Accounting Standards for Small and Medium-sized Entities (SMEs)

The staff noted that a discussion paper on this topic would be formally issued on Thursday, 24 June 2004, with comments due by 24 September. The staff has identified 40 organisations of SMEs, primarily in Europe, to which the discussion paper will be sent in an attempt to elicit comments from those directly involved in preparing SME financial statements, in addition to IASB's normal respondent base.

The Board then discussed extractions of SME standards from full IFRSs, considering IAS 1, IAS 8, and the IASB Framework. The Board will continue to consider extractions of standards at its July and September meetings while awaiting responses to the discussion paper. The Board agreed that the process for extractions would be to identify the principles in each existing IFRS, consider the appropriateness of the principles for SMEs, consider what additional requirements are needed to operationalise the standard, and where necessary provide additional guidance.

Accounting policy choices. If there is an accounting policy choice in an IFRS, the Board considered whether all of the policy choices in the IFRS should also be available in the related SME standard. The Board agreed that the SME standard should identify the policy choice that it believes is the simplest and most relevant, and generally include only that policy choice in the SME standard, with a cross-reference to the additional choice(s) in the IFRS, which SMEs may elect to apply.

Optional fallback to IFRS. The Board had already agreed that if an entity chooses to apply a treatment in a full IFRS rather than the SME provisions, it must apply the entire IFRS in which that treatment is addressed. For example, if the SME borrowing costs standard does not provide for capitalising borrowing costs, an SME could elect to capitalise by applying IAS 23. In that case, however, IAS 23 would be applied in its entirety.

Mandatory fallback. The Board then considered the 'mandatory fallback' when an SME standard does not address a particular transaction that is addressed in the full IFRS. For example, if the SME employee benefits standard only discussed how to account for defined contribution plans, which requirements would an SME with defined benefit plans be required to comply with? The Board agreed the mandatory fallback to an IFRS should be on an issue by issue basis, rather than a standard by standard basis. Accordingly, in this example, the entity would be required to comply with the requirements of IAS 19 as they relate to defined benefit plans, but would not be required to comply with all other requirements of IAS 19.

Preface. The Board agreed that there is a need for a preface, or similar document, for the SME series of standards. Such a document would explain which entities are eligible to use the SME standards and the rules relating to voluntary and mandatory fall-backs to full IFRSs. The staff agreed to prepare a proposed preface once comments on the SME discussion paper have been received.

Interpretations. The Board considered the role of SIC Interpretations and IFRIC Interpretations in the SME regime and agreed that if, for any reason, an entity must look to full IFRS in accounting for a transaction, that entity is also required to take account of the related SIC interpretations. The Board agreed that where Interpretations are relevant to SMEs those interpretations should be incorporated into the relevant SME standard.

Justifications for changing an IFRS in the SME version. The Board discussed appropriate reasons for the SME standards departing from full IFRS and agreed that a departure from full IFRS should be considered for the SME standards in the following situations:

• The issues are unlikely to be relevant to SMEs.
• Where the departures will better meet SME user needs.
• On the basis of a cost/benefit analysis.
• Where it is possible to simplify a measurement calculation without detracting from the principle.
• Where it is possible to provide guidance for a type of transaction that may be common for SMEs.

The Board agreed that the basis for conclusions of each SME standard should explain the rationale for changes to the full IFRS.

Going concern. The Board considered the requirement in IAS 1 for an entity to disclose whether or not it is a going concern, and agreed that this requirement should be retained in the SME standard. The Board considered the merits of providing guidance as to how to complete the accounting for an entity that is not considered to be a going concern and decided against it.

Classified balance sheet. The Board considered whether the SME version of IAS 1 should include balance sheet presentation both on the current/non-current basis and also the liquidity basis. The Board agreed that both alternatives should be retained in the SME standard, and further guidance should be provided on identifying which of the two alternatives provides the most relevant and reliable information.

Analysis of expenses. The Board considered whether the SME standard should require expenses to be analysed only by nature (IAS 1 allows a choice of nature or function), and agreed to leave both alternatives in the SME standard.

