22-24 May 2002, London

22 May 2002

Performance Reporting:

Analysis of Expenses by Nature or Function

The Board discussed whether the performance statement should analyse expenses by nature (for instance, staff costs, raw materials, and income taxes) or by function (for instance, cost of sales, administrative expenses, and selling expenses). The Board considered the following approaches:

• Require one of the two methods.
• Allow both methods.
• Require one of the methods with supplemental dislosure of information on the other basis (a 'mixed presentation').

Board members noted that analysis by nature is not as straightforward as it might appear becausee some companies do not produce information in that format for internal management purposes. Moreover, most Board members felt that reporting by function is more meaningful and it is used in managing the business.

An issue in analysis by function is allocating expenses to categories. For example, should freight costs be part of cost of sales or part of selling expenses? Some Board members felt that the IFRS should provide guidance on allocation; otherwise there is likely to be a lack of comparability between entities. On the other hand, a few Board members were concerned that adopting analysis by function may lead to a prescriptive approach.

During discussion, a majority of the Board indicated they would not support a requirement to produce two performance statements, one by function and one by nature.

No votes were taken, but the Board consensus seemed to support a functional analysis on the face of the performance statement, unless such as analysis is impossible or unmeaningful, and not to allow a mixture of function and nature. However, certain analysis by nature should be required in the notes, particularly labour, material, deprecation, and amortisation expenses. Moreover, disaggregation of the functional categories by nature should not be prohuibited (for example, cost of sales could be disaggregated into labour, materials, etc.).

The Board also decided that it should not prescribe which functional headings to be presented, since the appropriate headings would differ between industries or entities. The Board asked its staff to investigate whether presentation by function is likely to be inappropriate in particular industry sectors.

Discontinuing Operations

There was a brief discussion about reviewing the definition of discontinuing operations. It was noted that the IAS 35 definition is preferable to the UK ASB definition in FRS 3. The Board supported requiring a separate category in the performance statement. If the results of discontinuing items are shown as a single net figure on the face, the constituent line items must be shown separately within the notes.

Extraordinary, Exceptional, and Unusual Items

The Board agreed that these items should not be defined in the IFRS on performance reporting. Further, there would be no individual line for such items; instead, they should be included within the relevant line item -- either disaggregated on the face of the performance statement within the relevant item or disclosed separately in the notes.

Provisions - Revision to Estimates

Under the two-column approach being considered for the performance statement, gains and losses that arise on the remeasurement of assets and liabilities should be separately presented in column two. The Board discussed the distinction between the two columns. The Board felt that defining column one as 'events of the current period' is too simplistic because the facts that change an estimate are also an event of the current period. The general feeling was that initial recognition would be shown in column one and that remeasurement would appear in column two.

A vote was taken on the following three possible methods of showing revisions to estimates of provisions:

1. All revisions to estimates of provisions shown in column one.
2. All provisions and revisions to them relating to working capital items should be shown in column one. For non-working capital items, initial recognition should be in column one and revisions to estimates should be in column two. For example, revisions to estimates for warranties would be shown in column one, but revisions to environmental contamination provisions would be shown in column two.
3. For all items, initial recognition should be shown in column one and revision to estimates should be in column two.

Two Board members voted for method one, four voted for method two, and six favoured the third approach (two Board members were absent). It was noted that the third option would result in movements in bad debt provisions, write-offs of uncollectible accounts, and inventory write-downs presented in column two.

Other Items

The allocation of the unwinding of the discount on provisions was discussed. Some Board members felt this should go to column one. However, others believed that, if the operating-financing split is to be defined by reference to a net debt notion, it would need to go to column two. This issue was unresolved and will be discussed at a later meeting.

Another item discussed was the allocation on the performance statement of the difference between selling price and amount received on sales in foreign currency. While a formal vote was not taken, the Board seemed to conclude that this is s column two item to be shown in the same category as the bad debt expense (normally in administrative expenses).

Business Combinations:

Business Combinations - Phase I

Subsequent Recognition of, or Changes in the Values Assigned to, the Acquiree's Ientifiable Assets, Liabilities and Contingent Liabilities

The Board confirmed that at the acquisition date, the best estimate of fair values of net assets should be used. Regarding new information the comes to light after the acquisition has been initially accounted for, the Board agreed that an adjustment to the initial numbers (and hence to goodwill) should only be made where it is an adjustment for an error. The adjustment of the error in the fair values should be made as a prior year adjustment. Revisions of estimates other than errors should not lead to an adjustment to the fair values but, instead, should recognised in the income statement. The IFRS will provide guidance on what is an error and what is a change of estimate.

