Business Combinations Phase I

The IASB plans to issue IFRS 3 Business Combinations on or around 31 March 2004. In addition, the IASB intends to issue a limited exposure draft on certain issues related to difficulties arising in phase I. This exposure draft is separate from Phase II -- applying the purchase method -- for which an exposure draft is also expected in 2004.

IFRS 3 will include a requirement to measure the cost of a business combination at the net fair value of the acquiree's identifiable assets, liabilities, and contingent liabilities when (a) the acquirer and acquiree are both mutual entities or (b) the business combination is effected through contract alone without obtaining ownership interest at the transaction date. The staff recommended and the IASB agreed that these transactions be measured at the net fair value of the acquiree when no readily measurable consideration is exchanged to effect the combination.

Related to the limited exposure draft, the Board discussed costs attributable to a business combination. The staff recommended and the Board agreed (7-5-1) that when the cost of a business combination is measured as the net fair value of the acquiree's identifiable assets, liabilities, and contingent liabilities, that cost should not include costs directly attributable to the combination. Those costs should be recognised immediately in profit or loss.

The Board concluded that the transition and effective date of the exposure draft should be the same as IFRS 3. The exposure draft will have a 90 day comment period.

Financial Instruments – Fair Value Option

The IASB further discussed a draft exposure draft that would propose to limit the application of the new fair value option in IAS 39 to the following four situations, the first three of which it had previously discussed:

• (a) The item is a financial asset or financial liability that contains one or more embedded derivatives.
• (b) The item is a financial liability whose amount is contractually linked to the performance of assets that are measured at fair value.
• (c) The exposure to changes in the fair value of the financial asset or financial liability is substantially offset by the exposure to the changes in the fair value of another financial asset or financial liability, including a derivative.
• (d) The Board decided to add a fourth category to which the option may be applied as follows: 'By designation on initial recognition only, any available-for-sale financial asset other than a loan or receivable, on an asset-by asset basis'. (Note: This decision is irrevocable.)

The Board also clarified that criterion (a) applies to all financial instruments that contain an embedded derivatives. The Board acknowledged this would encompass mortgage loans since the holder generally has a prepayment option (considered an embedded that is closely related).

The Board discussed some drafting issues, including questions to ask in the exposure draft. The exposure draft will have a 90 day comment period.

Financial Instruments – Fair Value Hedge Accounting of a Portfolio Hedge of Interest Rate Risk (Macro Hedging)

The Board discussed two issues related to the final standard. First, the Board decided that when prepayment estimates change, the entity should assume the change was a result of movements in interest rates, unless the entity can prove otherwise.

In addition, the Board decided to remove a paragraph from the exposure draft related to the application of hedging portions. The Board was undecided about whether a UK pound overdraft could be hedged with a US dollar instrument. That is, if a bank charges a rate on UK pound-denominated debt greater than a US dollar treasury rate, is that US dollar treasury rate a portion of the larger UK pound-denominated rate? The Board has decided to take this issue up with the FASB as a matter of priority for convergence.

The Board also discussed problems with the mechanics of the approach and the abilities to manage earnings. One Board member suggested he would dissent on this issue. The Board will discuss those concerns further on Friday 19 March.

Proposed Amendments to IAS 37

The Board considered proposed amendments to the definitions of contingent assets and contingent liabilities in IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The Board reaffirmed its decision from an earlier meeting that the definition of contingent asset should be amended to read:

'a conditional right that arises from past events from which future economic benefits may flow based on the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity'.

The Board discussed at length the implications of these changes for the definition of a contingent liability. Particularly the Board considered what occurrence should be regarded as having given rise to the obligation - for example in the case of a lawsuit, is it the occurrence of the incident, or the filing of the suit? The Board also considered the conceptual merits of recognising contingent liabilities in business combinations where they would not be recognised in the absence of a change in ownership. The Board agreed to continue its deliberations of this matter at future meetings, including the issue of what is the appropriate accounting where there is more than one condition on which the existence of an actual liability depends.