Illustrative guidance. The Board discussed the status of the illustrative examples to IAS 1 and agreed that those examples should be retained in the SME standard with the same status as they have in IAS 1. That is, those examples that form part of the standard will be considered mandatory, and those that are identified as being an accompaniment to, rather than a part of, the standard will be considered non-mandatory.

Statement of changes in equity. The Board considered the format of the statement of changes in equity, and which of the alternatives in IAS 1 is most relevant to SME users. The Board agreed that the format that includes transactions with owners as owners is most relevant and should be required as part of the SME regime, with the SME standard cross-referring to IAS 1 should entities wish to use an alternative format.

Disclosure of management judgements and assumptions. The Board agreed that the requirement to disclose significant management judgements used in preparing the accounts should not be retained in the SME regime, but the requirement to disclose information about key assumptions concerning the future and other key sources of estimation uncertainty at balance sheet date should be included in the SME standard.

True and fair override. The Board discussed the appropriateness of including the "true and fair override" in the SME standard. The Board agreed that this requirement should be mentioned in the SME standard with a cross-reference to the explanation of the requirement in IAS 1.

Liability classification. One Board member noted that the FASB was unlikely to converge with the IASB on the classification of a liability as current at balance sheet date if a breach of a covenant is cured after balance sheet date but before the financial statements have been authorised for issue, because SMEs, in particular, often may be unlikely to identify a breach before the balance sheet date, and therefore would not have an opportunity to rectify it until after balance sheet date.

The Board agreed that if time permitted they would return to this topic at a later point in the meeting.

Matters Arising from IFRIC Meeting 3-4 June

The staff provided a brief update on the activities of IFRIC. IFRIC 1 has been released, and EFRAG is recommending that this interpretation be endorsed in Europe. The staff explained the way in which they are using national standard-setters to assist in IFRIC activities. They noted that IFRIC Draft Interpretations D2 to D6 are currently outstanding, and they anticipate that D7 through D14 will be released prior to the end of 2004. Staff were hopeful that the IFRIC will have released up to eight final interpretations by the end of 2004.

The Board considered a draft interpretation that would (a) remove the scope exemption from SIC 12 for employee share schemes and (b) clarify the scope requirements of SIC 12 relating to post-employment benefit plans. The Board did not object to IFRIC's issuing it for public comment.

Business Combinations (Phase II)

Fair value hierarchy. The Board discussed the fair value hierarchy. The FASB intends to issue an exposure draft soon outlining their fair value hierarchy, and the Board considered what its approach to this should be, given that a comprehensive and consistent fair value hierarchy is critical to the success of the Business Combinations Phase II project. The Board agreed that it should publish a proposed fair value hierarchy for public comment separately from the business combinations project. That is more likely to catch the attention of constituents that may have a limited interest in the Business Combinations project, for example investment banks, as the outcomes of the hierarchy debate will have wide ranging implications across all IFRS that require the use of fair value, including the requirements relating to financial instruments. The Board agreed that the proposed fair value hierarchy should highlight any differences with the hierarchy proposed by the FASB. The initial view of some Board members was that there did not appear to be any substantive differences, and the staff indicated their intention to work with the FASB staff to determine whether mutually acceptable drafting could be agreed upon.

Replacement grants of stock options. The Board considered the replacement of acquiree share-based payment awards by acquirers, and whether some or all of such replacements should be treated as part of the cost of the business combination. The Board agreed that where the acquirer has an obligation (legal or constructive) to replace the share-based payments at the date of acquisition the replacement must be considered as part of the cost of the business combination. The Board agreed that the requirements of IFRS 2 must be applied in determining the fair value of the replacement award. Where a replacement grant partly relates to future employee service it should be allocated between purchase price and post-combination expenses. Where this occurs future 'truing-up' of the expense should be relate only to the period between the date of the acquisition and the date of truing-up.

Where the fair value of the replacement grant exceeds the fair value of the original grant, the incremental fair value is to be treated a post-combination expense. The Board agreed that the measurement of post-combination expenses should be based on the acquisition date fair value of the instrument.

