18-20 February 2004, London

Wednesday 18 February 2004

Financial Instruments: Macro Hedging

Hedge Effectiveness

The Board considered the following issues:

• Should IAS 39's effectiveness tests apply to a macro hedge?
• How should IAS 39's effectiveness tests be applied to a macro hedge?
• Should the Board change or clarify IAS 39's effectiveness tests?

In respect of applying the effectiveness tests the staff recommended:

• IAS 39's effectiveness requirements should apply to a macro hedge. That is, the proposals in the ED are not an alternative to, and do not overrule, IAS 39's effectiveness tests.

• The final standard should clarify that if the entity's strategy is to 'rebalance' a hedge periodically by altering the amount of the hedging derivative to reflect changes in the hedged position, the entity, when assessing if the hedge is expected to be highly effective, needs to demonstrate an expectation that the hedge will be highly effective only for the period to when the hedge is next adjusted.

• The final standard should clarify that the retrospective effectiveness test should be assessed for all time buckets in aggregate and not individually for each time bucket.

• The words 'almost fully offset' should be removed from IAS 39's prospective effectiveness test and be replaced by a requirement that the hedge is expected to be highly effective (the same words as are used in US GAAP). Also, the final Standard should clarify that such an expectation may demonstrated in a number of ways, including a comparison of past changes in the fair value or cash flows of the hedging instrument and those of the hedged item, or by demonstrating a high statistical correlation.

• The final standard should clarify that when the hedged item is designated as a portion, ineffectiveness should be measured by looking at only changes in that designated portion. The Board should also consider referring other issues about hedging a portion to the IFRIC or addressing them in a separate amendment to IAS 39.

• The final standard should clarify that an entity cannot deliberately hedge less than 100% of the exposure on an item and designate the hedge as a hedge of 100% of the exposure. Rather, if an entity hedges less than 100% of the exposure on an item, such as 85%, it shall designate the hedged item as being 85% of the exposure and shall measure ineffectiveness based on the change in that designated 85% exposure.

The Board agreed that the prospective requirements would apply to these hedges. They clarified that this would not prevent hedging from being applied and a policy of adjusting hedges could be considered in order to achieve the prospective requirements. They further noted that these adjustments would require an ineffectiveness determination for the retrospective test. It was noted that even if the retrospective test was failed, prospective designation for remaining periods could occur provided suitable changes were made to address the reasons for the retrospective test failing.

The Board agreed to amend the wording in the application guidance in respect of prospective hedge determination. This would involve deleting the words 'almost fully offset', allowing various techniques to determine this and stating that deliberate underhedging is not permitted.

The Board further agreed to clarify that portions can be designated and that hedge effectiveness will be determined based on the portion designated. It was agreed to clarify that in designating portions in a fair value hedge, the fair value of the hedge components is determined at the time of designation.

Amortisation

The Board discussed how entities should amortise the separate balance sheet line item in either assets or liabilities that arise as a result of using fair value hedge accounting for a portfolio hedge of interest rate risk. The line item contains the change in the fair value of the hedged item.

The staff proposed that:

• The proposal in the ED that 'amounts included in these line items shall be removed from the balance sheet when the assets or liabilities to which they relate are derecognised' be retained.

• The amortisation of the line item using a systematic basis that is consistently applied throughout the period of the hedge be allowed.

The staff presented an example using a constant effective yield but noted this may be extremely difficult in practice. They therefore did not propose requiring this method.

The Board agreed with the staff's proposals but concluded that the standard should state that the principle is a constant effective yield amortisation. The standard should acknowledge that this may not be possible and state that a straight-line amortisation is the minimum.

It was noted that where the underlying hedged item is derecognised, no further amortisation in respect of that item would be necessary.

Transition

The staff recommended that:

• The final standard should contain guidance on how to transition from cash flow hedge accounting under the original IAS 39 and fair value hedge accounting. More specifically, the Application Guidance should confirm that an entity wishing to apply fair value hedge accounting to a portfolio that has been accounted for using cash flow hedge accounting should apply IAS 39.101(d) to discontinue cash flow hedge accounting and should designate a new hedge in accordance with the proposed amendments for future accounting periods.