IFRIC Issues – Employee Benefit Plans with Minimum Guaranteed Return

A draft of IFRIC Draft Interpretation D6 Employee Benefits Plans with a Guaranteed Minimum Return on Contributions or Notional Contributions had been sent to Board members for negative clearance. One member was sufficiently concerned by the proposals to request that the topic be discussed in Board session.

The Board discussed the issues and agreed that although they may not favour the outcomes of the Interpretation, the draft is an appropriate interpretation of the requirements of IAS 19. Board members noted that the conceptual concerns with the draft Interpretation are a result of conceptual shortcomings of IAS 19.

The Board agreed that IFRIC should proceed to issue the draft Interpretation. The Board noted that the FASB is currently considering a similar issue, and that the direction they are taking should be considered by the IFRIC in their deliberations prior to the issuance of a final interpretation. The Board reiterated the importance of re-opening IAS 19 for a comprehensive overhaul in the relatively near future.

Assets Held for Disposal and Discontinued Operations

The Board considered one final issue in relation to a draft of a final standard on Non-current Assets Held for Sale and Discontinued Operations. In February the Board agreed to remove from IAS 27 the exemption from consolidation for subsidiaries acquired with a view to immediate disposal and to include in the implementation guidance an example illustrating a 'short-cut' method of consolidation. In developing that example staff noted that the method provides the information required to be presented in the income statement and balance sheet, but not the required note disclosures. The Board reaffirmed its decision to remove the exemption from IAS 27, and decided to exempt entities acquired with a view to immediate disposal from a number of the disclosure requirements of the standard.

Thursday 18 March 2004

Convergence: Post-employment Benefits

The Board considered a pre-ballot draft of a proposed exposure draft. The staff identified two issues for further consideration.

Capitalisation of post-employment benefits

Paragraph 62 of IAS 19 notes that other IFRSs require the inclusion of employee benefit costs, including post-employment benefit costs, within the cost of assets such as inventories or property, plant, and equipment. The Board discussed whether, if actuarial gains and losses are recognised immediately, their full amount should be capitalised.

IAS 19 currently requires that if an entity recognises actuarial gains and losses in full in income, an appropriate proportion of the gains and losses must be included in the employee benefit costs that are capitalised.

The staff proposed that IAS 19 be amended so that only the current service cost is eligible for capitalisation.

The Board did not necessarily disagree with the staff's recommendations but believed the issue could not be dealt with adequately in this exposure draft.

The title of the statement of changes in equity that excludes transactions with owners

The staff recommended using the title "statement of total recognised income and expense" and proposed a consequential amendment to the illustrative example in IAS 1.

The Board agreed to retain the description in the revised IAS 1 appendix, being "statement of recognised income and expense".

No Board members indicated they would dissent from the exposure draft.

IFRIC Issues – IFRIC Interpretation 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities

The Board considered the proposed interpretation approved by IFRIC.

Some Board members queried whether IAS 37 should be interpreted as requiring a current interest rate. The majority of the Board believed it did.

Some Board members queried whether changes in the discount rate should be capitalised to the asset. The staff noted that separating the effects of changes in cash flows from changes in discount rates was difficult in practice.

Some Board members queried the interaction between the interpretation and the revaluation of assets as they believed this was unclear.

The Board agreed to ask IFRIC to clarify the revaluation issues.

Some Board members noted that the Interpretation required testing for impairment whenever the asset value was changed. Some Board members noted this would be a change to the requirements of IAS 36. It was agreed to discuss with IFRIC changing this to a consideration of impairment indicators.

Some Board members asked whether the guidance provided in respect of first-time adoption was correct and was capable of being applied. It was agreed that the liability should be determined using estimates at the date of transition. Consequently there could not be a requirement to restate the asset and redetermine depreciation for each prior period. The Board agreed to ask IFRIC to re-examine this.

