Insurance Contracts [Education Session]

The IASB had an education session presented by the International Actuarial Association, focussing on non-life claims liabilities.

Amendment to IAS 39 - Cash Flow Hedge Accounting of Forecast Intra-group Transactions [Education Session]

Representatives of Philips made a presentation to the Board. The presentation covered a series of transactions, including inter-group sales, that created risk exposures that require hedging as per the entity's policy. These illustrations highlighted the difficulty of applying the proposed amendment of IAS 39 to exposures that are generally common in practice. It also highlighted the difference between transaction risk and translation risk exposures.

One view expressed is that these issues arise in part because the IASB's proposed amendments have not gone far enough in converging with US GAAP.

Insurance Contracts

The staff indicated that it is too early to develop a detailed plan at the moment. Much depends on the advice that emerges from discussions within the Insurance Working Group and on the interaction with other projects. The staff will update this plan as the project progresses and make it more detailed.

The Board discussed the interaction of this project with the other projects that are currently underway: conceptual framework, revenue recognition, accounting measurement, performance reporting, financial instruments, and the liability and equity project. The staff indicated that the level of interaction makes it difficult to develop a detailed timetable at this stage.

The remit of the Financial Instruments Working Group was discussed in the context of how its work affects this project. The Board agreed that there would be consultation on an ad hoc basis rather than formulating a policy framework.

The Board noted that the interaction of the insurance project with the revenue recognition project would be challenging.

On the issue of convergence, the staff indicated that the FASB is not expected to commit resources to the insurance contracts project at this time. The Board indicated its intention to continue with the project.

The Board was asked whether any 'initial output' document should be issued for comment – something along the lines of a brief discussion paper, dealing only with certain 'hot spots' and indicating the Board's preliminary views. The Board agreed with this approach and advised the staff not to dwell on matters of detail. The following topics would be the main areas of focus in that paper:

• Model. Should the Board create a single model for all contracts, or different models for different types of contracts? Should the accounting model be based on direct measurements of contract assets and liabilities (asset-and-liability model), on deferral and matching of contract revenues and expenses (deferral-and-matching model), or some combination of the two?
• Measurement. Should an asset-and-liability model use measurements based on fair value, entity-specific value, or some combination of measurement attributes? If the measurement attribute is fair value, should it be a business-to-customer measurement (customer consideration) or a business-to-business measurement (legal layoff). Should the measurement address options or guarantees embedded in a contract?
• Discounting. Should the measurement of some or all amounts recognised in the balance sheet be based on their present values?
• Asset/liability interaction. Should the measurement model incorporate expectations about asset performance in determining the carrying amount of the contract liability?
• Risk/service adjustment. How should the accounting model approach the question of risk (or service) adjustment?
• Gain or loss on initial measurement/liability recognition. Should the accounting model be constructed in a manner that prohibits or significantly limits the recognition of net profit or loss on initial recognition?
• Policyholder behaviour. Should the accounting model incorporate expectations about cash inflows and outflows that are a consequence of policyholder renewals or cancellations of an insurance contract?
• Acquisition costs. Should costs incurred to acquire new insurance contracts be capitalised as assets and amortised?
• Unbundling. Should the measurement model unbundle the individual elements of an insurance contract and measure them individually?
• Participating contracts. How should the insurer's liability to holders of participating contracts be recognised and measured?
• Credit standing. Should the measurement include the effects of the entity's credit standing?

Amendments to IAS 39 and IFRS 4 – Financial Guarantees and Credit Insurance

The purpose of the Board's discussion was to assess whether the Board should proceed, in general terms, with the proposals in the ED on Financial Guarantee Contracts and Credit Insurance.

On the balance of considerations arising from the comment letter analysis and the deliberations regarding Insurance Contracts (Phase II), the Staff recommended that the proposal be withdrawn. The Board discussed this issue at length and reached some consensus that this issue should be brought back to the Board at a later date, whilst in the interim, the Staff would work on a proposal along the following lines:

• Clarify in the scope of IFRS 4 that financial guarantees are within the scope of IAS 39 whereas credit insurance contracts are dealt with in IFRS 4. This was generally viewed as providing a free choice as the 'labelling' of a contract could drive the accounting treatment.
• The revised guidance in the exposure draft would be incorporated into IAS 39.
• The IAS 39 scope paragraph would clarify that it applies to financial guarantees.
• The loss adequacy test in IFRS 4 would apply to credit insurance contracts on the basis of IAS 37.

It was noted that the accounting outcome for both types of contracts (financial guarantees and credit insurance contracts) would be substantially the same, regardless of which option is chosen.