• The final standard should not permit a fair value hedge of a portfolio of interest rate risk to be designated retrospectively, through a one-time election either on the date the amendments become effective (ie before 1 January 2005), or, alternatively, before a predetermined period expires (such as before the start of the accounting period in which the entity first applies the revised IAS 39).

• The final standard should not give explicit guidance for entities that wish to apply fair value hedge accounting for their portfolio hedges where possible, but do not meet the conditions to do so for all time buckets. Rather the usual requirements in IAS 39 for discontinuing fair value (or cash flow) hedge accounting and for re-designating a hedge should apply.

• Entities should adopt the amendments at the same time as they adopt the revised IAS 39.

The Board agreed with the staff proposals.

Other Issues

The Board considered various other issues on an exception basis.

No Board members indicated that they intended dissenting from the standard.

Short-term Convergence: Asset Disposals and Discontinued Operations (ED 4)

Definition of Discontinued Operations

The staff noted that the majority of commentators disagreed with the proposed definition and were concerned as to relatively small units being classified as discontinued and discontinuing operations being presented every year.

The staff proposed that the current definition in IAS 35 be used but that the timing of the classification be retained as being consistent with the timing of the classification of assets as held for sale.

After considerable discussion the Board considered whether to delay any amendments until the FASB or EITF has completed deliberations on any amendments. This was not accepted (9-5).

The Board then agreed to adopt the staff recommendation but to continue working on the definition of a discontinued operation with a view to converging in a subsequent amendment.

Current/Non-current Classification of Assets (and Disposal Groups) Held for Sale

To address certain commentators' concerns the staff recommended that, for the purposes of this standard only, the definition of non-current assets should be modified, as follows:

• for entities that use a current/non-current balance sheet presentation: assets that, until their final year of use, the entity would classify as non-current in the absence of a specific decision to sell; and
• for entities that use a liquidity presentation: assets that, until their last year of use, would, in the absence of a specific decision to sell, include amounts expected to be recovered more than twelve months after the balance sheet date.

The Board did not support the staff's proposal but requested that the staff provide further clarification that non-current assets would only be classified as current if they meet the held-for-sale classification.

The Board noted that they did not believe that non-current assets in their final year of use or the next years depreciation should be classified as current under the realised within 12 months or consumed within the operating cycle.

Associates and Joint Ventures

The staff noted the decision in January that assets should only be excluded from the scope of the measurement provisions if:

• they are already marked to market; or
• there would be difficulties in determining their fair value less costs to sell.

It was further noted that this would not apply to investments in associates and joint ventures in consolidated financial statements (except for those acquired and held exclusively for resale, which are accounted for under IAS 39).

The staff, therefore, recommended:

• that investments in associates and joint ventures in consolidated financial statements should continue to be included in the scope of the IFRS;
• the requirements relating to associates and joint ventures acquired and held exclusively for resale should be deleted from IASs 28 and 31; and
• requirements for associates and joint ventures that meet the criteria to be classified as held for sale to be treated in accordance with the standard should be added to IASs 28 and 31.

The Board agreed but requested the staff to add examples clarifying that the underlying assets and liabilities would be valued in accordance with this standard.

Short-Term Convergence Post-employment Benefits

The treatment of group defined benefit plans in the separate financial statements of entities within the group

The staff proposed amendments to IAS 19 that would bring group plans within the scope of the provisions for multi-employer plans. The staff informed the Board that IFRIC is proposing an interpretation in respect of multi-employer plans.

The Board agreed that this should apply to those entities that would fall under the conditions in IAS 27 for not preparing group financial statements. Otherwise IAS 19 would apply and a reasonable basis of application should be applied.

