IFRS News - May 2009

Emerging issues and practical guidance

In this issue:

• The Canadian Report
  • AcSB summarizes factors supporting move to IFRS in 2011
  • New publication available called GAPP or IFRS? An important choice to be made by private companies
• IAS 39 developments
• Fair value measurement: Boards take action
• Beginner’s guide: Consolidation
• Interview: Board member Mary Barth
• Cannon Street Press: Improvements project

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Board accelerates timetable for IAS 39 replacement

The IASB has accelerated its comprehensive project on the replacement of IAS 39 and expects to publish proposals within the next six months. This is in response to the call from the G20 “to take action by the end of 2009 to reduce the complexity of accounting standards for financial instruments.” Jessica Taurae considers what key issues need to be resolved in revising IAS 39 on this expedited basis.

The IASB and FASB reaffirmed their commitment at their meeting in March to a joint approach to the financial crisis and to the goal of seeking convergence between IFRS and US GAAP. The newly formed IASC Foundation Monitoring Board and the Trustees have stated their support for the IASB’s prioritization of the project to produce a new financial instruments standard rather than making further amendments to existing requirements. The new standard will replace IAS 39, on an accelerated basis, with a comprehensive standard that will address key issues arising from the financial crisis. The IASB plans to publish proposals within six months (see timetable below).

Tentative decisions so far

A number of key issues need to be resolved before an exposure draft can be issued; although, the IASB has already made some tentative decisions:

• The project’s primary objective is to provide information that improves decision usefulness; the secondary objective is to reduce complexity.
• It will focus on classification and measurement of financial instruments, including impairment if necessary.
• The question of whether to require fair value through profit or loss for all financial instruments has been taken off the agenda. After listening to comments from previous consultations, the Boards accept that a full fair value model would not simplify accounting at a time when determining fair value has become so much more challenging.
• There will, therefore, be two measurement categories: one fair value through profit or loss and a second measurement basis – see below.

Second measurement basis

The Boards are considering two other measurement methods. The first is amortized cost, which is currently widely used for loans and receivables and many liabilities, and is generally well understood. This seems to be the preferred approach of many IASB board members.

The alternative method is a current value measurement method. This involves a discounted cash flow model that reflects current economic conditions but not such factors as liquidity risk and market imperfections. Investors may consider this model more decision useful, as it reflects current inputs in the measurement process. This seems to be the preferred approach of many FASB board members.

Impairment

An impairment model will need to be determined if amortized cost is chosen as the second measurement model. The Boards favour one model for impairment of all financial instruments. Possible models under consideration are the incurred loss model in current IAS 39, an expected loss model or fair value.

• The incurred loss model does not seem to be the preferred model; there are concerns that it overstates revenue prior to a loss event and that the timing of loss recognition is too late.
• The expected loss model received the most attention at the IASB meeting in April. Interest revenue is recognized on a basis that factors in expected credit losses from day one but does not give rise to a credit loss recognized in profit or loss on initial recognition of the financial asset.
• The fair value model might require accounting at fair value through profit or loss once there is a decline in fair value below amortized cost; or once there is evidence of impairment based on a notion of a credit loss, an impairment loss should be recognized as the difference between carrying value and fair value; or if there is a decline in fair value below cost and management cannot assert its intent and ability to hold until recovery, an impairment should be recognized.
• Other: dynamic or “through the cycle” provisioning has been raised, some of the Boards’ members see these as regulatory rather than accountingprovisions and would not include them in financial reporting.

Classification

Once the Boards decide on the two measurement models, they will need to determine how to classify financial instruments into each category. They are considering a number of approaches, including classification based on the contractual nature of the instrument; classification based on the business purpose for which the instrument is held; classification as fair value through profit or loss (FVTPL) for all instruments that are quoted in an active market; or a combination of the above. The IASB has been focusing on considering the contractual nature of the instrument. If it has highly variable cash flows (for example, derivatives and equities), the instrument should be classified at FVTPL. For those with non-highly variable cash flows, the IASB would overlay a business approach such that if management had the intention to trade the instrument, it should also be measured at FVTPL.

Other matters to be considered

• Is there any ability to move instruments between categories after initial recognition?
• Depending on how classification is determined, should there be a fair value option?
• If liabilities are measured at FVTPL, what to do about changes in fair value due to own credit?
• What should the measurement basis be on initial recognition?
• How should financial instruments be presented?
• What should be in the scope of the ED (for example, own use contracts, loan commitments and financial guarantees)?
• How does hedge accounting need to be amended?
• What should be done about embedded derivatives?
• What disclosures need to be made?
• What should the effective date be and how should entities be required to transition to the new standard?