SIC 22, Business Combinations - Subsequent Adjustments of Fair Values and Goodwill Initially Reported, is being incorporated into the IFRS but will be amended to reflect the decision agreed on.

The draft IFRS is almost finished. It will be distributed to the Board on the evening of 22 May. The Board will have a 3 week period on which to make their comments.

Business Combinations - Phase II

The Board discussed several of the issues associated with the application of the purchase method that are being considered as part of the phase II joint project with the FASB:

Application of the Purchase Method - Value of Large Block of an Equity Instrument

The fair value of a large block of equity instruments might differ from the market price of a single equity instrument multiplied by the number of equity instruments issued. The FASB has tentatively agreed that consideration of this issue should be deferred until the resolution of a current SEC project addressing fair value and the blockage factor related to valuing unrestricted investments. Therefore, the FASB's Exposure Draft will note, consistent with the current guidance in Statements 141 and 142, that discounts may be appropriate in some circumstances when determining the fair value of securities issued in a business combination. However, current practice in the US for measuring the value of a business combination is to exclude discounts, or blockage factors, in determining the fair value of the consideration paid.

As part of phase I of the business combinations project, the IASB had agreed to include in the IFRS paragraph 10 of SIC 28. At today's meeting the Board agreed to remove the sentence of this paragraph that relates to where the "published price at the date of exchange is an unreliable indicator only when it has been affected by an undue price fluctuation or a narrowness of the market" and replace it with wording that is consistent with the revised IAS 39.

Application of the Purchase Mthod - Accounting for Acquisition-related Costs Incurred in a Business Combination

Acquisition-related costs

IAS 22, Business Combinations, includes directly attributable acquisition expenses (such as professional fees) as part of the cost of the investment. FASB agreed, however, that acquisition related costs are not part of the fair value of the exchange transaction and, therefore, should be expensed as incurred. The IASB agreed to adopt the FASB approach but agreed to defer finalising this decision until the outcome of the measurement basis project had been reached.

Restructuring provision

A previous IASB decision continued to require, in certain circumstances, the recognition of liabilities for terminating or reducing the activities of the acquiree that were not liabilities of the acquiree at the date of acquisition. The Board agreed that such liabilities should be included as part of the apportionment of the cost of acquisition only when the acquiree has, as at the date of acquisition, an existing liability for restructuring recognised in accordance with IAS 37, Provisions, Contingent Liabilities and Contingent Assets.

The FASB tentatively agreed that the acquirer in a business combination should account for the costs of a restructuring plan as an acquisition-related cost (and thus expense all costs incurred under the plan) unless the acquiree has a pre-existing obligation that meets the liability recognition criteria. In such circumstances, the liability would be treated as an 'assumed liability' of the acquiree and included as part of the apportionment of the cost of acquisition.

The IASB reconsidered its previous decision but reaffirmed that IASB still does not not believe that a liability exists at the date of acquisition. Thus, IASB did not change its earlier decision.

Post-employment benefit obligation triggered by a business combination

The FASB tentatively agreed that when a post-employment benefit obligation is triggered by a business combination, this is an assumed obligation in a business combination that should therefore be included as part of the apportionment of the cost of acquisition.

In a previous meeting, the IASB concluded that liabilities arising as a consequence of the business combination were not liabilities of the acquiree immediately before the business combination and therefore should not be included as part of the apportionment of the cost of acquisition. The IASB concluded that such obligations represent post-acquisition expenses of the combined entity and should, therefore, be recognised in the income statement of the combined entity.

The Board stated that it did not want to create any further areas of divergence but, at the same time, it did not fully understand the basis of the FASB's decision. Therefore, the Board delayed changing its previous decision in this area.

23 May 2002

First-Time Application of IFRS:

A draft Exposure Draft is currently under review by IASB members, who directed the staff to aim for a publication of the document in July. The proposed effective date of the Standard would be 1 January 2003, with an earlier application permitted.

At the meeting, the Board reconsidered certain earlier tentative decisions and proposed:

• To reverse its decisions at the March meeting on the treatment of available-for-sale financial assets and to require that, at the date of transition to IFRS, such instruments follow a treatment consistent with IAS 39. As a result, in the opening IFRS balance sheet, the adjustment to fair value of an available-for-sale financial asset would be recognised in a separate component of equity and gains or losses arising on subsequent disposal of the investment would include the 'recycling' in net profit or loss of all the fair value adjustments recognised in that separate component of equity. At the March meeting, the Board envisaged prohibiting the subsequent 'recycling' of any fair value adjustments (whether recognised or not in a separate component of equity) on available-for-sale financial assets existing at the date of transition to IFRS, to prevent cherry-picking in the classification of financial instruments, particularly between the categories of financial assets held for trading and available-for-sale.
• To provide exemptions for the application of the proposed Standard on First-Time Application in the following two cases:
  • if an enterprise is a wholly owned subsidiary that already reports to its parent under IFRSs. If this enterprise must prepare first IFRS financial statements for local GAAP purposes, it could use the financial information reported to the parent. A reconciliation would be required of the amounts published in the first IFRS financial statements to the amounts that would have been obtained had the Standard on First-Time Application been applied; and
  • if an enterprise adopts a full restrospective application of IAS requirements to prepare its first IFRS financial statements.

