Standard setters continue their work on financial instruments (FI) accounting in response to the financial crisis. The FASB has released its long-awaited comprehensive exposure draft (ED) on accounting for FI. The IASB continues its topic-specific approach, releasing its proposal for accounting for financial liabilities. Elizabeth Lynn of PricewaterhouseCoopers’ (PwC) Accounting Consulting Services central team looks at the details of the proposals.
Both boards have undertaken a comprehensive review of FI accounting. The IASB is approaching its project in phases: classification and measurement, impairment and hedging. The IASB’s proposals for changing the accounting for financial liabilities were contained in the May 2010 ED, Fair Value Option for Financial Liabilities. The IASB has already published guidance on accounting for financial assets, in IFRS 9, Financial Instruments, in 2009.
The IASB’s proposals on impairment and interest recognition are different from those of the FASB.
The FASB’s proposal includes classification and measurement, impairment and revisions to hedge accounting. It also proposes extensive new presentation and disclosure requirements. The IASB and FASB are working on these projects at the same time, so the FASB’s proposals may impact the IASB’s deliberations.
The classification and measurement of financial liabilities under IFRS will remain the same, except where the financial liabilities are designated at fair value through profit or loss (FVTPL). Existing requirements for liabilities are generally seen to work well, and none of the alternative approaches considered by the IASB would be less complex or provide more useful information.
The only proposed change in accounting is for entities with financial liabilities designated at FVTPL. First, all changes in fair value of the financial liability would be recognized in the profit or loss. Second, the change in value due to changes in the liability’s credit risk would be recognized in other comprehensive income (OCI), with an offsetting entry to profit or loss.
The main concern regarding liabilities is the impact of “own credit” for liabilities recognized at fair value—that is, fluctuations in value due to changes in the liability’s credit risk in the income statement. This can result in gains being recognized in income when the liability has had a credit downgrade, and losses being recognized when the liability’s credit risk improves. Many users find this result counterintuitive, especially, when there is no expectation that the change in the liability’s credit risk will be realized.
Financial liabilities that are required to be measured at FVTPL (as distinct from those that the entity has chosen to measure at FVTPL) will continue to have all fair value movements recognized in profit or loss with no transfer to OCI. This includes all derivatives, such as foreign currency forwards or interest rate swaps, or a bank’s own liabilities that it holds in its trading portfolio.
The FASB has published significantly different proposals from the IASB on financial instrument accounting in its proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities. The more significant difference relates to the classification and measurement approach for financial assets. IFRS 9 requires amortized cost measurement for certain financial instruments; versus a proposed fair value through OCI approach under US GAAP.
Classification and measurement
The FASB proposes that most financial instruments should be measured at fair value, except for core deposit liabilities of financial institutions, which would be valued using a new remeasurement methodology. Trade receivables and payables may be recognized at amortized cost if certain criteria are met. All changes in fair value would be recognized in net income unless an instrument qualifies and the entity elects to recognize those fair value changes in OCI. The determination of whether an instrument qualifies for OCI treatment focuses on an entity’s business strategy and the instrument’s characteristics. There will also be a limited exception that allows certain financial liabilities to be recognized at amortized cost.
Financial assets for which OCI treatment or amortized cost is elected would be subject to a single credit impairment model. A credit impairment would be recognized in net income when an entity does not expect to collect all of the contractually promised cash flows. An entity would no longer wait for a probable event before recognizing a loss.
Hedge accounting would be available for financial instruments where OCI or amortized cost treatment has been elected. The risks that are eligible for hedge accounting would remain unchanged. However, it would be easier to qualify for hedge accounting because a hedging relationship would only need to be reasonably effective (no longer highly effective).
The IASB’s proposals impact entities that have designated financial liabilities at fair value through profit or loss. For example, they will impact financial institutions that have designated liabilities at FVTPL to eliminate an accounting mismatch with financial assets that are held at FVTPL, or to avoid bifurcating an embedded derivative.
If the proposals are agreed, they will be applicable for financial periods beginning on or after January 1, 2013.
The FASB’s proposals will affect entities applying US GAAP across all industries that hold or issue financial instruments and that apply hedge accounting. Financial institutions (especially, retail and commercial banks) are likely to be most significantly impacted
by these changes.