Whether actuarial gains and losses that are recognised outside the income statement should be recognised in a separate component of equity

The Board considered the issue of whether actuarial gains and losses that are recognised outside the income statement, in a statement of total recognised income and expenses, should be shown in a separate component of equity and not included in retained earnings.

The staff recommended that actuarial gains and losses should be recognised immediately in retained earnings, not a separate component of equity.

The Board agreed.

Whether, when actuarial gains and losses are recognised immediately, an amount in equity represented by the defined benefit asset or liability should be presented separately

The staff recommended not requiring the separate presentation of the amount of equity represented by the defined benefit asset or liability.

The Board agreed.

How should an adjustment relating to the asset ceiling be treated when actuarial gains and losses are recognised outside income

The Board considered whether the affect of the asset ceiling limit should be treated as an actuarial gain or loss and recognised outside the income statement or as an adjustment to be recognised in the income statement.

The staff recommended treating the entire impact of the asset ceiling as an actuarial gain or loss.

The Board agreed.

Whether the sensitivity information previously proposed by the Board should form part of the short-term amendments

The Board agreed to not include this within the short-term amendments.

IFRIC Matters

The Board noted a general summary of IFRIC projects.

IFRIC draft interpretation on multi-employer plans

The Board considered the draft IFRIC interpretation on multi-employer plans. The staff noted that the draft interpretation proposed an amendment to IAS 19 to exempt entities whose employees are in a state pension plan from defined benefit accounting and this required Board approval to expose. The Board expressed concern as to the definition of a state plan and requested the staff to reconsider the definition to ensure it is limited to government plans.

Thursday February 19, 2004

Short-term Convergence: IAS 20 Government Grants and Disclosure of Government Assistance

The staff presented two options, namely:

• Amend IAS 20 to reflect the requirements for government grants contained in IAS 41
• Withdraw IAS 20 in its entirety

The staff recommended the second option and that the Basis for Conclusions should state:

• The standard has been withdrawn because it is an impediment to accounting for a government grant in a manner that is consistent with the Framework;
• The withdrawal is a temporary measure, because the Board is addressing the accounting of government grants as part of its revenue recognition project;
• Entities should follow the requirements in paragraphs 10-12 of IAS 8 for developing an accounting policy in the absence of specific requirements.

The Board decided that IAS 20 should be retained. The guidance in the standard on accounting for government grants should be removed and replaced with the guidance from IAS 41. The Board decided the only amendment to the guidance in IAS 41 should be to withdraw the references to assets measured at fair value. The Board agreed in principle that no further amendments should be made until such time as the revenue recognition project is completed.

As a result of the foregoing, the basic principles of IAS 20 would be revised as follows:

• An unconditional grant would be recognised as income when the grant becomes receivable.
• A conditional grant would be recognised as income when the conditions attaching to the government grant are met.

Business Combinations Phase II

The staff noted a previous Board decision to amend the definition of a contingent asset as follows:

"a conditional right that arises from past events that may result in a future cash inflow (or other economic benefits)based on the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity."

They further noted that the Board had considered two examples namely:

• a conditional right that arises from an in-process legal claim against a competitor through the courts, and
• a conditional right that arises from an application for an operating licence.

The Board had previously observed that for each of the above two examples, there exists two elements: an unconditional (or non-contingent) element and a conditional (or contingent) element. The Board agreed that the unconditional element gives rise to an asset while the conditional element gives rise to a contingent asset.

The staff requested the Board to consider whether any unconditional rights, if any, associated with a pending contract in the acquired entity at the time of a business combination would qualify for recognition separately from goodwill.

The staff had proposed that these rights would not be separately recognised from goodwill but noted that some Board members have expressed concern that if this is the case and the contract is signed after the acquisition date, the value of the pending contract would continue to be subsumed in goodwill indefinitely, which seems inappropriate if the contract has a finite life.

