IFRS News 1 IFRS News Shedding light on the IASB’s activities* IFRS News – Issue 60 February 2008 In this issue… 1 Standard setting Symposium round-up 2 IFRS 2 amendment Vesting conditions and cancellations 3 Improvements Project Minor change or major overhaul? 4 IFRS 1 and IAS 27 amendments Implications of the exposure draft 5 Portions ED Exposures qualifying for hedge accounting 6 IFRIC 12 Implications for the EU 7 Contacts Issue of the month Standard setting in an age of complexity Key figures from the standard setting and regulatory communities met at the Global Public Policy Symposium last month to debate the benefits of principles-based accounting standards. Dick Kilgust, PwC global regulatory partner, acted as moderator at the Symposium. In this article he provides background to the event and gives an update on the views of panellists Sir David Tweedie, Bob Herz, and Conrad Hewitt. A growing dialogue has developed in recent years about the future of financial reporting – and in particular the relevance and complexity of today’s reporting model. PwC and the other large accounting firms have engaged in discussions with stakeholders around the world on a number of issues critical to the long-term strength and stability of the capital markets, including financial reporting. These discussions have indicated overwhelming support for IFRS as a single set of high- quality accounting standards that can be used around the world. Stakeholders indicated their support for IFRS in part because it is perceived as more principles-based than US GAAP. There was, however, a lack of consensus on the key characteristics of principles- based standards. As a contribution to the debate, the large firms published a White Paper ‘Principles-Based Accounting Standards’ to coincide with the Global Public Policy Symposium hosted by the firms in New York. The paper proposes a framework to use in developing principles-based standards and suggests changes needed on the part of participants in the financial reporting process to support such a system. It is acknowledged in the paper that neither a purely rules-based nor a purely principles- based system has ever existed, or will ever exist. Each accounting standard will exist somewhere along a spectrum between rules and principles. The goal must be to seek the “sweet spot” on that spectrum. Many commentators argue that, today, we are too skewed towards the rules-based side of the spectrum and the focus should be on pushing the pendulum towards a system which would enable principles-based standards and a greater use of judgement to become the norm. *connectedthinking PRINT CONTINUED
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IFRS News
1
IFRS NewsShedding light on the IASB’s activities*
IFRS News – Issue 60February 2008
In this issue…
1 Standard setting Symposium round-up
2 IFRS 2 amendmentVesting conditions and cancellations
3 ImprovementsProject Minor change or major overhaul?
4 IFRS 1 and IAS 27amendments Implications of theexposure draft
Standard setting in an age ofcomplexityKey figures from the standard setting and regulatory communities met at theGlobal Public Policy Symposium last month to debate the benefits ofprinciples-based accounting standards. Dick Kilgust, PwC global regulatorypartner, acted as moderator at the Symposium. In this article he providesbackground to the event and gives an update on the views of panellists SirDavid Tweedie, Bob Herz, and Conrad Hewitt.
A growing dialogue has developed in recent years about the future of financial reporting –and in particular the relevance and complexity of today’s reporting model. PwC and theother large accounting firms have engaged in discussions with stakeholders around theworld on a number of issues critical to the long-term strength and stability of the capitalmarkets, including financial reporting.
These discussions have indicated overwhelming support for IFRS as a single set of high-quality accounting standards that can be used around the world. Stakeholders indicatedtheir support for IFRS in part because it is perceived as more principles-based than USGAAP. There was, however, a lack of consensus on the key characteristics of principles-based standards.
As a contribution to the debate, the large firms published a White Paper ‘Principles-BasedAccounting Standards’ to coincide with the Global Public Policy Symposium hosted by thefirms in New York. The paper proposes a framework to use in developing principles-basedstandards and suggests changes needed on the part of participants in the financialreporting process to support such a system.
It is acknowledged in the paper that neither a purely rules-based nor a purely principles-based system has ever existed, or will ever exist. Each accounting standard will existsomewhere along a spectrum between rules and principles. The goal must be to seek the“sweet spot” on that spectrum. Many commentators argue that, today, we are too skewedtowards the rules-based side of the spectrum and the focus should be on pushing thependulum towards a system which would enable principles-based standards and a greateruse of judgement to become the norm.