Accounting Standards for Small and Medium-sized Entities

The Board reviewed and affirmed the summary of tentative decisions that the Board had made in December 2004 on the appropriate way forward for the project. The Board agreed to clarify, in the summary, that the same IASB Framework should apply to all entities. However, the Board should consider recognition and measurement simplifications for SMEs, as well as disclosure and presentation simplifications, based only on user needs and cost-benefit considerations as provided for in the IASB Framework. There should be no preconceived objections to such changes.

The staff has developed a project plan that includes:

• expanding the Advisory Group by adding preparers and users of SME financial statements; organising round-table meetings with preparers and users of SME financial statements;
• soliciting the views of the Standards Advisory Council;
• holding a meeting of the Advisory Group;
• leveraging several upcoming conferences at which SME accounting issues will be addressed.

A meeting of the Board's internal SME subcommittee has been scheduled to discuss the plan and provide guidance to the staff.

Several Board members proposed that another name or title for this project should be considered, as the 'SME' title was causing an expectation gap. Staff will provide recommendations to the Board at a future meeting.

Thursday 20 January 2005 (afternoon only)

Segment Reporting

The Board considered an analysis of the differences between IAS 14 Segment Reporting and SFAS 131 Disclosure about Segments of an Enterprise and Related Information. IAS 14 focuses on segment information that is consistent with the consolidated financial information in the financial statements, while SFAS 131 focuses on information that reflects the manner in which the entity manages the business. It was noted that prior to the introduction of SFAS 131 the US standard was based on similar principles to those currently in IAS 14. The Board noted that both academic research and meetings with analysts had revealed that the SFAS 131 approach was preferred and provided more useful information.

It was noted that information prepared for the purposes of decision making was likely to be more accurate than that prepared solely to satisfy external reporting requirements. The one concern noted by some analysts and board members about the SFAS 131 approach was the fact that SFAS 131 does not require consistent accounting policies to be used between segment information and other financial reporting information; however differences in accounting policies must be disclosed. It was noted that the objective of this project is to achieve convergence, and it is highly unlikely the FASB would move to a model where consistent policies were required. The Board agreed that in the interests of convergence, SFAS 131 should be brought to them in IASB Exposure Draft form for consideration and release for comment. The Board also noted that SFAS 131 itself was developed in conjunction with the Canadian standard setter, and therefore is already in a format more consistent with IFRS than most US pronouncements. However, the Board noted that there have been differences of interpretation between Canada and the US, and that the Board should endeavour to resolve those so that only one interpretation is possible under IFRS.

The Board agreed to consider the Exposure Draft at a future meeting, and that as few changes as possible should be made to the US pronouncement. If any issues arise as a result of commentators concerns these could be brought to the attention of the FASB for attention at a later time.

Convergence – Income Tax

The Board considered a number of issues relating to the deferred taxes project, which had been considered by the FASB at their meeting on Wednesday 19 January 2005.

Enacted vs. Substantially Enacted

At its meeting in April 2003 the Board had decided to retain the phrase 'substantially enacted' (when determining which aspects of tax law to take into account) so that the changes to tax law need to be virtually certain before being taken into account. However, staff of FASB and IASB had proposed that this should be altered to state that changes in tax law should be taken into account only when remaining steps in the process were considered perfunctory. At its meeting the FASB had suggested that 'ceremonial' might be more appropriate than 'perfunctory'.

The Board noted that in the US, the signature of the president would be necessary for the 'virtually certain' criteria to be met, whereas in other jurisdictions, the giving of 'royal assent' would not be necessary for the virtually certain criteria to be met. The Board noted that the requirement should focus on the process of passing tax law rather than the probability of law being passed. The Board agreed to retain the principle of 'substantively enacted' and 'virtually certain' - clarifying that this means changes in tax law should be recognised when the process of making the law is complete - that is the remaining steps in the process will not change the outcome. The basis for conclusions will clarify that in the US environment this criterion is only met following the signature of the president.

Undistributed rate vs. Distributed rate

In April 2003 the Board agreed that the undistributed rate should be used in recognising tax in the consolidated accounts, as distribution is the trigger for the applicability of the distributed rate, and until the distribution occurs (or at least is declared), it is not possible to claim that the distributed rate will be applicable. However, the FASB believe that the distributed rate should be used because the event giving rise to the tax is the earning of the income, and this is consistent with how we account for other rights that give rise to assets (the right to distribute and thereby apply a more favourable tax rate is an asset of the company). The IASB did not agree with this logic, particularly as in some cases solvency requirements may prevent the payment of a dividend, and it seemed counter-intuitive to recognise an asset that the entity is unable to realise. The majority of the Board favoured using the undistributed rate, and therefore this item will be brought to the joint meeting of the Boards in April 2005 for debate.

Should a parent company always use the same rate as its foreign subsidiaries?