The comment period for the IASB ED closes on July 16, 2010. The FASB comment period closes on September 30, 2010. We encourage management to reply.
The IASB has published an exposure draft (ED) that would require all entities to present a single statement of comprehensive income. This amendment to IAS 1, Presentation of Financial Statements, will eliminate the option in the existing version of the standard to present a separate income statement. The proposals have been developed jointly with the FASB, which has issued a similar proposed amendment to US GAAP.
The proposals retain the concept of net profit, but entities will also be required to present total comprehensive income on the face of the single performance statement. Subtotals for net profit or loss and other comprehensive income (OCI) will be presented as separate sections of the single statement of comprehensive income. Earnings per share will continue to be based on net profit or loss.
The proposals make no change to the items that are presented in net profit or loss and OCI, and the option to report the components of OCI, either gross or net of income taxes, will be retained. Items included in OCI that may be recycled into profit or loss in future periods (for example, cash flow hedges and the cumulative translation adjustment) will be presented separately from those that will not be recycled (for example, revaluations of property, plant and equipment and actuarial gains and losses).
The title of the statement will change to statement of profit or loss and other comprehensive income. However, the flexibility to use other titles for the primary financial statements is retained.
The proposed amendment will affect all entities and change the appearance of the performance statement. Entities that currently present a separate income statement will be required to prepare a single statement showing both net profit and OCI. Entities that currently present a single statement will be required to change the format of the OCI section to separate items that might be recycled from items that will not be recycled.
The measurement of net profit or earnings per share will not change, but these will be presented differently in the financial statements. Management should consider how this will be explained to investors and other users of the financial statements.
Comments on the proposals are due on September 30, 2010. The Board expects to finalize the amendment in the second
half of 2010. Management should consider whether to respond to the IASB. Management should also consider the implications of the proposed changes for the presentation of results and how this should be communicated to the users of the financial statements.
PwC’s Global Communications Industry group hosted the 7th annual Global Communications GAAP Summit on June 7-8. The Summit was a day-and-a-half event that focused on changes and technical accounting issues occurring in the communications industry.
This year’s event was held in Madrid, Spain, with a theme of “Ready for the next wave?” The agenda focused on the commercial, accounting and reporting issues that the industry faces with impending new standards, including pronouncements on:
• Revenue recognition – impact on key metrics and systems complexity?
• Leases – bad for gearing but good for EBITDA?
• Liabilities and provisions – a new layer of complexity?
• Joint ventures and consolidation – potential for simplification?
The conference covered existing areas of GAAP that continue to pose questions for operators, including accounting for new service offerings, network and operational costs and licences. Guest speakers from Deutsche Telekom, Telcom Italia and Telefónica shared their views on the industry and on some of the regulation that affects the communications sector. Over 100 people from operators around the world attended.
Contact: firstname.lastname@example.org for more details.
Shelley So of PwC’s Accounting Consulting Services in Hong Kong looks at items under scrutiny in the IASB’s pre-implementation review of the new business combinations standard.
IFRS 3 (revised 2008) (IFRS 3R) is the first “official” converged standard between IFRS and US GAAP. The new standard has resulted in more earnings volatility—for example, expensing transaction costs, gain/loss in fair valuing the previously held interests and subsequent measurement of contingent consideration. Few preparers have adopted early, so 2010 is the first year most will adopt IFRS 3R and IAS 27R.
Unusually, amendments have been made that apply to IFRS 3R and IAS 27R before they were even effective. The IASB has received a number of requests for clarification and guidance since the standards were issued two years ago.
The IASB did not wait for a post-implementation review but has decided to look at some of the implementation issues earlier. These issues include transition arrangements, contingent consideration, non-controlling interests, implications for equity accounting and separate financial statements.
The Board and IFRIC have been discussing the implementation issues since May 2009. Four issues were included in the 2010 Annual Improvements, but other clarifications have come from IFRIC agenda decisions, IASB Updates and other guidance.
Below is an overview of the issues that the Board and IFRIC have considered so far.
The Board looked at transition arrangements in a number of areas, as described below:
• Contingent consideration arising from business combinations whose acquisition dates preceded the adoption of IFRS 3R (pre-adoption contingent consideration). The IASB has amended the IFRS 3R transition provisions and made consequential amendments to IFRS 7 and IAS 32 to clarify that pre-adoption contingent consideration has been grandfathered (2010 Annual Improvements). The IASB has carried forward the IFRS 3 (issued 2004) requirements on accounting for contingent consideration into the transition provisions of IFRS 3R.