The Board agreed the following principles with respect to replacement of employee benefit awards:

• Where vested awards are replaced with vested awards, the full acquisition date fair value should be included in the cost of the business combination.
• Where a vested award is replaced with a non-vested award the fraction of the acquisition date fair value relating to prior requisite service must be included in the cost of the business combination, and the remainder is treated as a post combination expense. The staff noted that this represents non-convergence with FASB, as the FASB have agreed to allocated based on the total period outstanding (for example, ten years between grant date and new vesting date) while the IASB have agreed to allocate based only on the requisite service periods (for example, an employee may have needed to do four years service for it to vest initially, and another three under the new conditions - IASB would allocate the amount between seven years, while the FASB would allocated between the total number of years elapsing between grant date and final vesting which may be significantly greater than seven years).
• Where a non-vested award is replaced with a non-vested award the entity must recognise the effect of any acceleration of the vesting conditions as a post-combination expense immediately. Where no acceleration occurs the acquisition date fair value of the replacement award is allocated between cost of acquisition and post combination expense based on the fraction of the requisite service period still outstanding.
• Where a non-vested award is replaced with a vested award the acquisition date fair value is allocated between cost of acquisition and post-combination compensation expense based on the fraction of the requisite service period of the original award still outstanding. The effect of the immediate vesting is then recognised immediately as a post combination expense.

Post-acquisition date events. The Board agreed that where post-acquisition-date events alter the measurement of share-based payment awards the purchase price of the acquisition should not be amended for the effect of those events.

Mutual entities. The Board considered the inclusion of business combinations between one or more mutual entities within the scope of the FASB's Phase II project on Business Combinations. The Board agreed that they should discuss at the September meeting the issues the FASB considered in reaching this conclusion and determine whether or not those issues have been adequately addressed by the Phase II project. If the Board believe the issues have been addressed then such transactions will be within the scope of the Phase II Business Combinations project.

Transition - contingent consideration. The Board considered the transitional provisions in relation to contingent consideration as the current version of IFRS 3 requires that the accounting for a business combination be adjusted based on the outcome of contingent consideration agreements, while the future project will require that contingent consideration to be fair valued and included at acquisition date without subsequent amendment. The current version of IFRS 3 also requires that the initial accounting for a business combination be adjusted for deferred tax assets not recognised at the date of acquisition that subsequently prove to be recoverable. The Board considered the alternatives, and determined that they would converge with the FASB in requiring that business combinations occurring before the date of application of the Phase II standard should be adjusted for changes to the contingent consideration but not changes to the recoverability of tax balances.

Transition - contingent liabilities. The Board agreed that when the Phase II Business Combinations standard comes into effect any existing contingent liabilities recognised as part of a business combination in accordance with the current version of IFRS 3 that do not satisfy the revised recognition criteria should be derecognised immediately via an adjustment to goodwill. Where this would result in the creation of or increase of negative goodwill, the adjustment should be recognised directly in retained earnings.

Valuation techniques. The Board agreed that the Phase II Business Combinations document should include guidance on using valuation techniques (such as a market-based approach and an income approach) to measure the fair value of businesses acquired.

Bargain purchase. The Board agreed that where a business combination appears to contain a bargain purchase, any excess of the fair value of the acquirer's interest in the business acquired over the fair value of the consideration given for that interest should be recognised as a reduction in the total amount of goodwill until the goodwill is reduced to zero, and any excess remaining after the total amount of goodwill has been reduced to zero should be recognised immediately in profit or loss.

Short-term Convergence - Income taxes: Definition of 'Tax Base'

The staff provided a brief update on the income tax convergence project. Both the FASB and the IASB have yet to discuss the allocation of tax items to shareholders' equity, issues relating to investments in subsidiaries, branches, associates and joint ventures, and disclosure issues. The staff noted that the FASB has yet to discuss certain issues already agreed by the IASB including scope exceptions that currently exist in SFAS 109 for inter-company transfers of inventory, accounting for foreign non-monetary asserts, and certain criteria for measuring deferred tax assets and deferred tax liabilities, such as the use of enacted rates versus substantially enacted rates. The staff noted that all these issues will have been discussed by both Boards by the end of October.