The Board discussed the scope addition in respect of mineral rights and reserves as it was unlikely that these assets would be affected. The Board agreed to ask IFRIC to reconsider this issue.

Subject to any changes arising from the above the Board agreed to approve the Interpretation (9-4-1).

Consolidation

The Board considered the notion of "effective control" and guidance on how to assess the power to control when potentially conflicting notions of power occur simultaneously.

The staff recommended that the following be clarified:

• An entity with a current ability to determine strategic operating and financing policy only meets the power criterion in the absence of a third party able to dominate policy determination.
• An entity that does not dominate the determination of strategic operating and financing policy in practice but that has the ability to dominate such determination meets the power criterion. This is the case even if the entity has a history of not utilising its ability to dominate and/or has no intention of utilising this ability.

The staff noted that even if an entity is currently able to dominate policy determination, in some circumstances it may be difficult to determine whether that entity has power when potential voting rights can reduce its proportionate interest in the investee such that it would not have an enforceable right to power (sometimes referred to as 'legal control'). The staff recommended that a case-by-case assessment should be made, rather than concluding that an entity can never have power where taking into account potential voting rights, its proportionate interest in an investee is reduced and it will not have an enforceable right to power.

The Board agreed with the staff's recommendations but noted that care needs to be taken to assess the current situation and not whether the power to control will exist in the future.

Convergence: Income Taxes

The Board discussed how to account for the tax effects of acquisitions of assets that are not accounted for as a business combination where the amount paid is different from the tax base of the asset acquired.

The staff noted that this issue is currently dealt with under the 'initial recognition exemption' and that the Board had previously tentatively agreed to eliminate this exemption.

The Board discussed three different views:

View A: Recognise the deferred tax asset or liability as the difference between the consideration paid and the tax base multiplied by the tax rate; the resulting deferred tax benefit or expense is recognised immediately in profit or loss;

View B: Allocate the consideration paid between the asset and the related deferred tax asset or liability using the simultaneous equations method; and

View C: Allocate the consideration paid between the asset and the related deferred tax asset or liability using the simultaneous equations method; however, any tax benefit in excess of the cost of the related asset is recognised immediately in profit or loss.

The staff recommended View C but noted that even if the IASB and FASB agreed to adopt View C, due to differences in other areas of accounting (primarily differences in the impairment models), full convergence will not be achieved.

The Board supported the staff's recommendations but acknowledged that it was not a perfect solution in all scenarios.

The Board discussed how this would impact assets that have no tax deduction if the asset is used but has a deduction of cost if the asset is sold. Certain Board members stated that the intention, in drafting IAS 12, was that the tax base was the amount deductible on sale but that this was not clear. The staff stated that they were intending to propose changing the definition of tax base to adopt this view.

Reporting Comprehensive Income

The staff noted the purpose of a recently formed joint working group (JWG) of the staffs of the IASB, FASB, and UK ASB is:

• to identify areas where the Boards converge and where the Boards differ between their projects on reporting financial performance,
• recommend an action plan to reduce areas where Boards' views differ, and
• develop a timetable to issue public proposals or discussion documents.

It was reported that the JWG identified two overall project goals, namely:

• Goal 1: Consistent set of required primary financial statements.
• Goal 2: Determine a basis to display the effects of the "mixed-attribute" model and whether there is value in the notion of recycling.

The staff proposed a two-phase approach as follows:

• Phase I representing those issues that may be resolved in the short-term (approximately one year) and may result in an exposure draft.
• Phase II representing those issues that require more research and deliberation and are likely to result in a discussion paper as a first step. Phase II issues either possess underlying conceptual issues requiring changes to the current model that constituents (particularly users) may perceive as far reaching or are issues for which the Boards have indicated divergent goals.

