will encounter difficulty in raising funds to meet commitments associated with financial instruments. Liquidity risk may result from an inability to sell a financial asset quickly at close to its fair value.

• Cash flow interest rate risk. The risk that the future cash flows of a financial instrument will fluctuate because of changes in market interest rates.

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Financial statement users can generally obtain the information they require on the risks arising from involvement in financial instruments through two types of disclosure:

Narrative or qualitative disclosures. These explain the risks the entity is exposed to; how the entity evaluates these risks; how the entity uses financial instruments to manage financial risks and major policies adopted to limit and control risk. This information will

• Quantitative disclosures. This information is used for evaluating the extent to which the entity is exposed to market risk, credit risk, liquidity risk, or cash flow interest rate risk.

Central banks will typically hold significant volumes of financial instruments as part of their operations. Hence, central banks can face significant financial risks in their own operations. The risks typically include: foreign currency risk from the management of foreign reserves; interest rate risk on foreign and local currency assets and liabilities; liquidity risk associated with the management of foreign reserves; and credit risk on local and foreign currency assets. In addition, central banks face risk associated with general operations (operational risk) and the risk of damage to the central bank’s credibility and reputation (reputation risk).

Users of central bank financial statements will be concerned with the extent to which the central bank is using financial instruments in appropriate circumstances and that the central bank is appropriately managing the risks that arise from involvement in financial instruments. Disclosures that demonstrate the central bank is appropriately managing financial risks are important because the central bank is managing public resources. The central bank can use these disclosures to demonstrate that appropriate care and responsibility are being taken to manage these public resources.

Transparent qualitative and quantitative disclosure can demonstrate that the central bank is aware of the risks associated with financial instruments and that these risks are being appropriately managed. Even if the central bank deliberately chooses not to manage specific risks arising from involvement in financial instruments, the disclosure of this information may enhance the credibility of the central bank. For example, a central bank could explain the reasons why exposure to foreign currency risk is not managed in order to avoid external criticism in the event the central bank incurs large unrealized foreign currency gains or losses.

In addition, many central banks have a responsibility for supervision of commercial banks within their countries including the regulation of commercial bank disclosures. This provides central banks with an opportunity to promote best practice in disclosure and transparency concerning financial instruments in areas they have in common with commercial banks.

Similarly, the RBNZ is responsible for the supervision of commercial banks in New Zealand. The New Zealand approach to supervision is based on public disclosures of information. The failure of traditional supervisory approaches to prevent substantial bank failures and the risk of moral hazard have caused the RBNZ to adopt a public disclosure regime for commercial banks. As a result, commercial banks have, in some situations, looked to the RBNZ practices to gain illustrations of best-practice disclosure. Therefore, the RBNZ has committed to preparing its financial statements according to best-practice accounting and disclosure requirements as applicable to a central bank. In pursuing this objective, the RBNZ attempts to set an example, where appropriate, for commercial banks to follow.

C. Narrative and Qualitative Disclosures

Qualitative disclosures provide management with an opportunity to explain the risk management objectives of the central bank, and how these objectives fit into the overall central bank objectives. This can include information on the nature and extent of involvement in financial instruments, risk management policies in general, specific risk management policies for each of the major risk categories (i.e., the policies used for managing interest rate risk, credit risk, foreign currency risk and liquidity risk), and the accounting policies for financial instruments.

D. Quantitative Disclosures for Financial Instruments

Quantitative information provides users with an understanding of the degree of risk exposure within each major risk category. IAS 32 requires certain quantitative information for interest rate risk, credit risk, and fair values. IAS 30 requires quantitative information for liquidity risk and foreign currency risk. This section provides an overview of the quantitative disclosures for the requirements of IAS 30 and IAS 32, excluding liquidity risk. The requirements for liquidity risk disclosures have been outlined in an earlier section.¹⁷

Interest rate risk

IAS 32 requires disclosure of information concerning the entity’s exposure to interest rate risk for each class of financial asset and financial liability. This allows financial statement users to understand the economic impact for the entity owing to changes in interest rates.

IAS 32 expects the disclosure to include information on the maturity or interest rate repricing dates for various financial instruments and information on effective interest rates. Interest rate repricing dates are the dates at which the interest rate on variable financial assets or liabilities will change. The basic idea is that the present value of financial assets and liabilities will change when there is a change in interest rates. An increase in the level of interest rates will result in a decrease in the present value of financial assets and liabilities, and vice versa. The magnitude of this change will generally depend on the remaining time to maturity of the financial instrument. All things being equal, financial instruments with longer terms to maturity will be subject to greater present value changes because of a change in interest rates. This logic evolves from the “time value of money” concept that underpins modern financial markets.