The White Paper proposes sixcharacteristics which the firms believeare the key elements of a high-quality,principles-based accounting standard: 1. Faithful presentation of economic
reality2. Responsive to users' needs for clarity
and transparency3. Consistency with a clear Conceptual
Framework4. Based on an appropriately-defined
scope that addresses a broad area ofaccounting
5. Written in clear, concise and plainlanguage
6. Allows for the use of reasonablejudgment.
While each of the six characteristics isfundamental to the success of anyprinciple-based system, the first two areregarded as pre-eminent. The need forthem should be self-evident. Indeed, thewhole purpose of requiring companies topublish audited financial statements is toprovide investors with a tool to gaugeeconomic and management performanceand prospects. Yet the reality is thatunder today’s accounting this goal isoften not met. Companies can complywith the strict letter of the requirements,yet may fail to provide the informationthat provides a clear picture of theeconomic state of the enterprise.
The firms’ paper was discussed by apanel at the Symposium comprising SirDavid Tweedie and Bob Herz, respectivechairmen of the IASB and FASB, andConrad Hewitt, Chief Accountant at theUS Securities and Exchange Commission.
The panel participants welcomed thepaper, while noting that similar papershave been prepared by otherorganisations in the past. They identifiedkey issues as being those ofcomparability and the exercise ofjudgment. Bob Herz commented “Weneed to flush out the comparability issue.Regulators have tended to believe in theneed for comparability and this may havecontributed to the model we have today.”Sir David agreed “The minute that usersand regulators want things to becomparable, the standards have to belonger. We could provide a financialinstruments standard that is twoparagraphs long, but the existingstandards are full of exceptions.”
Both standard-setters also agreed on theneed for all involved in financial reportingto respect the exercise of reasonablejudgment. Sir David noted “Principles-based standards can fail if not applied ina spirit of integrity. At the same time,preparers and auditors should not ask forvoluminous interpretations, andregulators need to avoid ‘second-guessing’”. Conrad Hewitt added his ownadvice that "The IASB needs to defenditself against every request for guidance."
The White Paper sets out the changesthat different groups will have to considerto ensure successful implementation of asystem of principles-based standards.Preparers of financial statements willneed to put more emphasis on theexercise of professional judgment tofaithfully report the economic substanceof their enterprise. The financial reporting
process will be less driven by seeking toidentify the rule that directs how torecord a transaction or make adisclosure, and will place more emphasison the exercise of judgment. Regulatorsshould focus on the soundness of theunderlying judgments that are the veryessence of good business reporting andexternal auditing.
The audit profession, for its part, shouldcontinue to act in investors’ interests andprovide reasonable assurance that thefinancial statements are fairly stated inaccordance with the standards. That istrue today. It will be all the more criticalas we shift to a more principles-basedsystem that relies on sound professionaljudgment and where clarification cannotconstantly be sought from the standardsetter.
Looking back on the White Paper and theSymposium discussion, I believe theimportant thing is how we now take thisdebate forward. We are not talking aboutthe standards that will be issuedtomorrow, but how the standard settingprocess will evolve and the standardsthat might be issued in five or ten yearstime. We should hold the standard-setters to these principles as we assesstheir proposals in the years to come.And, at the same time, we as auditorsneed to avoid continually asking for moreguidance and interpretation.
The White Paper ‘Principles-BasedAccounting Standards’ can be obtainedfrom the Symposium websitewww.globalpublicpolicysymposium.com
The amendment to IFRS 2, Share-basedPayments dealing with vesting conditionsand cancellations has been issued after along gestation period. The exposure draftappeared in spring 2006. Theamendment limits vesting conditions to
service conditions and performanceconditions. Other features of a share-based payment are not vestingconditions. These features are included inthe grant date fair value for share basedpayment transactions. That is, these
features will not impact the number ofawards expected to vest or theirvaluation subsequent to grant date, butonly impact the grant date fair value.