It is not surprising that the IASB’s staff has indicated that it will schedule additional meetings in August, as well as in between the usual monthly meetings (for example, the IASB discussed the current value measurement model on May 5, 2009). The IASB will also reach out to other interested parties, including Basel Committee on Banking Supervision, securities regulators, the Financial Crisis Advisory Group, the Standards Advisory Council and the IASB’s Financial Instruments Working Group. The next six months will be extremely challenging for the Boards as they try to reach decisions on these issues. Rely on IFRS news to keep you updated.

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FASB and IASB act on fair value measurement

Jessica Taurae looks at actions taken by the FASB and IASB to address political concerns over fair value measurement in the economic crisis.

The IASB and FASB have issued discussion documents in the last few weeks that respond to politicians’ concerns over fair value measurement.

Pressure from the US Congress resulted in the FASB publishing staff position papers (FSPs) on fair value and impairment of debt securities. The IASB then initiated a shortened 30-day consultation process on the FSPs, given the urgency of the issues and the desire of many constituents for consistency on matters relating to the financial crisis.

New FASB requirements

Estimating fair value after a decrease in market activity

FSP 157-4 clarifies the factors that should be considered in estimating fair value when there has been a significant decrease in market activity. The guidance does not change the objective of fair value: to determine the price that would be received to sell an asset or transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants under market conditions at the measurement date.

Other-than-temporary impairments of debt securities

FSP 115-2 establishes a new method of recognizing and reporting other than temporary impairments of debt securities. Impairment is now considered to be other than temporary if an entity:

• intends to sell the security;
• is more likely than not to be required to sell the security before recovering its cost; or
• does not expect to recover the security’s entire amortized cost basis (even if the entity does not intend to sell) — that is, a “credit loss.”

This credit loss is based on the present value of cash flows expected to be collected from the debt security. If a credit loss exists but an entity does not intend to sell the impaired debt security and is more likely than not to be required to sell before recovery, the impairment is other than temporary. It should, therefore, be separated into:

• the estimated amount relating to the credit loss
• all other changes in fair value.

Only the estimated credit loss amount is recognized in profit or loss; the remaining change in fair value is recognized in other comprehensive income. This approach more closely aligns the impairment models for debt securities and loans by reflecting only credit losses as impairment in profit and loss.

IASB proposals

The IASB has considered more than 70 responses received to its Request for Views consultation on the FSPs, as well as comments from the Financial Crisis Advisory Group, Standards Advisory Council and other interested parties. The Board’s conclusions are set out below.

Fair value measurement

The IASB agreed with respondents that the FASB guidance on fair value measurement was broadly consistent with existing guidance on IFRS contained in the IASB’s Expert Advisory Panel (EAP) report. The two documents have different emphases (the FSP focuses on indicators of inactive markets; the EAP requires management to consider all available information and to apply judgment) and a few subtle differences (for example, on transactions that are not orderly). However, this was not expected to result in differences in practice. Guidance from the FSP and the EAP will be included in the exposure draft on fair value measurement that the IASB is expecting to publish in May 2009.

Impairment of debt securities

There are a number of significant differences between IFRS and US GAAP on impairment. The IASB will consider the accounting for all aspects of impairment of financial assets in the context of their broader project on financial instruments, rather than making limited short-term amendments at this time to level the playing field. The IASB is working with the FASB on this comprehensive project; both Boards plan to issue an exposure draft within the next six months.

These decisions are consistent with the recommendations and timetable set out by the G20 in April for standard-setters “to take action by the end of 2009 to reduce the complexity of accounting standards for financial instruments” and to “improve accounting standards for provisioning and valuation uncertainty.”

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Beginners’ guide: Consolidation

What is on- and, more importantly, off-balance sheet has received a lot of attention during the credit crunch. Michael Stewart and Yulia Feygina of PricewaterhouseCoopers’ (PwC) Global Accounting Consulting Services’ Central team look at how consolidation decisions are made.

Consolidation is the reporting in one set of financial statements the assets and liabilities of all the entities that the reporting entity controls. Consolidated financial statements are presented as if all of these controlled entities (the group) were a single reporting entity. Why is this important? Analysts and other users want information that is useful in predicting an entity’s future cash flows and, in particular, a good picture of the entity’s obligations.

Future cash inflows arise from the reporting entity’s ability to use economic resources (assets) to its advantage. Future cash outflows reflect its need to use cash to meet obligations (pay liabilities). Management should, therefore, consolidate the appropriate assets and liabilities to give a balanced view of the group. Consolidating more assets than the reporting entity has the ability to control, or excluding liabilities that the reporting entity is required to pay, would present a misleading picture. Users of the financial statements might draw the wrong conclusions about the group’s likely future cash flows. Investors’ views of a reporting entity’s future cash flows have a direct impact on the entity’s share price. Unexpected changes in the market’s views of those cash flows will cause the share price to change and may lead to a loss of confidence in the reporting entity’s management and its prospects for the future.