The amendment is effective for annual periods beginning on or after July 1, 2010. However, it requires retrospective application from the date when the entity first applied IFRS 3R. Entities should adopt the amendment at the same time that they adopt IFRS 3R.
The Board has not extended this exemption to first-time adopters. First-time adopters that adopt IFRS 3R in their first IFRS financial statements should account for subsequent changes in contingent consideration in accordance with IFRS 3R regardless of when the related acquisition happened.
The change from minority interest to NCI was more than a change in name; it was also a change in definition. This change has widened the scope of instruments included in NCI—for example, options or warrants over an entity’s own shares that are classified as equity and the equity component of a convertible instrument are now in NCI. The Board and IFRIC have addressed several NCI-related issues in addition to the transition requirement for negative NCI (above). These are considered below.
Measurement of NCI
IFRS 3R allows an entity to measure NCI, either at its acquisition-date fair value or at the NCI’s proportionate share of the acquiree’s identifiable net assets. The Board confirmed in the 2010 Annual Improvements that such measurement choice is only applicable to present ownership instruments that entitle their holders to a proportionate share of the entity’s net assets in the event of liquidation. All other components of non-controlling interests are measured at their acquisition-date fair values unless IFRS requires another measurement basis. This might be, for example, IFRS 2 for the acquiree’s employee share options. The Board has also included some illustrative examples in the annual improvement.
Unreplaced and voluntarily replaced share-based
An aquiree’s equity-settled shared-based payment transactions are a component of NCI under the revised standards. IFRS 3R specifies the accounting for the acquiree’s share-based payment transactions that the acquirer is obliged to replace or that expire as a consequence of the business combination. It is silent on the accounting for unreplaced or voluntarily replaced share-based payment transactions.
The Board has added additional guidance in this area in the 2010 Annual Improvements. It distinguishes the accounting treatment for transactions that expire as a result of the acquisition, which is recognized as post-acquisition expense, from those that do not expire in the event of a business combination—that is, NCI. The measurement of the replaced or unexpired share-based payment transactions is split between transferred consideration and post-combination expense.
Transaction costs for NCI
IAS 27R requires acquisitions and disposals of NCI that do not result in a loss of control of the entity to be accounted for as equity transactions. IAS 1 paragraphs 106(d)(iii) and 109 state that transaction costs related to transactions with NCI are not part of the income statement. The IFRIC, therefore, rejected a request to add the accounting of transaction costs for NCI to its agenda, confirming that the treatment of transaction costs for raising equity is clear.
Reattribution of other comprehensive income (OCI)
The Board has confirmed that when there is a change in ownership interest in a subsidiary without loss of control—that is an equity transaction. The parent reattributes OCI between the owners of the parent and NCI.
The interaction between IFRS 3R and the financial instrument standards is intensified. Contingent consideration is now within the scope of IAS 39. Written puts over NCI as well continues to be a challenging area.
Designation of contingent consideration
Neither IFRS 3R nor IAS 39 specifies the categories into which contingent consideration assets and liabilities are classified; although, the guidance on measurement is explicit. Contingent consideration not classified as equity is generally accounted for as if it were a derivative in IAS 39. Changes in fair value are recognized in the income statement. However, IAS 39 (and IFRS 7) requires classification of financial assets and financial liabilities into categories for determining what disclosures are required of financial instruments. The Board, in its May 2009 meeting, decided to address this issue in the IAS 39 replacement project. The IFRIC has also recommended the Board bring together in one IFRS the measurement guidance for contingent consideration that is a financial instrument.
Classification of contingent consideration
The “fixed-to-fixed” question arises when a contingent consideration arrangement is settled in an entity’s own shares. IAS 32 allows equity classification only when an entity will settle the contracts by delivering a fixed number of its own shares in exchange for a fixed amount of cash or another financial asset.
As the fixed-for-fixed assessment is not unique to contingent consideration arrangements, the Board has decided that this issue should be addressed in the debt/equity project and not on a stand-alone basis for IFRS 3R.
Put options written over non-controlling interests (NCI put)
A parent company may enter into a commitment through a call option, a written put or a forward purchase to acquire shares in a subsidiary held by NCI. The initial and subsequent accounting for these instruments continue to challenge preparers and auditors.