The amendment also specifies that all
Amendment to IFRS 2 dealing withvesting conditions and cancellationsThe IASB published an amendment to IFRS 2 Share-based Payments, on 17 January 2008. RichardDavis looks at the changes and their impact.
cancellations, whether by the entity orby other parties, should receive thesame accounting treatment, ieacceleration of the expense based onthe grant date fair value.
These changes will have an impact onthe accounting for share-basedpayments which include conditionsunrelated to service, especially thosewhich an employee can choose to meetor not. Common examples will beawards which include a condition thatthe employee must hold a number ofshares or awards linked to savingsplans.
Consider an example where employeesagree to invest 100 per month for 5years in a savings vehicle. The vehicleguarantees interest of 180, payable atthe end of the 5 years. The employeecan take the accumulated savings atany time, but will only get the interest ifhe completes the full 5 years. Anemployee that remains with thecompany and continues to makeinvestments can use the accumulatedfund of 6,180 [(100 x 12 x 5) + 180] to
purchase shares at an exercise price of80% of the share price at the start ofthe savings period.
Applying the amendment to IFRS 2, therequirement to stay with the companywill be a vesting (service) condition andthe requirement to invest will be a non-vesting condition. This means that thegrant date fair value for the IFRS 2expense must include the effect ofemployees choosing to give up theiroptions by stopping saving. This is aseparate assessment from anyassumption regarding employeeturnover. If employees do stop savingthis will lead to an acceleration ofexpense recognition but there will beno truing up for any variation betweenactual experience and the assumptionsused in calculating the grant date fairvalue.
This may seem relativelystraightforward at first glance, eventhough it may lead to a quite volatileexpense. If past experience indicatesthat 25% of employees stop savingwhilst still working then don’t we just
reduce the value of the option by25%?
Unfortunately it is not that simple. Someemployees will decide to stop saving forfactors that are unrelated to the shareprice; they may have other obligationsor other investment plans. Thisintroduces an element of economicallyirrational behaviour that must beincorporated in the grant date fair value.Other employees may stop savingbecause the option is underwater andthey see no value in continuing to save.If the only circumstance in whichemployees ceased saving was when theoption had no value it would have noimpact on the determination of the fairvalue of the options.
Applying these provisions in practicewill need judgement. It is important thatpreparers start to gather the data tosupport those judgements soonerrather than later.
The amendment will apply for annualperiods beginning on or after 1 January2009, with earlier application permitted.
The IASB published its first annual‘Improvements’ exposure draft inOctober 2007. The project aims toprovide an efficient process foraddressing a number of minor, yetessential, changes to existingstandards that may not warrantseparate exposure drafts on a stand-alone basis.
The exposure draft proposed 41amendments affecting 25 standards –illustrating the far-reaching scope of theproject. The amendments proposedvaried from a substantive change to thedefinition of a derivative, to minoramendments to provide consistency of
terminology used in the standards. 41seems a large number for improvementannually. Observers hope that thenumber represented a ‘backlog’ ofminor amendments that hadaccumulated for this project. Thataside, did the exposure draft stick to itsadvertised scope?
PwC’s comment letter to the Boardexpressed overall support for theproject's objectives. However, it raisedconcern that six of the proposedamendments fell outside the scope ofthe project. These six seem importantenough to warrant debate on aseparate basis.
One of the most notable of these relatesto IAS 1, Presentation of financialstatements. A proposed amendment tothis standard introduces the requirementto make additional disclosure where anentity is unable to make an explicit andunreserved statement of compliancewith IFRS. This would be the casewhere, for example, an entity hasapplied IFRS as adopted by the EU anddifferences result from full IFRS. Suchdisclosure would have to qualitativelydescribe each difference between thebasis used and IFRS, and how thereported financial position andperformance would have differed hadfull IFRS been applied.
Annual Improvements Project – minorchange or major overhaul?Avni Mashru, senior manager in PwC’s global accounting consulting services group, explains thescope of the proposed amendments in the IASB’s ‘Improvements’ project, and gives PwC’s viewson the proposals.