Accounting standards (IAS 27, Consolidated and Separate Financial Statements, and Standard Interpretations Committee 12, Consolidation — Special Purpose Entities) require consolidation of all entities controlled by the reporting entity. Control is defined as the power to govern financial and operating policies of the subject entity so as to obtain benefits from its activities.

Most consolidation decisions are straightforward. Control is deemed to exist when a reporting entity, directly or indirectly, owns more than 50% of the subject entity’s voting shares. This is because holding a majority of voting rights normally ensures sufficient representation on the subject entity’s board of directors, or equivalent governing body, to convey the power to govern that entity’s actvities. Consolidation analysis seldom has to go further than this. A large multinational group might have hundreds or even thousands of wholly owned subsidiaries that are legal entities, and the consolidation decision may be very simple for all of them.

Ownership of a majority equity interest, however, is not always representative of the ability to govern a subject entity. Key operating and financial decisions may require more votes than a simple majority, or board of directors’ representation may not be proportionate to the equity interest held. A closer analysis of the governance of the subject entity may be needed. This requires a thorough understanding of what key decisions need to be taken in the normal course of business, how these decisions are made and the extent of the reporting entity’s involvement in making these decisions. It is the power to unilaterally govern the subject entity that drives a conclusion whether the reporting entity controls.

Complications may arise, however, when the subject entity is an SPE. An SPE is an entity established to accomplish a narrow, well-defined objective – for example, to effect a lease or a securitization transaction.

Reasons for the use of SPEs

• Risk sharing: Corporates may use SPEs to legally isolate a high-risk project/asset from the parent company and to allow other investors to take a share of the risk.
• Competitive reasons: An SPE may be established to develop and own intellectual property to take advantage of preferential tax rate and regulations or protect it more effectively from competitors.
• Regulatory reasons: An SPE may be set up to overcome regulatory restrictions, such as regulations relating to nationality of ownership of specific assets.
• Tax schemes: Some jurisdictions have different tax rates for capital gains and gains from property sales. SPEs are created to hold specific properties and are sold and bought instead of the actual properties, effectively converting property sale gains into capital gains for tax purposes. An SPE may also transfer tax benefits from one entity to another or move taxable income into a lower tax jurisdiction. These are some of the most common reasons that SPEs are used, often more than one applies in any particular SPE. A close relation of the SPE is the single asset entity, in which a single revenue-producing asset such as a ship, an investment property or an airplane is in a corporate wrapper but is the only asset of the legal entity.

A distinguishing feature of an SPE is that it lacks routine decision-making processes relating to its activities compared with a regular operating entity. This is because an SPE’s activities are limited and predetermined from the outset. Another characteristic of an SPE is that it is normally funded largely by debt, with only a modest amount of equity, if any at all. The equity may be held by a non-profit organization. There is usually little or no residual interest that flows to the equity holders after the debt holders are paid.

These characteristics make it harder to determine who controls the SPE. An analysis of the governance and voting rights used for regular operating entities is not relevant to an SPE. Consideration is, therefore, given to other factors. The starting point is an analysis of an SPE’s activities and understanding on whose behalf they are conducted. For example, when a reporting entity creates an SPE to securitize loans that it originated, the SPE’s activities typically serve the reporting entity’s business needs; it will, therefore, often end up consolidating the SPE. If a reporting entity establishes an SPE into which third party loans are securitized, the SPE’s activities are conducted on behalf of those third parties; the reporting entity will seldom consolidate the SPE unless there are other circumstances that indicate control.

Another factor is the participation in the risks and rewards of the SPE. Entitlement to a majority of the rewards from an SPE’s activities and exposure to the majority of its risks may indicate that the reporting entity controls the SPE and should consolidate it. The logic behind the risks and rewards approach is that an entity that derives the majority of the rewards from an SPE and has exposure to the major risks of its activities must have control; otherwise, it would not have accepted the risks and would not have been given access to the rewards.

Possible rewards include fees, a better credit rating and reduced borrowing costs, and participating in the potential upside of SPE assets. Benefits can be of a regulatory nature. For example, the reporting entity can conduct business in a regulated market by conducting the business activities through an authorized SPE.