The Board agreed to amend the definition of tax base so that it reads as follows:

Tax base is a measurement attribute. It is the measurement under existing tax law applicable to a present asset, liability or equity instrument recognised for tax purposes as a result of one or more past events. That asset, liability or equity instrument may or may not be recognised for financial reporting purposes.

The Board agreed that examples of tax base should be included as application guidance to a revised IAS 12. The Board agreed that an entity should only recognise deferred tax assets and liabilities for basis differences that will result in taxable or deductible amounts where the reported amount of the asset or liability is recovered or settled. The Board agreed to eliminate the guidance in IAS 12 relating to the way in which management intent as to how the carrying amount of an asset or liability will be recovered can impact the tax base of that asset or liability.

The Board agreed that additional guidance should be provided to support the notion of a 'tax balance sheet' in order to clarify to constituents that this is a balance sheet that would be presented if tax law was used as the basis for accounting.

Tuesday 22 June 2004

Liabilities and Equity - Reassessed Expected Outcomes Approach

The FASB staff presented the Reassessed Expected Outcomes (REO) approach for determining classification, unit of account, measurement, and earnings per share for financial instruments involving an issuer's own shares and a list of 'touchstones' developed by the FASB staff based on objections heard from FASB Board members and others to various possible approaches to resolving liability and equity issues.

This approach breaks down equity-linked instruments into its base components of ordinary share equity, liabilities, and assets by analysing the expected future cash flows and other flows of economic resources at each reporting date. A financial instrument or portion thereof would only be classified as equity if its expected payment varies directly with the share price.

This method would, therefore, change the existing liability and equity distinction, which is based on amounts repayable in cash. Although the allocation would be recalculated at each reporting date, the reallocation would be based on the original proceeds, and the only effect of share price movements would be to change expected outcomes.

The Board expressed concern about the approach and, in particular, about the manner in which this would change the nature of accounting for equity and liabilities. They did, however, support exploring the approach further in conjunction with the FASB.

Revenue Recognition

The staff noted that the Board had previously tentatively concluded that the fair value of an entity's performance obligations should be measured at the 'legal layoff amount'. In considering this the Board noted that different prices exist and requested the staff to consider why these prices arise.

The staff noted that the price differences arose from different bundles of goods and services. The staff recommended that the 'legal layoff amount' should be measured at the minimum amount the entity would incur to settle the specific bundle of goods and services including internal costs such as arranging delivery or insurance. Certain Board members continued to express concern as to this approach. It was noted that discussion on this topic would continue.

The Board agreed that estimates used in revenue recognition should be subject to the same reliability threshold as used for other estimates in financial reporting.

The Board discussed various examples with differing ways of determining the fair value of the performance obligation to determine what factors they would accept as evidence of fair value.

Leasing

The Board discussed subsequent accounting for amounts recognised as assets and liabilities under leases. They noted that their previous discussions had concluded that the assets arising under lease agreements tend to be rights associated with the lease agreement, rather than physical assets, and that accounting should recognise those rights and obligations. Accordingly, the term depreciation was not considered appropriate, and Board members found it helpful to think of the charge as an allocation of rights of use over the period of the usage.

The Board discussed examples of subsequent accounting in the case of:

• Straight forward leases.
• Leases with lease payments that are conditional on external price changes.
• Leases with lease payments that are conditional on the lessee's usage.
• Leases with lease payments that are conditional on the lessee's revenues.
• Leases with renewal options.

The Board noted that it would be possible to make subsequent accounting adjustments to the value of the rights arising under the lease without necessarily being on the fair value model.

The Board asked the staff to prepare a paper considering the accounting for the rights of use (considering the appropriateness of IAS 16 and IAS 38) and the liability (in accordance with IAS 37 or IAS 39) for discussion at a future meeting.

Wednesday 23 June 2004

Financial instruments - Amendment to IAS 32: Financial Instruments Puttable at Fair Value

The Board discussed creating an exception to the liability classification for shares that evidence a residual interest in the assets of an entity and that are puttable to the entity at fair value. It was noted that IAS 32 currently requires classifying these instruments as liabilities. If the fair value exceeds the recorded net asset value, this results in a recorded net liability position.