For banks, the IAS 32 disclosure is typically by way of an interest rate repricing table. Assets and liabilities are grouped into various periods based on the maturity or interest rate repricing period. Interest rate risk increases if there is a mismatch between the repricing of financial assets and liabilities. A mismatch arises where the maturity or repricing dates for financial assets and liabilities are different. Where a mismatch exists, the present value of the assets and liabilities will change by different amounts when interest rates change.

For example, consider an asset with a remaining maturity of five years and a liability with a maturity of one year. If interest rates change, the value of the asset will change by a different amount to the value of the liability. The existence of this situation could be highlighted in the following table:

Maturity	1 year	2 years	3 years	4 years	5 years
Assets					100
Liabilities	100
Gap (Assets less  Liabilities)	(100)				100

View Table

Maturity	1 year	2 years	3 years	4 years	5 years
Assets					100
Liabilities	100
Gap (Assets less  Liabilities)	(100)				100

A repricing schedule increases the understanding of interest rate risk because it compares the maturity or repricing of assets and liabilities over future periods. This allows users to identify any significant “gaps” in the repricing of financial assets and liabilities. Hence, the financial statement user may obtain an understanding of how much the entity would gain or lose because of a change in interest rates.

The RBNZ provides a comprehensive interest rate repricing schedule, using the asset and liability categories presented on the face of the balance sheet (note 19). This has been extended to provide repricing gap information by currency to further enhance understanding of potential exposure to interest rate risk within specific currencies.

The balance sheet asset and liability categories have also been used to present the quantitative risk disclosures for credit risk and foreign currency risk. The approach of using the balance sheet asset and liability categories is intended to provide users with a comprehensive presentation of the RBNZ’s assets and liabilities and the risk profile for each category of assets and liabilities. This approach allows the financial statement user to understand the reasons why the central bank holds different assets and liabilities and the extent of the risk associated with each category of asset and liability.

As discussed in the section on qualitative disclosures, information can be provided on the exposure to interest rate risk as measured by VaR. VaR models predict the loss that would arise on financial assets because of changes in the level of interest rates or foreign currencies. Note 21 provides the RBNZ VaR measures. This information includes the year-end VaR position, internal limits, peak exposure, average exposure, and the lowest exposure. The peak exposure is the maximum VaR position that has arisen during the financial year. Information on the peak, average, and low exposure allows users to understand the extent to which risk limits have been utilized during the period.

E. Collateral

An entity’s policies for and extent to which financial assets are pledged or received as collateral can provide important information on the extent to which financial assets may be encumbered or available for other purposes.

IAS 32 requires disclosure of the amount of financial assets pledged as collateral for liabilities or contingent liabilities and any material terms and conditions relating to assets pledged as collateral. Where an entity has accepted collateral that it is permitted to sell or repledge, it shall disclose the fair value of the collateral accepted, sold, and any material terms and conditions associated with its use of this collateral.

Central banks that have pledged financial assets as collateral do not have those assets available for other purposes. For example, in the situation where funds were needed for foreign exchange intervention, any assets pledged as collateral under repurchase transactions would not be available to fund intervention.

The RBNZ provides information on the collateral pledged and received under interest rate swaps, repurchase and reverse repurchase agreements in note 1(f).

F. Offsetting Financial Assets and Liabilities

Readers generally expect financial assets and liabilities to be presented on a gross basis in the balance sheet. This means that assets and liabilities should not be netted against each other for reporting purposes. This approach ensures that the balance sheet presents all the obligations and resources of the entity—netting obligations may understate actual assets and liabilities and misrepresent the underlying economic position.

However, offsetting assets and liabilities is permitted under IAS 32 when the entity has a legally enforceable right to set off the recognized amounts and the entity intends to settle the obligations on a net basis. A legal right of set-off will usually arise under either:

• contract law—where parties to the agreement explicitly acknowledge a right to set off.

• common law—through the traditional acceptance of a right of set off and the practice of doing so.

To be recognized in the balance sheet, a legal right of set-off should be enforceable in a liquidation or bankruptcy.

The RBNZ typically follows the strict practice of not setting off assets and liabilities in the balance sheet.

G. Other IAS 32 Disclosure Requirements

IAS 32 has several other disclosure requirements. The RBNZ is not currently affected by the events or activities that give rise to disclosure under these requirements. Therefore, the RBNZ financial statements do not provide examples of these other IAS 32 disclosures. These disclosures arise from the following:

• Debt/equity classification of financial instruments (IAS 32 paragraphs 15, 26, 28, 33, 35). IAS 32 sets out the classification and disclosure of financial instruments as financial liabilities, financial assets or equity instruments. This includes guidance on how to separately classify and disclose financial instruments in these categories and the treatment of payments arising from the instruments as dividends or interest.

• Derecognition (IAS 32 para. 94 (a)). Disclosure is required where financial assets have been derecognized when the entity has transferred all or part of a financial asset.

