We believe the best way to identify these risks is to first identify the individual and/or groups of assets of the entity, the nature of its operations, and its significant contractual relationships. Once this is done, you can go through each item and identify the related risks. Here’s an Excel file that provides good format for doing this analysis. The risk identification step is highlighted in blue. The other highlighted areas refer to later steps in this analysis process and will be addressed later. Once you have completed each step, this spreadsheet will reflect you completed analysis.
For purposes of this analysis, ‘risk’ is the cause of variability in fair value. You can also think of variability in terms of cash flows since fair value is often a present value cash flow analysis, particularly for financial instruments. But, since cash flows are not the only input to fair value, cash flows should not be the only view you take of risk.
The only risks that should be listed are those that the entity was designed to create or be exposed to. Incidental risks are not created by design and should not be considered. ASC 810 provides a short list of risks that cause variability:
- Credit risk
- Interest rate risk (which includes prepayment risk)
- Foreign currency exchange risk
- Commodity price risk
- Equity price risk
- Operations risk
Often a review of the legal entity’s governing documents and contract will reveal the risks it was designed to create and pass on to variable interest holders since the interests themselves are often evident in documents and tied to specific variability.