The Board members indicated that:

• They supported the project goals and sub-goals.
• They would prefer to start two projects simultaneously, one being to achieve convergence of presentation (or the form and content of financial statements) and one tackling the conceptual issues.
• There was general agreement with the staff's proposals as to whether the sub-goals can be addressed as part of the convergence or conceptual project except that sub-goal E would be part of the conceptual project.

Revenue Recognition

Regarding the definitions of income and revenues, the staff recommended that:

• it is important to define income before defining revenues;
• definitions of income and revenues should be based on Approach A (defining the items that compose income) and not Approach B (defining the inflows of economic benefits – recognised increases in assets and decreases in liabilities – that are excluded in arriving at income);
• the definition of income under Approach A should be developed from the following initial draft:

  "Income is:
  (a) recognised increases in assets or decreases in liabilities arising from a transaction or event in respect of which there are also related recognised decreases in assets or increases in liabilities that result from the provision of goods or services to customers; and
  (b) increases in equity resulting from other recognised changes in assets or liabilities, except those resulting from investments by owners."

The Board discussed whether the distinction in part (a) of this definition should be based on customers vs non-customers as currently drafted or based on activities of the business. This would determine which transactions are reported gross and which are reported net.

The Board agreed with the first two staff recommendations and asked the staff to develop further the definition of income.

Friday 19 March 2004

Accounting Standards for Small and Medium-sized Entities

The Board discussed a proposed Discussion Paper based on preliminary and tentative Board views based on discussions to date. The Discussion Paper includes specific questions for respondents with respect to the Board's preliminary views. It also sets out alternatives that were considered and the arguments for and against each.

The Board asked the staff to make a number of clarifications in the draft Discussion Paper. The staff will redraft the Discussion Paper based on the Board members' comments with the objective of seeking the Board's approval to issue at the Board's April 2004 meeting, with a 90 day comment period.

The staff noted that the paper will be sent to the advisory panel after the Board meeting for comment.

Board Agenda Priorities

The Board reviewed a staff paper on Board project priorities. The staff recommended:

• the objectives of the April joint IASB/FASB discussions should be to agree:
  • a resource allocation plan that reflects the two Boards' commitment to building a complete and cohesive conceptual framework while at the same time improving financial reporting through development of comprehensive new standards and short-term convergence efforts;
  • the objective of moving toward a single conceptual framework that would be used by the two Boards and the proposed plan for building that framework;
  • the major projects agenda that should be handled jointly;
  • the short-term convergence agenda projects that should be completed as soon as possible;
  • the projects that should be considered as candidates for admission to the joint agenda in the future, as resources permit; and,
  • the timing and sequencing of agenda and research projects.

• that the IASB and FASB develop a plan which has as its objective convergence of the IASB Framework and the FASB's Statements of Accounting Concepts, having regard to the work of the other national standard setters (NSS) on framework matters. High priorities within that plan should be the definition, recognition, and derecognition of the elements and furtherance of the work on measurement. There should also be an emphasis on the interrelationships between the building blocks of the conceptual framework.

• that the following projects (which have both Framework and standards aspects) should be pursued jointly with FASB and, in three cases, also with another NSS:
  • Reporting comprehensive income (with the UK ASB)
  • Liabilities and equity
  • Initial measurement and impairment (with Canadian AcSB)
  • Disclosure framework (with Canadian AcSB)

• that the IASB seek agreement for the following to be added to the list of joint projects with FASB as soon as is practicable:
  • Consolidations (including special purpose entities);
  • Post-employment benefits; and
  • Leases (with the UK ASB).

  The staff noted that this would leave Insurance, IAS 37 revisions, IAS 20 revisions, further stages of the work on IAS 32/39, SMEs, financial risk disclosures, and any other repairs and maintenance work as "IASB only" projects.

• that both IASB and FASB adopt the following research agenda and encourage the other national standard setters to further develop the following with a view to the output being used in joint projects:
  • MD&A (with New Zealand, Germany, Canada and United Kingdom)
  • Extractive activities (with Australia, Norway, Canada, and South Africa)
  • Intangibles (with Australia)
  • Joint ventures (Australia, Malaysia, Hong Kong, and New Zealand).