The staff consequently requested the Board to consider whether, as an exception to the principle of not adjusting goodwill for events after the acquisition date, the fair value at the acquisition date of the pending contract should be subsequently credited to goodwill, with the corresponding recognition of an intangible asset (ie the contract) if:

• the pending contract transforms, within twelve months of the acquisition date, into a contract that would have qualified for recognition separately from goodwill, and
• the pending contract's fair value at the acquisition date is reliably measurable.

The staff proposed that the above not be adopted and that goodwill not be adjusted for events that occur after the acquisition date.

In addition the staff proposed that there should be an acknowledgement that events that occur shortly after the acquisition date, such as a contract signing, should be carefully considered to determine whether they provide substantive evidence of the existence of an intangible asset at the acquisition date that, in fact, meets the criteria for recognition separate from goodwill.

Some Board members noted that the wording needed to be clear in distinguishing between conditional and unconditional rights and that those conditional rights are not unrecognised but are subsumed within goodwill.

It was noted that the transfer of probability from recognition to measurement gave rise to the need for a recognition screening mechanism.

The Board requested that the staff prepare a paper setting out the differences between conditional and unconditional rights.

Consolidation

The staff noted that the Board had previously agreed that when an Investor has the power to determine the strategic operating and financing policies of another entity ('Power Criterion'), has the ability to benefit ('Benefit Criterion'), and (c) is able to use that power so as to increase, protect or limit the risk of downside in that benefit, the Investor has control of that other entity and should consolidate it.

Potential Voting Rights and Control

The staff requested the Board to consider the circumstances when unexercised or unconverted instruments that on exercise/conversion will give the holder voting power or reduce another entity's voting power over the financial and operating policies of an investee ('potential voting rights') are relevant to a present assessment of control.

The staff proposed:

• a. that the following potential voting rights be considered in an assessment of current Power. Instruments that are:
  • i. presently exercisable (that is, not reliant on the further passage of time or the occurrence of a future event);
  • ii. for which there are no impediments to exercise (such as exercise being contingent on regulatory approval); and
  • iii. where the option has economic substance (it is not for example set at a strike price that is artificially high so that exercise is not possible in any foreseeable circumstances);

• b. in addition, potential voting rights should be considered in assessing Power if they enable their holder to determine an investee's strategic operating and financing policies in practice.

• c. that an entity with a current ability to determine strategic operating and financing policy as a result of a holding of relevant potential voting rights can only meet the Power Criterion in the absence of a third party with a present enforceable right to dominate policy determination;

• d. that presently exercisable / convertible instruments with no impediments to exercise should always be considered to determine if they are relevant to current control. However, it should not be compulsory that all such holdings actually be included in the final assessment of control (that is, they should all be considered for inclusion but if for example, a holder has no ability to benefit they would not ultimately be included in the assessment of control).

The Board discussed various concerns as to the different circumstances in which potential voting rights could be applied to consolidate (and consequently deconsolidate) entities and how this would be applied in practice. The Board indicated that they did not believe the concept of potential voting rights could be used to determine whether passive influence amounted to control.

The Board did not reach any conclusions.

Strawmen

The staff requested the Board to consider the circumstances when the holdings of entity's strawmen (being entities that effectively hold interests as some form of agent for another entity), should be included with those of an entity in assessing whether that entity meets the Power Criterion.

The staff proposed including a requirement that the holdings of strawmen be considered. This would clarify that Power can be held both directly and indirectly, so consideration must be given both to an investor's direct sources of Power and those that it may have available through the holdings of third parties.

The Board indicated a preference for a rebuttable presumption rather than a requirement as they believed that an indication of who might be considered Strawmen could be wider in those circumstances.

Revenue Recognition The staff presented various recognition and measurement principles based on the Board's tentative decisions to date. These principles are:

Fundamental Revenue Recognition Principle

A reporting entity should recognise revenues in the accounting period in which they arise and measure them at their fair value on the date that they arise if it can determine both their occurrence and measurement with sufficient reliability.

The following recognition principles amplify and extend the fundamental revenue recognition principle:

Recognition Principle #1

Contractual revenues cannot arise before a contract with a customer exists.