How might a reporting entity be exposed to the risks of an SPE? A reporting entity sells loans and receivables to an SPE that is financed by third party investors. The reporting entity provides a guarantee to the SPE’s investors that credit losses will be no more than a preset percentage of assets. The credit guarantee effectively returns the risks associated with the loans and receivables sold to the SPE back to the reporting entity; the investors act, in substance, as capital providers with a promised minimum return. Exposure to risks, combined with the fact that the SPE’s activities are conducted on behalf of the reporting entity, may lead to the conclusion that the reporting entity should consolidate the SPE.

Management analyzes an SPE by considering all relevant facts and circumstances together. For example, in the scenario above, the major risk associated with the SPE is credit risk. The same arrangement with a third party insurance policy to cover the credit risk does not necessarily mean that the insurance company has the majority of risks and should consolidate the SPE. It is the substance of the relationship with an SPE that drives the consolidation decision. Assessing control over an SPE needs to be updated. Changes in the reporting entity’s involvement with the SPE, in the SPE’s governing rules, in its capital structure or in contractual arrangements may indicate that the substance of the relationship has changed and, thus, change the consolidation decision.

Credit crunch

Banks establish SIVs in the normal course of business. An SIV is a type of SPE established to invest in diversified portfolios of interest earning assets, usually asset backed securities (for example, mortgages) and other debt instruments. SIVs are typically funded through the issue of commercial paper, medium-term notes or other senior debt (collectively referred to as senior debt), as well as via subordinated notes (commonly referred to as capital notes). This level of subordination determines the order in which investors receive cash flows from the SIV.

See the typical SIV funding structure below.

A bank typically provides only limited liquidity support to the senior debt investors through liquidity facilities. It would not have consolidated the SIV. Liquidity in SIVs is primarily managed by refinancing debt at maturity or, if that is not possible, by selling assets to provide protection to senior debt holders.

This worked well until mid-August 2007, when markets started experiencing severe liquidity disruptions, driven by valuation concerns over securities linked to US sub-prime mortgage loans. This resulted in funding difficulties for many SIVs. It soon became clear that the liquidity constraints were not temporary. Some sponsoring banks provided additional funding to the SIVs and sometimes initiated restructuring of the affected entities. This allowed third party investors to exchange their capital notes in the existing structures for notes issued by the restructured SIVs, with liquidity provided by the bank. The support provided by the banks indicated that the substance of their relationship with the SIVs changed such that the banks were required to consolidate the SIVs from that point onward.

Consolidation helps provide information about the assets that a reporting entity has access to and the obligations it must pay. This allows a user of the financial statements to consider the implications for the reporting entity’s future cash flows. What happens when the current involvement of the reporting entity and, hence, its risk exposure, of a reporting entity is limited so that consolidation is not required? A change occurs in the degree of involvement between the reporting entity and the SPE. Suddenly, the reporting entity has potentially undetermined additional exposures. This became an acute concern as the credit crisis unfolded and SPEs’ sponsoring banks stepped in, in some circumstances, to provide liquidity to support the vehicles they had created.

Concerns were expressed about consolidation decisions, particularly, for SPEs, and about the perceived inadequate disclosures for non-consolidated SPEs. The Financial Stability Forum called on the IASB to accelerate work on a new consolidation standard. ED 10, Consolidated Financial Statements, was published in December 2008. The ED retains the principle of control and the prime driver of consolidation decisions but will incorporate additional guidance for more challenging decisions. ED 10 also proposes additional qualitative and quantitative disclosures of the entity’s involvement with unconsolidated SPEs. It is expected to be issued as an IFRS in December 2009 and become mandatory in 2010.

Entities should start thinking about the SPEs they are involved with and their related exposures now. Many observers felt that ED 10 will not bring fundamental change in consolidation decisions, but the final standard will need careful analysis.

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Memoires of a founding IASB member

Mary Barth has been a member of the IASB since its inception in 2001. Her term ends next month. She talks to IFRS news about the highs and lows.

What were you main areas of focus during your time at the Board?

I joined the Board right back when it first started in 2001. Since then I’ve worked on a variety of technical projects, like all members. I also became the unofficial editor of some of the Board’s texts and was consulted on editorial detail. My background in academia I guess gave me the reputation for caring about this sort of thing.

Board members also act as ‘board advisers as a resource for the staff. The staff can call on us to work through issues. For example, I consulted on the conceptual framework, revenue recognition, IAS 37 and fair value measurement, among other areas. Again, because I’m an academic, I often found myself involved in projects that were more about conceptual thinking. That suited me just fine; that’s the way I think about things.

But I have a number of other roles outside the Board, which were pretty complementary to my role as board member — the various roles are somewhat inseparable. I engaged the accounting academics by doing presentations on research, kept them up to date on developments, helped them figure out how to do research that would help the Board, and advised on how to teach IFRS. None of these roles is a part-time job – it’s more like having several full-time jobs. But there’s a nice synergy, which makes it workable.