  The staff noted this leaves hyperinflation and concessions as "IASB only" research projects.

The Board agreed with the staff's recommendations. It was noted that other national standard setters may wish to be more active observers in certain projects.

Certain Board members queried whether aspects of joint venture accounting could be dealt with as a short-term convergence project. It was noted that results from the research project would start to flow later this year and any decision should be deferred until then.

Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk (Macro Hedging)

The Board discussed the following issues:

What should be included in the final Standard about hedging a portion of a financial asset or financial liability?

Earlier in the meeting the Board discussed whether a designated portion need have some relationship to the instrument being hedged. The Board decided that it should not give any guidance on portions beyond that already contained in IAS 39 and the macro hedging exposure draft.

The staff proposed retaining the proposed new paragraph AG99A but removing the rest of the proposed new guidance on portions.

AG99A would state:

"If a portion of the cash flows of a financial asset or financial liability is designated as the hedged item, that designated portion must be less than the total cash flows of the asset or liability. For example, in the case of a liability whose effective interest rate is below LIBOR, an entity cannot designate (a) a portion of the liability equal to the principal amount plus interest at LIBOR and (b) a negative residual portion. However, the entity may designate as the hedged item the change in fair value or cash flows of the entire liability that is attributable to the hedged risk (eg that is attributable to changes in LIBOR). In addition, if a…"

The Board agreed.

What are the implications of the decision made at the last meeting that an entity cannot designate, as a hedged item, a portion of a financial asset or financial liability that is bigger than the total exposure on the asset or liability?

The staff proposed clarifying this issue by amending AG99A as follows:

"If a portion of the exposure on cash flows of a financial asset or financial liability is designated as the hedged item, that designated exposure portion must be less than the total exposure inherent in cash flows of the asset or liability. For example, in the case of a liability whose effective interest rate is below LIBOR, an entity cannot designate (a) a portion of the liability equal to the principal amount plus interest at LIBOR portion and (b) a negative residual portion. However, the entity may designate as the hedged item the change in fair value or cash flows of the entire liability that is attributable to the hedged risk (eg that is attributable to changes in LIBOR). In addition, if a…"

The Board agreed.

Whether to give implementation guidance on how cash flow hedges may be presented in the balance sheet.

The Board discussed three possible presentation formats and agreed to include these within an appendix as guidance. It was noted that further wording should be added to clarify what would not be permitted and that there may be other possible presentation formats.

Proposals put forward by the European Banking Federation (FBE) for a new kind of hedge accounting for hedges of interest rate margin.

In summary, the proposal is that:

• a. There would be a new kind of hedge accounting inserted into IAS 39 (in addition to fair value hedge accounting and cash flow hedge accounting) for hedges of interest rate margin.

• b. In a hedge of interest rate margin, the entity would designate as the hedged item a portfolio of assets and liabilities, accounted for at amortised cost. The hedging objective would be to reduce the potential variability of recognised (ie accrual accounted) interest margin that arises when interest rates change if the fixed (or floating) rate assets in the portfolio do not match the fixed (or floating) rate liabilities.

• c. The entity would also designate one or more derivatives (eg interest rate swaps) as the hedging instrument.

• d. To the extent that the designated derivative(s), when accrual accounted, have the effect of reducing variability of recognised interest rate margin, the hedge is effective.

• e. An effective hedge is accounted for as follows: In the income statement, both the hedging instrument (for instance, the interest rate swaps used to hedge) and the hedged item (that is, the portfolio of assets and liabilities) are accounted for using the effective interest method. In addition, the hedging instrument is measured at fair value in the balance sheet and an equal and opposite liability (or asset) is reported in the balance sheet in an account called 'interest rate margin hedge'. For example, if the designated hedging instrument is a swap and its fair value increases from zero to CU100 (hence the swap is an asset), the entity would recognise both an asset of CU100 for the fair value of the swap and a liability of CU100 for 'interest rate margin hedge'.