Recognition Principle #2

A reporting entity should recognise contractual revenues when an increase in its claims against its customers can be determined to have occurred and the fair value of that increase can be measured with sufficient reliability.

Recognition Principle #3

A reporting entity should recognise contractual revenues when a decrease in claims against it by its customers can be determined to have occurred and the fair value of that decrease can be measured with sufficient reliability.

Recognition Principle #4

Increases in assets or decreases in liabilities that give rise to contractual revenues stem from contractual promises that may be either express or implied.

Recognition Principle #5

Contractual revenues should be recognised at contract inception if the fair values of the contractual assets obtained on that date exceed the fair values of the contractual liabilities simultaneously incurred, and if those revenues can be measured with sufficient reliability.

Recognition Principle #6

Subsequent to contract inception, contractual revenues should be recognised upon the reporting entity's performance of its obligations under the contract, as evidenced by a decrease in its contractual liabilities or an increase in its contractual assets, the fair value of which can be determined with sufficient reliability.

Recognition Principle #7

Contractual revenues should be recognised upon contract completion to reflect any final increases in the fair values of contractual assets or final decreases in the fair values of contractual liabilities.

Fundamental Measurement Principle

A reporting entity should measure revenues arising from an increase in its assets or a decrease in its liabilities (or a combination thereof) at the fair value of that increase or decrease.

The following measurement principles amplify and extend the fundamental measurement principle:

Measurement Principle #1

The estimates of the fair value that the reporting entity uses to measure revenues arising from increases in its assets or decreases in its liabilities should be those that have the highest relative reliability.

Measurement Principle #2

The estimates of the fair value of revenues that are consistent with Level 3 of the fair value hierarchy should be developed by means of multiple valuation techniques that maximise market inputs, such as a market approach or an income approach, whenever information necessary to apply those techniques is available.

Measurement Principle #3

The fair value of revenues arising from increases in the reporting entity's contractual assets reflects the effects of credit risk, the time value of money, and dilution risk.

Measurement Principle #4

The measures that reflect the effects of credit risk on the fair value of a reporting entity's revenues also should reflect expectations of recoveries, if any, in case of breach of the contract by the customer.

Measurement Principle #5

Any express or implied rights of return and refund, allowances, rebates, discounts, credits, and other similar rights granted to customers that reduce revenues by reducing the reporting entity's contractual assets or increasing its contractual liabilities should be measured at fair value.

Measurement Principle #6

Revenues arising from increases in contractual assets that stem from the reporting entity's rights to the customer's stand-ready performance in case of occurrence or non-occurrence of a specified event should be measured at fair value that reflects the assessment of the probability that the specified event will occur.

It was noted that the use of fair value was adopted as a working principle, and no formal decision on this has been taken. In addition it was noted that strictly speaking fair value would apply to assets and liabilities and not revenue.

The Board noted that there were certain of these principles, and the effects of these principles, that they still needed to discuss and the principles could be expanded.

The Board agreed that the effects of the time value of money and credit risk would only ever be disregarded as a result of materiality.

The staff noted that, for the revenue recognition project, conditional is defined as 'subject to the occurrence of an event that is not certain to occur (such as performance by the counterparty)' and unconditional as 'only the passage of time is required to make performance due.'

The Board agreed.

Business Combinations Phase I

The Board discussed an issue as to the proposed wording that specifies adjustments should be made to an associates' profit or loss in recording the investors' equity accounted earnings in respect of goodwill but does not specify adjustments in respect of other business combination type adjustments. The Board agreed to clarify the wording.

The Board discussed a further issue that arose as a result of consequential amendments from IAS 16 that could result in an interpretation that in determining cash flows in an impairment test, the cash flows could be limited to the period of the shortest component separated out by IAS 16. The Board agreed to clarify the issue in the short-term but agreed that the issue would need to be addressed in more detail in the future.