• Compound financial instruments with multiple embedded derivatives (IAS 32 para. 94(d)). If an entity has issued an instrument that contains both a liability and an equity component and the instrument has embedded derivative features whose values are interdependent, IAS 32 requires disclosure of these features.

• Disclosure from the application of IAS 39 Financial Instruments: Recognition and Measurement. The disclosure requirements that were previously included in IAS 39 are now part of IAS 32. These disclosure requirements include:

• IAS 32 para. 58. Information on hedge accounting under IAS 39 including a description of the hedge, the financial instruments designated as hedging instruments, and the nature of risks being hedged.

  • IAS 32 para. 59. Gains or losses on hedging instruments recognized in equity including the amounts recognized in equity for the period and amounts removed from equity.

  • IAS 32 para. 94(e) and 94(f). Information on the carrying amounts of financial assets and liabilities that were designated as held for trading and as financial assets a financial liability at fair value through profit or loss.

  • IAS 32 para. 94(g). The reasons for any reclassification of financial assets as one measured at cost rather than fair value.

  • IAS 32 para. 94(h). Material items of income, expense, and gains and losses resulting from financial assets and financial liabilities, whether included in profit or loss or as a separate component of equity.

  • Impairment (IAS 32 para. 94(i)). The nature and amount of any impairment loss recognized in profit or loss for a financial asset shall be disclosed.

  • Defaults and breaches (IAS 32 para. 94(j)). Information with respect to any defaults of principal or interest, and any other breach during the period of the loan.

• Dummy List

H. Summary

This section has discussed issues for central banks in applying IAS 32. Central banks have an important role in disclosures of financial instruments, since central banks will typically hold significant volumes of financial instruments as part of their operations. Hence, users of central bank financial statements will be concerned with the extent to which the central bank is using financial instruments in appropriate circumstances and that the central banks are appropriately managing the risks that arise from involvement in financial instruments.

Transparent qualitative and quantitative disclosure can demonstrate that the central bank is aware of the risks associated with financial instruments and that these risks are being appropriately managed.

In addition, many central banks have a responsibility for supervision of commercial banks within their countries, including the regulation of commercial bank disclosures. This provides central banks with an opportunity to promote best practice in disclosure concerning financial instruments.

A. Introduction

This section outlines some of the issues to be considered in the preparation of the statement of cash flows. IAS 7: Cash Flow Statements (IAS 7) requires the presentation of the cash flow statement as an integral part of an entity’s financial statements. Some of the issues that can arise for a central bank include:

• the purpose of the cash flow statement;

• how cash should be defined;

• defining investing and financing cash flows;

• presentation of gross or net cash flows; and

• the direct or indirect method of presenting operating activities.

B. Purpose of the Cash Flow Statement

The purpose of the cash flow statement is to help users of financial statements assess an entity’s ability to generate cash flows and the needs of the entity to utilize those cash flows. The cash flow statement is based on the concept that the purpose of a business is to make a profit, realize it in cash, and do this repeatedly. The entity’s cash flows are required to be classified according to the activity that gave rise to them.

• Operating activities. The principal revenue-producing activities of the entity and other activities that are not investing or financing activities.

• Investing activities. The acquisition and disposal of long-term assets and other investments not included in cash equivalents.

• Financing activities. Activities that result in changes in the size and composition of the equity capital and borrowings of the entity.

These classifications can be thought of as an entity raises money (financing activities), invests this money in long-term assets (investing activities), and obtains income and expenses from those assets (operating activities). The cash flow statement shows how the entity generates cash flows and presents information on changes in the entity’s investing and financing structure.

Owing to the definition of cash, a statement of cash flows does not always represent the actual liquidity of a central bank. Moreover, a central bank will often be responsible for issuing circulating currency and managing the liquidity of the domestic banking system. Some commentators consider that these factors reduce the information value of the cash flow statement in the central bank’s circumstances. For example, the Reserve Bank of Australia expresses presentation concerns in the opening introduction to their statement of cash flows:

The following cash flow statement appears as a matter of record to meet the requirements of AAS28; in the RBA’s view, it does not shed any additional light on the RBA’s financial results. For the purpose of this statement, cash includes the notes and coin held at the Reserve Bank and overnight settlement system account balances with other banks.¹⁹

The Reserve Bank of New Zealand (RBNZ) experienced similar concerns that resulted in a substantial review of the RBNZ’s cash flow statement to improve the presentation and to ensure the cash flow statement provided an improved indicator of the RBNZ’s liquidity.

In central bank circumstances, the RBNZ view is that the statement of cash flows and related notes to the accounts can be used to provide information on the:

• Extent to which operating income was generated in cash and the extent to which reported profits are available to distribute as dividends.

• Cash impact of the major changes in the RBNZ’s balance sheet structure during the financial year by presenting the net cash changes in the major balance sheet categories. This approach is intended to assist the financial statement users understand how cash has been generated and applied to change the RBNZ’s balance sheet structure during the financial year.