The IFRIC has decided to add the accounting for puts over NCI to its agenda. Having observed that there is a potential conflict between IAS 32 and IAS 39, and the requirements in IAS 27R, the IFRIC will attempt to provide guidance in this area. The IFRIC staff will develop a paper for further discussion in its July 2010 meeting.
The revisions of IFRS 3 and IAS 27 have had an impact on the standards for equity accounting and joint ventures.
Significant economic event
The Board previously concluded that the loss of control of an entity and the loss of significant influence/joint control over an entity are economically similar events and should be accounted for in a similar manner. It, therefore, has revised the accounting for loss of significant influence/joint control in IAS 28 and IAS 31 as part of the consequential amendments of IAS 27R.
However, during recent deliberations of the joint venture project, the Board has tentatively decided to redefine “significant event” in the context of loss of joint control and significant influence; and that a move from joint control to significant influence is not a significant event. The Board considers this change to be consistent with the conclusion that a retained interest is not remeasured when an entity has lost joint control but retains significant influence in an investee.
The Board has also tentatively decided that when an entity disposes of a partial interest in a joint venture or in an associate, it only reclassifies the interest it committed to dispose as held-for-sale; it continues to account for the retained interest using the equity method until the disposal occurs.
The impact of this Board decision is not limited to IFRS 5 and could be pervasive. Recently, the Board tentatively decided to amend IAS 21, The Effects of Changes in Foreign Exchanges Rates, to treat the loss of joint control with the retention of a significant influence as a partial disposal instead of a disposal. The IFRIC will also reconsider a request to amend IAS 21, Repayment of Investment/CTA, and has directed the staff to continue this analysis for future deliberation. It remains to be seen if there will be other implications from this Board decision.
Interaction with separate financial statements (SFS)
Many IFRS preparers look to the definition of cost of a business combination in IFRS 3 for guidance to measure the cost of investment in subsidiaries, associates and joint ventures in their SFS. This is partly because cost is not defined in IAS 27R, and many preparers believe that the initial measurement for the consolidated and separate financial statements should be the same. IFRS 3R eliminated the notion of the cost of a business combination. It is unclear how the change from cost to consideration should impact the measurement of the cost of investment in the SFS, in particular, with respect to contingent consideration, transaction costs and fair value adjustments.
The Board, in its May 2009 meeting, considered that a detailed review of these issues should be performed as part of the consolidation project. However, given the current scope of that project and the expected timing, it is unlikely that SFS issues will be addressed in the project.
Certain issues have already been identified as potential candidates for the post-implementation review. These include non-contractual customer relationships; whether indemnification assets are part of the business combination transaction or a separate transaction; and whether any diversity has appeared around “what’s a business.”
The FASB has also been looking at early issues arising from the converged standards. Two issues have been discussed by the IASB as well: assumed contingent consideration arrangements and the meaning of “subsidiary.”
Assumed contingent consideration of the acquiree
The FASB concluded that assumed contingent consideration retains its nature as contingent consideration under US GAAP and is measured in accordance with SFAS 141(R) (at fair value through profit and loss). The IASB in its June 2009 meeting clarified that assumed contingent consideration does not meet the definition of contingent consideration in the acquirer’s business combination in accordance with IFRS 3R. Instead, it is one of the identifiable contractual liabilities assumed in the subsequent acquisition. However, because of the difference in the accounting for financial instruments under US GAAP and IFRS, treating it as part of the identifiable assets and liabilities of the acquiree or as contingent consideration will generally not have different accounting consequence under IFRS. This is because most contingent consideration obligations are financial liabilities within the scope of IAS 39. Accordingly, the Board did not add this item to the annual improvement project.
Meaning of a subsidiary
The FASB clarified that ASC 810 applies to the disposal of businesses that are not subsidiaries. The IASB considered the issues addressed by the ASU. It considered that the definition of a subsidiary included unincorporated entities and concluded that no further guidance was necessary.
The Board covered a wide range of issues at the pre-implementation stage of IFRS 3R, addressing some of the practical difficulties in implementation. Some issues remain and, with the implementation of the revised standards, this year, additional practical issues will continue to arise. The implementation of the revised standards is just the beginning of the journey.