The Board expressed mixed views. Some were concerned about reporting a net liability position, and they favoured an immediate solution. Others believe that the issue is more fundamental because it relates to the definitions of equity and liabilities; they want to wait for that project to be finalised. The Board asked the staff to explore the issue further and consider whether a short-term solution that can be restricted to solving the immediate problem is apparent.

Financial instruments - Disclosures: Sweep Issues

During the preballot draft some Board members questioned whether the requirement to disclose "the effective interest rate on the liability component (excluding any embedded derivatives that are accounted for separately)" provides additional information whose value exceeds the cost of providing it. The full proposed disclosure is:

"If an entity has issued an instrument that contains both a liability and an equity component (see paragraph 28 of IAS 32) and the instrument has multiple embedded derivative features whose values are interdependent (such as a callable convertible debt instrument), it shall disclose the existence of those features and the effective interest rate on the liability component (excluding any embedded derivatives that are accounted for separately)."

A number of Board members questioned what a user would do with this information. The Board agreed to remove this requirement.

Exploration for and Evaluation of Mineral Resources - Redeliberation of ED 6

The Board commenced discussions considering comments received on the exposure draft.

Definitions. The Board considered whether any changes should be made to the definitions of exploration and evaluation assets, exploration and evaluation expenditures, and exploration of and evaluation for mineral resources, and in particular whether further guidance on the inclusion of general and administrative expenses in the initial measure of these assets should be provided.

Exemption from IAS 8 hierarchy. The Board agreed that no changes be made to the definitions but that further guidance be provided. In addition they agreed that no guidance be provided on general and administrative expenses or the inclusion of any other expenses.

The Board agreed to retain the exemption from the IAS 8 hierarchy for exploration and evaluation activities, as proposed in ED 6, but to provide further guidance for new entities consistent with the standard on insurance contracts.

Revaluation. The Board agreed to retain the ED 6 proposals permitting revaluation of assets.

Changes in accounting policies. The Board agreed to retain the ED 6 proposals regarding changes in accounting policies.

Classification of exploration and evaluation assets. The Board agreed that classification of exploration and evaluation assets could continue under either IAS 16 (tangible asset) or IAS 38 (intangible asset).

Impairment. The Board discussed the ED 6 proposals in respect of impairment of the assets and the cash generating unit. The Board noted that a number of commentators had expressed concern about those proposals. The Board concluded that certain relief should be provided to ensure that the proposals are workable. The staff were requested to develop proposals to require an impairment test in certain circumstances. The specific circumstances need to be developed.

Disclosure. The staff recommended that an explicit requirement be added to require the disclosures required by either IAS 16 or IAS 38 whichever is relevant. The Board agreed.

Timetable. Publication of a standard is anticipated in December 2004.

Consolidation

The Board discussed a paper considering the characteristics of a fiduciary relationship that indicate that a controlling relationship does not exist, and agreed that the exposure draft on this issue should focus on the impact of those characteristics, rather than being based on a definition of 'fiduciary relationship', as such a definition may not be relevant to all jurisdictions.

The staff recommended, and the Board agreed, that the following observations about the control test should be included in the Exposure Draft:

a. An entity need not have unrestricted power to satisfy the power criterion. In particular, restrictions on the entity's decision-making that only have the effect of providing protection to third parties are not inconsistent with the entity having power;

b. An entity with the following characteristics does not satisfy the control test:

(i) it has power but is explicitly required by agreement or at law to use its power for the benefit of third parties. This requirement prevents the entity acting in its own interests to the detriment of those third parties;

(ii) the entity's ability to benefit from the assets over which power is held is limited. In particular, its entitlement must be agreed between itself and the third parties in whose benefit it must act (or entities representing those interests); and

(iii) its benefits from the assets over which it has power are, in effect, limited to a fee for services provided.

The Board asked staff to consider whether it might be possible to issue authoritative guidance on whether a fund manager that does not have a dual relationship is considered to control an investee in a more timely manner than they expect to complete this project.

At its September meeting the Board will consider a paper on structures of Special Purpose Entities.

The Board agreed that active communication with the FASB on the progress of this project should be maintained. This topic will be discussed at the joint IASB-FASB meeting to be held in October.

Meeting with Nordic Regional Standard-Setters

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