What changes have you seen in standard setting during this time?

We have matured as an organization and figured out how to operate, although there’s still more to learn. It has been fun to watch. At the start, few countries and companies were using our standards, and then Europe came on board and others started to follow. We didn’t expect this would happen. We all had a vision, which is why we wanted to be part of it and put our energies into it, but I don’t think any of us would have predicted we’d get to where we are today. We never thought the US would even consider adopting IFRS. We dreamed that within, say, ten years of the board’s inception, the U.S. Securities and Exchange Commission (SEC) would have removed reconciliation requirement; and when it happened (last year), it was a big milestone. But this potential for the US to adopt IFRS has come as quite a surprise.

It is great what has happened. I don’t attribute it to the IASB’s success – we can’t force anyone to adopt IFRS – but it has happened on our watch, we helped facilitate it. From that point of view, it’s great because we believe in what we’re doing: making financial reporting better around the world. Having said that, being in the limelight is also being in the firing line! In terms of the way the process has evolved in these eight years, we have become more efficient and effective – the introduction of the board adviser concept mentioned above is one example of how we have improved.

What should the Board’s priorities be?

I believe our main priority — to work to improve the standards — is right. But as for which projects are priorities, the Memorandum of Understanding (MoU) is important because it helps us to improve the standards, which in turn promotes convergence and gets us closer to our ultimate vision that we all use the same standards. The US is the last major capital market that hasn’t adopted IFRS (besides Japan, which also is planning to adopt IFRS soon), so we hope the MoU will help promote convergence.

How is the US convergence project going?

Fine! The MoU’s targets and time frame are pretty aggressive, and the FASB is helping us meet those targets. That is within our control. However, the SEC’s decision to adopt IFRS is not within our control; we can only do our best to write high-quality standards and move things along. I’m an eternal optimist and a globalist, and I don’t think the US has any choice but to mandate IFRS — it’s a question of “when” not “if.”

There is no reason to have different standards around the world. The rest of world has worked this out. When we started, people saw US GAAP as the international standards by default. But as more territories took on IFRS, this changed. I believe there may be more entities as a percentage of market capitalization using IFRS than US GAAP. This is powerful.

Who will take over from Sir David Tweedie?

I wish I knew! He has two more years left as chairman. But the qualities needed are more than technical accounting. The chairman needs to be able to manage an organization and the whims of the various constituents and politicians. It takes a diplomat, someone who is even-handed and has a thick skin. You have to know how to take the criticism but also when to defend your position.

Will the absence of women change the dynamic of the Board?

It is hard to tell. The new board members have not been announced yet, and I’m hopeful there won’t be an absence of women. It’s important to have women on board because female accountants (and all women) need role models and to see other women in these positions.

What will be the best memory you take away with you from your time at the Board?

One event in particular that I will never forget is when the SEC decided to remove the reconciliation requirement. We stopped the board meeting that was going on at the time and put the video screen up. We all watched the live webcast of the SEC meeting, and everyone was stunned. We had been working toward it so for long and yet, when it happened, we couldn’t believe it. It was a shared moment where we saw the tangible evidence of progress being made.

Being on the Board has been an unbelievable experience. On a professional level, it has been very interesting, challenging, thoroughly enjoyable. But mostly I have enjoyed the people I have interacted with. The Board is made up of very special individuals, and we spend a lot of time together. And beyond that are our constituents around the world. Continuing in academia fortunately means I will see some of these people again.

What are your plans for the future?

I will now focus on being of professor of accounting at Stanford. I will not disappear from the standard-setting scene. I want to continue to support the Board and its mission. I’ll be talking at the International Accounting Standards Committee Foundation conferences and about teaching and research. I won’t miss the air travel though!

What one piece of advice would you give to a new board member?

That the number one job of the Board is to improve the standards. Any new member needs to focus on that, on getting the principles right, and should try not to get frustrated or distracted by the slings and arrows from outside. It takes time and energy to deal with these onslaughts, but you have to keep your eye on the ball and have the courage of your convictions. Remember, it’s not personal. Find it interesting and don’t panic.

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Cannon Street Press

Board amends 12 standards

The 2009 Annual Improvements have been published by the IASB in April. There are three amendments to IAS 39 out of five considered by the Board. The other two were postponed as the Board will reconsider these as part of the new financial instruments standard. The amendments are effective for annual periods beginning on or after January 1, 2010. Early adoption is permitted. They are subject to EU endorsement.

See table: 2009 Annual Improvements

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