The disclosure might provide valuableinformation to users of financialstatements. However, it might proveimpossible to operationalise without thecooperation of the global regulatorycommunity and the auditing profession.For example, a jurisdiction could simply'carve out' the text from the version ofstandard that it endorsed or adoptedthus creating a circular problem. Thus,this amendment does not seem to fallinto the category of an annualimprovement.
A further amendment that seems to beoutside the scope of an annualimprovement is the proposed change inthe definition of a derivative under IAS39. The definition of a derivativecurrently excludes contracts whosevalues change in response to a non-financial variable and that variable is
specific to a party to the contract. Theamendment proposes to remove theexclusion with respect to non-financialvariables, resulting in these contractsbeing classified as derivatives withmeasurement at fair value. This wouldaffect a wide range of contracts such asloans where the interest payable variesdependent on the performance of theborrower, or lease contracts wherepayments are linked to performancemeasures specific to the lessee.
This proposal could well have thesubstantive result of an entity having tofair value its own business risk or itsown future profit streams. This seems asubstantive conceptual change inaccounting for derivatives. Accountingfor these contracts under the currentversion of IAS 39 provides a bettermeasure of changes in the contract’s
value rather than fair valuemeasurement.
Four additional amendments appear asif they might have a similar significantimpact if they were implemented asdrafted. These are: the change to IFRS 5involving classification of a subsidiary'sassets and liabilities when a sale planwith a loss of control is in place; theamendment to IAS 16 (andconsequentially to IAS 7) with respect toassets held for rental; the change to IAS19 in respect of entitlement to benefitsand the amendment to IAS 38 withregard to costs of advertising andpromotional expenditure. A challenge forthe Board to take forward to the nextproject is to draw the distinctionbetween minor and significantamendments. Significant amendmentsdeserve a comprehensive debate.
There are two particular challenges forparent companies adopting IFRS, usingthe existing IAS 27, in their separatefinancial statements:• If management applies a policy of
carrying a subsidiary at cost (asopposed to fair value), that cost isdetermined in accordance withIFRS. Cost determined underprevious GAAP may not beconsistent with IFRS and recreatingthis cost basis could beimpracticable.
• Dividends received by a parentcompany are split between thosearising from pre- and post-acquisition profits. The former arecredited against the investment; thelatter are recorded in income. Aparent company would have toassess whether it had ever receiveda distribution out of a subsidiary’spre-acquisition profits as part of
calculating the restated cost ofinvestment under IAS 27.
The Board issued an ED in January2007, giving some relief for theseissues, and received 47 commentletters. The Board has decided toamend its original proposals as well assuggesting two further changes basedon respondents’ comments. Given thesignificance of the further changes, ithas re-exposed the proposals.
Amendments to IFRS 1 (amendedproposals):• An entity may use either the fair
value in accordance with IAS 39 orthe previous GAAP carrying amountas deemed cost for an investmentin a subsidiary on transition to IFRS.The Board had previously proposedfair value or a net asset value.Respondents felt that net assetvalue could be difficult to apply and
was no less arbitrary than aprevious GAAP amount. The Boardhas amended its proposals,removing the net asset option andallowing a previous GAAP carryingamount. A similar exemption forconsolidated financial statementswas already given for businesscombinations occurring prior totransition.
• This exemption is extended toinvestments in associates and jointventures in the separate financialstatements at transition date.
Amendments to IAS 27 (newproposals):• The definition of the ‘cost method’,
which requires dividends to be splitbetween pre- and post-acquisition,is deleted from IAS 27.
• Investors should recognise asincome all dividends received from
ED amendments to IFRS 1 and IAS 27The IASB released a second exposure draft (ED) last month proposing amendments to IFRS 1,First-time Adoption of International Financial Reporting Standards and IAS 27 Consolidated andSeparate Financial Statements. The proposed amendments provide relief from certain requirementsin the separate financial statements of a parent. Michelle Orozco of the Global ACS Central teamexplains the proposals.