Insurance Contracts Phase I

The staff noted that the Board had previously decided that if a financial guarantee contract meets the definition of an insurance contract and was not incurred or retained on transferring financial assets or financial liabilities to another party, the contract is within the scope of the IFRS on insurance contracts. However, as decided by the Board in finalising IAS 39, the issuer should initially recognise it at fair value, and subsequently measure it at the higher of (i) the amount recognised under IAS 37 and (ii) the amount initially recognised less, where appropriate, cumulative amortisation recognised in accordance with IAS 18. The issuer is subject to the derecognition provisions of IAS 39.

The staff requested the Board to consider whether this decision should be re-exposed and in the meantime the issue should revert to what was exposed in ED 5.

Some Board members expressed concern that such a change would equally be a change to what was exposed and considered in finalising the financial instrument standards.

It was agreed to revert to the proposal in ED 5 in finalising the Insurance Contract standard and to expose the issue as soon as possible as part of an Omnibus exposure draft arising from recently approved or soon to be approved standards.

Standards for Small and Medium-Sized Entities (SMEs)

The staff noted a decision summary to date as follows:

Some Board members expressed concern as to the use of the word "small" in D2(b). It was agreed to amend D2 to state that the IASB's SME standards would be suitable only for entities that do not have public accountability. The Board agreed to combine all scope concepts together.

Various changes to clarify who would be able to apply the standards were proposed.

The Board agreed to add the following objective to D3:

"To provide a single set of high quality, understandable, and enforceable accounting standards suitable for SMEs throughout the world."

The Board discussed the following question relating to decision D2: Must an SME choose either (a) the complete set of full IFRS or (b) the complete set of SME standards, and not be allowed to choose, principle by principle, some of the SME standards and some standards from full IFRS? The Board did not reach a tentative decision on this question.

The Board agreed to consultation with an informal user group to assess user needs. The Board also agreed to issue an Invitation to Comment on the tentative decisions to date. The Board suggested that examples be prepared for them to consider for inclusion in the comment document.

The Board considered examples of potential SME standards based on IAS 2 and IAS 10.

Financial Instruments: Recognition and Measurement - Fair Value Option

The Board noted that it has received comments from regulators about the permission in IAS 39 to designate any financial asset or financial liability as one to be measured at fair value with changes in fair value reported in profit or loss (the 'fair value option').

Consequently the Board considered amending IAS 39 so that the fair value option could be applied only in specified circumstances. The specified circumstances would be those that the Board had in mind when it developed the option, ie for a financial asset or financial liability that is reliably measurable and meets one of the following:

• i. The item is a financial asset or financial liability that contains one or more embedded derivatives as described in paragraph 10 of IAS 39.
• ii. The item is a financial liability whose amount is contractually linked to the performance of assets that are measured at fair value.
• iii. The exposure to a change in the fair value of the financial asset or financial liability is substantially offset by the exposure to the change in the fair value of another financial asset or financial liability, including a derivative.

The staff proposed that the fair value option could be limited by requiring that the fair value be verifiable. This would only occur if the variability in the range of reasonable fair value estimates made in accordance with paragraphs 48, 48A, 49 and AG 69-82 is not significant. This requirement is met, if for example, the fair value estimate is based on:

• a. Observable current market transactions in the same instrument (that is, without modification or repackaging)
• b. a valuation technique that is calibrated regularly to observable current market transactions in the same instrument (ie. without modification or repackaging) or to other observable current market data
• c. a valuation technique commonly used by market participants to price the instrument that has been demonstrated to provide reliable estimates of prices obtained in actual market transactions, or
• d. a range of possible outcomes whose probability can be reasonably assessed.

In the case of (ii) and (iii), the Board discussed a requirement that the fair value option be applied to both the financial asset and the related financial liability, unless classified as held for trading. This would ensure that both 'legs' of a matched position are measured at fair value through profit or loss and thus prevent entities from reporting volatility from applying the fair value option to only one leg of a matched position.

The Board discussed various concerns expressed by the European Central Bank which resulted in wording amendments.

The Board approved proceeding with an exposure draft. (Vote 11-3)

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