Insurance Contracts:

The Board acknowledged that the timetable for completion of the project on insurance contracts will not enable companies that will have to apply IFRS in 2005 for the first-time to prepare for the change sufficiently in advance. Therefore, in addition to continuing its work on the main project, the Board envisages publishing guidelines (or may be a Standard) that would explain how an insurance company can be compliant with IFRS while no Standard on insurance contracts is available. This guideline would include:

• A reminder that all existing IFRS are applicable, including IAS 39 on financial instruments. However, the Board acknowledges that some guidance may be needed on how to apply IAS 39 to certain specific features of insurance activities.
• An indication that, as long as the IASB has not published a Standard on insurance contracts, an enterprise should continue to apply its current accounting policies, as long as they do not conflict with the Framework.
• If possible, guidance on the treatment of catastrophe provisions and equalization reserves, discounting of liabilities and deferred acquisition costs. However, the Board acknowledge that it might be difficult to come to a consensus on the latter two items as long as the main project is not completed.
• Requirements for enhanced disclosures of the accounting policies followed by an insurance company, specific risks (particularly insurance risks) and how risk and uncertainty is considered in preparing the financial statements.

The staff also presented to the Board:

• A paper highlighting the issues associated with the accounting of performance-linked contracts. The Board acknowledged that these issues were complex and that further research was needed;
• A paper considering the application of 4 models to a basic insurance contract, including the US GAAP treatment, the proposed treatment under the Insurance DSOP, and a model where the level of risk and uncertainty to measure the insurance liability would be set (and adjusted with subsequent events) so that no profit or loss would be recognised on initial recognition of the insurance contract. The Board rejected to continue research on this latter model, since it would prevent, among other things, recognition of losses on initial recognition of a contract which is expected to be at loss at inception by the insurance company. Instead, the Board directed the staff to continue research based on the Insurance DSOP proposals and consideration of a principle that would say that, at inception of a contract and in the absence of the contrary, the premium charged for the contract is the best evidence of its fair value.

Share-Based Payment:

The Board is currently developing an Exposure Draft on accounting for share based payment. The Board's tentative conclusions to date include:

• 'in principle' all share based payment transactions should be recognised in the financial statements, resulting in the recognition of an expense in the income statement when the goods or services received are consumed;
• such transactions should be measured using a fair value measurement basis;
• when share based payment transactions are measured at the fair value of the equity instruments issued (or to be issued), fair value should be estimated at grant date;
• when an observable market price does not exist, an option pricing model should be used to estimate the fair value of share options.

Employee Share Purchase Plans

It was put forward that employee share purchase plans should not be exempt from the proposed exposure draft. The only reason that suggests that they should be exempt is that governments use such plans as vehicles to encourage wider ownership of company shares. However, this was not deemed to be a sufficiently persuasive point to allow exemption. The Board agreed that employee share purchase plans should not exempt from a standard on share based payments.

Non-Employee Share-Based Payment

Most respondents to the discussion paper agreed with valuation on a fair value basis. The only current guidance is the US EITF 96-18, which covers date of measurement. The Board agreed that the issue was to value goods and services as at grant date. The value of what was received for issuing shares was what was being measured i.e. the value of the goods and services.

Unlisted and Newly Listed Companies

With regard to unlisted companies, the issue is valuing the equity instrument, which is an option rather than a share. This is difficult, as the volatility of the share price is not known. In the US the minimum value method is used, but this is usually only for employee share based payments only.

It was decided that further research would be carried out, and the Board would revisit this issue in June. For newly listed companies the issue is simpler as they have a market share price. It was agreed that they would not be permitted to use the minimum value method. Any ED should give guidance on the estimation of volatility. This guidance should be based on or be the same as US GAAP guidance.

Repricing

It was agreed that the existing FAS 123 guidance should be used for repricing.

24 May 2002

Share-Based Payment:

The discussions continued from the previous day and centred on the following areas:

• Vesting conditions.
• Whether grant date measurement was appropriate.
• Whether the grant date measurement should be subsequently adjusted (e.g. via a true-up payment, which is where the numbers are adjusted to show what has subsequently proved to be the correct figures).