Portions ED IFRS News – Issue 60February 2008
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a subsidiary, jointly controlled entityor associate in their separatefinancial statements.
• The receipt of dividends wouldrequire investors to test the relatedinvestment for impairment inaccordance with IAS 36.
The changes to the cost method take aquite different approach to accountingfor subsidiaries in separate financialstatements. It is a simplification but it
will require proper application of IAS 36to ensure that income is not overstated.
The ED also considers the situation of areorganisation within a group where anewly established entity is added to thetop of a group to become the owner ofan existing parent. The ED proposesthat the new parent measures the costof this investment using the carryingamounts of the equity, assets andliabilities in the separate financial
statements of the previous parent at thedate of the new parent’s formation.
The scope of the amendment is narrowbut it touches on other issues aroundseparate financial statements, groupreorganisations and other commoncontrol transactions.
Comments on the ED are due by 26February 2008.
What are Portions?
IAS 39 permits an entity to ‘carve’ afinancial instrument into portions forhedging purposes and designate aportion of cash flows or fair value of aninstrument as a hedged item. Forexample, designating only the LIBORportion of a floating-rate debt that paysLIBOR plus a spread. Hedging aportion of a financial instrument can beuseful because an entity can designatea portion that matches the risks thatare hedged with a derivative. This helpsto reduce ineffectiveness.
Reasons for the exposure draft
The IFRIC received a number ofsubmissions requesting guidance onwhat qualified as a portion under IAS39. Rather than answer each individualissue, the IFRIC sought to developguidance on what IAS 39 meant by a“portion”. The matter was referred tothe IASB when the IFRIC failed to reacha conclusion.
The Board decided to develop detailedguidance to:(i) specify the risks that qualify for
designation as a hedged risk; and (ii) provide additional guidance on what
can be designated as a hedgedportion in a hedging relationship.
The IASB stated its goal was to clarifyits original intentions regarding whatcan and cannot be designated as ahedged item, rather than to changeexisting practice.
An alternative proposal
Our response letter proposed a set ofprinciples that would permit flexibility in
which portions were eligible for hedgeaccounting. These are:
Principles underlying portions• A portion of the cash flows of a
hedged item is a separatelyidentifiable subset of the total cashflows of the hedged item
• A portion of the fair value of ahedged item is a separatelyidentifiable component of the fairvalue of the hedged item thatmarket participants could considerin determining the fair value of theinstrument.
Principles underlying risks• A risk eligible for hedge accounting
must have a predictable and reliablymeasurable effect on the cash flowsor fair value of the designatedhedged item.
These principles satisfy one of theBoard’s key concerns – the ability toassess hedge effectiveness reliably.
Hedging Future Cash FlowsUsing Purchased Options
Companies commonly hedge one-sided risks. An entity that has floatingLIBOR debt, for example, might
Exposures qualifying for hedgeaccounting (the ‘Portions’ ED)The IASB published an exposure draft ‘Exposures Qualifying for Hedge Accounting’ in September2007. Scott Bandura of the Global ACS Central team sets out the implications of the proposals andgives PwC’s views on what is often referred to as the ‘portions’ ED.
PwC’s View
This seems to be a rules based approachfor determining which portions may behedged. We support a principles basedapproach as:l IFRS is a principles-based set of
standards;l Principles are more consistent with
the IASB’s objective to simplifyhedge accounting;
l Principles are more durable thanrules and can be applied to newproducts and hedging strategies;and
l Rules lend themselves to structuringopportunities by reducing theopportunity to apply judgement
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purchase an interest rate cap to mitigaterisks of LIBOR increasing beyond acertain level. This is a one-sided risk asthe entity will not suffer if interest ratesfall. An entity that has forecast futuresales in a foreign currency mightpurchase a foreign currency option tomitigate the risk of the currency movingagainst the entity.
IFRIC was asked whether (in a hedge ofone-sided risk), it is possible to designatethe hedged item as a hypothetical writtenoption (using what is commonly called a‘hypothetical derivatives’ method todesignate the hedged risk and testeffectiveness). The IFRIC tentativelyconcluded that IAS 39 does not permitsuch an approach and published atentative agenda decision to this effect.This was later withdrawn pending the
publication of the Board’s exposure drafton portions, which attempts to confirmIFRIC’s previous decision.