• The liquidity of the RBNZ. This information was only possible following a revision in the RBNZ’s definition of “cash.”

The cash flow statement is likely to be most important in supporting the distribution of central bank profits. Central banks are often confronted with having large unrealized gains that should not be distributed as part of the central bank dividend. The distribution of unrealized gains may have monetary policy implications because the central bank may not hold the liquidity to fund the distribution to the government’s budget. This would result in a monetary emission to the government.

A properly constructed central bank cash flow statement will clearly present cash flows from operating activities, which demonstrates the extent to which the central bank’s current year profit has been converted into cash. This presentation will provide a mechanism to support any decisions not to distribute unrealized profits, as it will illustrate the central bank’s cash position, and where profits have yet been realized as cash. Equally, if the central bank does distribute unrealized gains, these unrealized gains will need to be funded by selling assets (investing activities), issuing currency or borrowing from third parties (financing activities). The cash flow statement will clearly demonstrate how a central bank has funded any distribution of profits.

C. Definition of Cash

Cash is generally defined to include cash on hand, demand deposits, and highly liquid investments that are readily convertible cash and which are subject to an insignificant risk of changes in value. However, due to the high liquidity of most central bank assets, a wide definition of cash could lead to a high proportion of the central bank’s assets being considered cash.

This would mean that the disclosure of cash flows in the investing (how cash has been applied) and financing (how cash has been generated) sections would be contained entirely in the opening and closing cash positions. While this may be a better indicator of a central bank’s liquidity it does reduces the ability of the cash flow statement to accurately provide information on how cash is generated and applied.

The RBNZ approach has been to consider cash as those financial instruments that are highly liquid and are used in the day-to-day cash management of the central bank. This definition has included the highly liquid foreign reserve assets of the RBNZ and local currency financial assets that arise from the RBNZ’s management of the New Zealand Government bank account held with the RBNZ.

The definition of cash ensures that the RBNZ’s cash balances provide an indicator of the actual liquidity of the RBNZ. Previously, the RBNZ defined cash in a way that resulted in a negative cash balance being reported. This approach was not considered to provide a fair presentation of the actual liquidity of the RBNZ.

D. Defining Investing and Financing Cash Flows

IAS 7 suggest presentations of cash flows according to the definitions of operating activities, investing activities, and financing activities. In a central bank, these definitions could be applied as follows:

• Operating activities. This category includes the main cash revenue and expense flows such as paying and receiving of interest, fee income, and operating expenses. Remaining activities that have not been classified as investing or financing are usually included as operating activities.

• Investing activities. These comprise investments from monetary policy and foreign reserves operations, any other investment of circulating currency, and the sale and purchase of fixed assets.

• Financing activities. This includes issue and repayment of circulating currency, loans used to fund long-term borrowings (such as the funding for holdings of foreign reserves or funding from the IMF), and disbursement of the annual dividend.

The effect of exchange rate changes on cash and cash equivalents held or due in a foreign currency is reported in the cash flow statement in order to reconcile cash at the beginning and the end of the period. This amount is presented separately and includes the differences, if any, had those cash flows been reported at end-of-period exchange rates.

E. Presentation of Gross or Net Cash Flows

Cash flow statements are generally expected to present gross flows of cash. However, cash flows may be reported net when they are on behalf of customers and reflect the activities of customers rather than those of the entity. In addition, cash receipts and payments may be reported net for items in which the turnover is quick, the amounts are large, and the maturities are short.

It is generally accepted that net cash flows are appropriate when the cash movements arise through external factors such as a client depositing funds with a retail financial institution. However, gross cash flows may be more useful to provide a scale of the risks facing the entity either in terms of cash handling (i.e., the business has handled this volume of cash) or in trading activities (i.e., the volume with which a portfolio is bought and sold).

F. Direct and Indirect Methods of Preparation

IAS 7 suggests that entities should report cash flows from operating activities using either the direct or the indirect method. Under the direct method, major classes of gross cash receipts and gross cash payments are disclosed, while the indirect method presents the net profit or loss and adjustments for the effects of noncash transactions including balance date accruals and unrealized gains and losses.

Entities are encouraged to use the direct method because this may provide information useful in estimating future cash flows since it adds new information unavailable from the balance sheet and income statement. In addition, the direct method is considered to best reflect the gross inflows and outflows of cash from operating activities.

G. Summary

A cash flow statement can provide useful information on central bank activities that is not available in other sections of the financial statements. The cash flow statement can be used to assist the financial statement users in understanding how cash has been generated and applied to change the central bank’s balance sheet structure during the financial year and provide an indication of the liquidity of the central bank. Moreover, the cash flow statement provides a basis for understanding the extent to which the central bank profit has been generated in cash and how distributions to government are funded.