Example

Most of the conversation centred on the following example:

There are 500 employees, each of whom have 100 options. At grant date it is estimated that 80% of these options will vest, and that the options are worth $15. The options vest after 3 years working with the company. It is estimated that 80% of employees will work for 3 years (and thus their options will vest) and 20% will leave within the 3 year period. For the purposes of the example, it is assumed that those who leave within 3 years will do so evenly over the period.

Valuation

There was a debate about whether the share options should be valued at $15 and only 80% of the options should be valued, or if all of the options should be valued at $12. As both give the same results, after much discussion, it was decided that it did not matter.

Proposed Accounting - Method 1

At grant date there are 500 employees, each with 100 options valued at $15 (market price), and it is estimated that 80% of these will vest. This gives a valuation of:

500 * 100 * 15 * 0.8 = $600,000

At grant date it is expected that 80% of employees will give 3 years service, and 20% will leave evenly over the 3 year period. Thus the 20% will each on average work for 1.5 years. This gives the total estimated number of hours worked as:

(0.8 * 500 * 3) + (0.2 * 500 * 1.5) = 1,350 years of service

Therefore the cost per year of service (per employee) to be charged to the income statement is:

$600,000/1,350 years = $444.44 per year per employee

If employees leave as estimated, then the actual charge to the income statement will be $600,000. If, for example, fewer people leave than is expected, then the amount of services received from employees will be higher. This will increase the charge to the income statement, as the amount charged is still $444.44 per year per employee, regardless of the fact that the actual figures for service hours are different from those estimated.

Proposed Accounting - Method 2

Method 2 involves taking the $600,000 charge as calculated above and spreading this over the 3 years. No adjustments are made. This is an approach that was recommended by experts that the advisory committee consulted, but was rejected by the Board.

Proposed Accounting - Method 3

This method involves adjusting either of the above methods by a 'true-up' amount. This is the difference between what has actually been charged, and what should have been based on actual results. This is also an approach recommended by experts, and of the two methods that options analysts recommended, this was the preferred.

Valuation - Revisited

After working through the example, there was more discussion on how the $12 and $15 should be arrived at. It was decided that, where possible, a model (e.g. the Black Scholl's model) should be used. This is likely to be the case where the vesting conditions are market-based conditions (e.g. the share price getting above a certain level). This price should then be adjusted for other vesting conditions that could not be entered into the valuation model (e.g. employment conditions). Hence the $12 surrogate price is arrived at by adjusting the market price ($15) for expectations of how many employees with share options will remain in service for the next 3 years. Had there been other vesting conditions, then these would also need to be factored in.

It was noted that the same criterion is used to determine the number of options expected to vest and the price of those options. This caused concern, but seemed to be inevitable under Method 1 above, which was the method the Board advocated.

There was much discussion on whether true-ups should be used. They are used in the US. However, it was pointed out that when they are used, then the measurement date starts to move towards a service or vesting date, rather than grant date. Since the Board decided that grant date should be used, having a true-up adjustment was inconsistent. The same is true of adjusting the price of the options.

Additionally, share options are considered to be part of equity, and therefore movements in the price of the options should not go through the income statement. This is consistent with setting a measurement of cost per year per employee at grant date and then applying this to the actual number of employees.

Potential Pitfalls

The project manager pointed out that if Method 1 is used, there is potential for abuse. By adjusting the forfeiture expectations at grant date, the expense can be manipulated. However, the Board felt that regardless of what method is chosen, there is always room for abuse by manipulating expectations.

Tentative Conclusion and Going Forward

The Board tentatively concluded that Method 1 should be used, and that there should be no true-up or option price adjustments. However, the project manager was asked to again consult experts and the advisory board and present them with this proposal.

IFRIC Update

IFRIC asked that two items be mentioned to the Board. The first was the potential problems surrounding the removal of the paragraph on dividend escalators in the financial instruments project. There was concern that the removal of this paragraph may send certain signals to the market.

The second item was the situation where a subsidiary issues preference shares that the parent company guarantees. The issue is whether at the parent level they should be reclassified or not. As currently stands they should not, and IFRIC felt this to be odd.

Consolidation of Special Purpose Entities (SPEs)

The Board was notified that FASB is proposing to add an additional exception to the basic principle for consolidation of an SPE -- when the SPE was established principally to diversify risk. Three criteria will be proposed, and the SPE should be consolidated if any two are met. The three criteria are (although this may change):

1. The investor has broad discretionary powers over the purchase and sale of the SPE's assets;
2. The investor provides guarantees or back-up borrowing arrangements; and
3. The investor provides fees that are not market based.

This summary is based on notes taken by observers at the IASB meeting and should not be regarded as an official or final summary.