Transition
The exposure draft proposesretrospective application of the changesto the standard.
IFRIC 12 addresses the accounting byprivate sector operators in public-to-private service concessionarrangements. It is effective for periodsbeginning on or after 1 January 2008.
IFRIC 12 introduces significant changesto ways in which many operatorscurrently account for service concessionarrangements. The Interpretation requiresthat infrastructure constructed orupgraded as part of a service concessionarrangement is accounted for as either afinancial asset or an intangible asset. Anoperator recognises a financial asset tothe extent that it has an unconditionalcontractual right to receive cash oranother financial asset from or at thedirection of the grantor. An operatorrecognises an intangible asset to theextent that it receives a right (a licence) tocharge users of the public service.
IFRIC 12 is not new, so why is itnewsworthy now?
European listed groups are required toprepare their consolidated financialstatements using ‘IFRS as adopted foruse within the European Union’, meaningthat standards issued by the IASB needto be ‘endorsed’ before they can be usedwithin the European Union. IFRIC 12 hasnot yet been endorsed and there aresigns that endorsement should not beassumed.
Some starkly opposing views wereexpressed at the November meeting ofthe European Commission’s AccountingRegulatory Committee. One memberargued that IFRIC 12 should beconsidered a temporary solution to theproblem of accounting for serviceconcession arrangements and that the
Commission should continue to workwith the IASB towards finding a moreacceptable solution. Another memberargued for a quick endorsement.
The European Commission has initiatedan effect analysis on IFRIC 12 as inputto the endorsement process. Theanalysis takes the form of a shortquestionnaire, similar to that undertakenfor IFRS 8 prior to its endorsement inNovember 2007. The Commission isinterested in the views of users offinancial statements as well as theoperators themselves. The deadline forcomment was 25 January 2008 and itwill be interesting to see whetherrespondents are concerned more aboutthe specifics of IFRIC 12 or the benefitsof aligning EU-endorsed IFRS and IFRSas issued by the IASB.
PwC’s View
We support use of the hypotheticalderivatives method in assessingeffectiveness of options based hedgingstrategies for both financial and non-financial hedging relationships.
The ED’s basis for conclusions indicatesthat its guidance will only apply tofinancial items. However, option basedhedging strategies are common for non-financial hedging relationships such ashedges of forecast foreign currency saleswith currency options. The Board mayhave intended to prohibit use of thehypothetical derivative method in non-financial hedging relationships. However,the modifications to the standard ascurrently drafted do not achieve that goal.
PwC’s View
The transition requirements should beconsistent with past changes to thehedging guidance in IAS 39. That is, thestandard should require redesignationon the transition date and allowcontinued deferral of existing amountsin equity that were recognised prior tothe change in the standard.
IFRIC 12 – the political debateThe IFRIC published IFRIC 12 Service Concession Arrangements in November 2006. Global ACSpartner Peter Hogarth explains the implications for entities operating in the EU.
What are the implications for aEuropean entity that wants toapply IFRIC 12 before it isendorsed?
The IFRIC’s role is to interpret standardsand issue interpretations that fill gapsbetween standards. It cannot by itselfissue or amend standards. This meansthat, unless an IFRIC interpretation is
accompanied by a consequentialamendment to a standard, it may beused independently of the endorsementprocess. However, IFRIC 12 did containconsequential amendments (to the scopeof IFRIC 4 Determining whether anArrangement contains a Lease and to thedisclosures required by SIC 29 Disclosure– Service Concession Arrangements).Whilst additional disclosure may enable
an entity to comply with SIC 29’srequirements both before and after itsamendment, the lack of endorsement forthe amendment to IFRIC 4 is moreproblematic. Many service concessionarrangements currently fall within thescope of IFRIC 4 and the accountingtreatment may be quite different untilsuch time as the arrangements are takenoutside its scope.