The staff noted that the approach has the following features:

• a. It results in amounts being recognised as assets and liabilities that do not meet the Framework's definitions. In the above example in which the entity recognises a liability of CU100 for 'interest rate margin hedge', there is no liability as defined in the Framework. That is, there is no present obligation that is expected to result in an outflow of economic benefits.

• b. The hedged exposure is an accounting exposure (ie the potential variability in accrual accounted interest margin). Under the fair value hedge accounting and cash flow hedge accounting models in IAS 39, the hedged exposure is an economic exposure (to changes in fair values or cash flows).

• c. It follows from (b) that the proposed effectiveness test is rather different from the effectiveness tests in IAS 39. The tests in IAS 39 compare the change in fair value of the hedging instrument with the change in fair value or cash flows of the hedged item. The test proposed for this new kind of hedge would compare how the recognised (accrual accounted) interest rate margin varies with movements in interest rates before and after the hedge.

• d. The hedge would be judged to be effective to the extent it reduces the variability of recognised (accrual accounted) interest margin. Thus no ineffectiveness arises if changes in the hedged portfolio result in the entity becoming under-hedged.

• e The hedged portfolio may include (i) core deposits that are assumed to be fixed rate liabilities up to the date that, on a portfolio basis, they are expected to be withdrawn, and (ii) held-to-maturity assets. IAS 39 would not permit fair value hedge accounting for the former and would not permit either fair value hedge accounting or cash flow hedge accounting for the latter. Hence the proposed approach would permit hedge accounting to be applied in cases when IAS 39 would not.

The Board noted that the FBE did not see this as an alternative to macro hedging, and wanted those proposals to continue, but rather as a proposal to assist in accounting for demand deposits.

The Board noted that work needed to be done to determine how effectiveness testing would be done.

The Board expressed concern as to the inclusion of items that would not meet the framework definitions on the balance sheet. The Board agreed that further work would continue in this area.

Concerns raised earlier at the Board meeting about entities 'ability to game' the macro hedging requirements.

The Board discussed an example that demonstrated how this could be done and acknowledged that it was possible.

The staff recommended that the final Standard retain the proposals in the Exposure Draft that prepayment dates should be re-estimated when interest rates change and that those re-estimates should be in accordance with the entity's risk management procedures and objectives.

The Board agreed with the staff's proposals.

Financial Guarantees and Credit Insurance

The staff proposed the following text for IAS 39 paragraph 2(f):

[This Standard shall be applied by all entities to all types of financial instruments except] "financial guarantee contracts (including letters of credit and other credit default contracts) that provide for specified payments to be made to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due under the original or modified terms of a debt instrument (see paragraph 3 and paragraph AG4A of Appendix A). Although such a contract is an insurance contract as defined in [soon to be issued] IFRS 4 Insurance Contracts, it is excluded from the scope of IFRS 4. An issuer of such a financial guarantee contract shall initially recognise it at fair value, and subsequently measure it at the higher of (i) the amount recognised under IAS 37 Provisions, Contingent Liabilities and Contingent Assets, and (ii) the amount initially recognised less, where appropriate, cumulative amortisation recognised in accordance with IAS 18 Revenue. Financial guarantees are subject to the derecognition provisions of this Standard (see paragraphs 39-42 and Appendix A paragraphs AG57-AG63)."

The Board agreed that any changes to this arising from the exposure draft previously agreed would be effective from 1 January 2006 and would be applied retrospectively.

Tribute to Retiring Board Member Harry Schmid

The Chairman closed the meeting by noting that this was Harry Schmid's last meeting and, on behalf of the Board, thanked him for his many years of input and support as a member of both the IASB and the predecessor IASC.

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