The Board then considered whether subsidiaries should use the distributed rate in their accounts, as they had previously agreed should occur, and whether this was consistent with the decision above. The Board agreed that it is reasonable to assume that profits will be distributed within the group, but not to assume that they will be outside of the group. It was noted that potential payment of dividends to external shareholders does not give rise to a temporary difference - to recognise a deferred tax asset for this is to recognise based on a supposition of one alternative as to what the entity might do with the money. Conversely, in the group situation, it is necessary for the entity to provide for all taxes that would need to be paid in order for the group as a whole to benefit from the earnings. Therefore the use of the distributed rate in subsidiary accounts is not inconsistent with the above conclusion.

The FASB had noted the exemption from the use of the distributed rate that applies to situations where money is permanently reinvested in foreign subsidiaries. They had expressed concerns about the use of distributed rate for subsidiaries not meeting this criterion, because this would lead to inconsistent assumptions between subsidiaries.

The Board reaffirmed its decision that the distributed rate should be used for subs, with the exemption for permanent reinvestment simply being a practicality exemption rather than a technical exception. The Board agreed that comprehensive examples should be brought to the joint meeting in April for debate.

Probable

The FASB noted the decision of the IASB to continue to use the word 'probable' in the criteria for recognising deferred tax assets, but to clarify the meaning of probable is 'more likely than not' (the words used in the US standard). No further issues were raised in relation to that decision.

Other items

The Board considered the following additional differences between SFAS 109 and IAS 12 that might need to be scoped into the project:

• Accounting for deferred taxes where graduated tax rates apply (the FASB had noted that it would be nice to use the same words on this issue, but that this was not a big issue); and
• Accounting for tax attributes of an acquirer that become realisable as a result of the acquisition (the Boards both agreed this should rather be resolved in the joint project on business combinations).

The Board agreed that any guidance that is currently in SFAS 109 that is not in IAS 12 should be considered by the Board for inclusion in the Exposure Draft. The Board agreed that a joint ED should be issued, and the same wording should be used as far as possible for amendments being made to the existing standards; but the fundamental structure of the existing standards need not be changed.

Conceptual Framework – Initial Communications Document

The Board considered an 'initial communications document' on the joint conceptual framework project. This document is a staff paper which will highlight to interested parties the objective and intentions of this project. The target market for this paper is the parties who normally actively participate in the standard setting process by way of formal comment. The paper will be posted on the website and distributed to subscribers. The key points of the paper include a discussion of how principle based standards tie in to concepts, the difficulty of reaching joint conclusions when underlying concepts are different, and a discussion of the elements of the frameworks. The Board agreed the paper should acknowledge the intention to grab aspects of conceptual frameworks from other national standard setters in instances where those frameworks are found to be superior, and that national standard setters will be actively involved in this project.

The Board agreed that this document should be jointly issued as a staff paper, and agreed to provide drafting amendments out of session, and consider the re-drafted paper prior to issue. It was also agreed that a more high level document, targeted at the CFO level, would be prepared by a professional business writer, and common materials would be prepared for Board members to explain the project to such audiences. The Board noted that a detailed project plan for this project is currently being prepared, and indicated an intention to discuss this plan at the February meeting.

Friday 21 January 2005 (morning only)

IAS 39 and IFRS 4 – Financial Guarantees and Credit Insurance

Following Wednesday's discussion, the staff presented to the Board, four options:

1. Not to proceed with the ED. This would mean abandoning, at this time, the IAS 39 revisions therein.

2. Proceed with the ED in its present form.

3. Amend IFRS 4 to make IAS 37 provisions mandatory. This would change accounting for insurance contracts which would not be consistent with the original intention of IFRS 4.

4. Allow a free choice between IAS 39 and IFRS 4, after the following amendments:
a. IAS 39, incorporate the ED amendments thereto, or IFRS 4 as is currently drafted.
b. IAS 39, incorporate the ED amendments thereto, or IFRS 4 including an IAS 37 adequacy test which would be a 'strengthening' of the IFRS 4 adequacy test, only for such contracts.

After much discussion the Board agreed to proceed with 4b.

Amendments to IAS 39: The Fair Value Option

Summary of Comments Received on the Preliminary First Draft of a Possible New Approach

A clarification was made at the outset to consider the responses to the exposed paper as 'reactions' and not comments in the normal sense, due to the process followed in obtaining those responses. It was also pointed out, that due to this process, the reactions received which included oral and email communication, none of the responses had been posted onto the IASB website.

It was indicated that the wide variety of needs in this area results in difficulty when determining the appropriateness of the fair value option to those that can and want to use it, whilst trying to place restrictions on it in order to address the needs of others.

After some discussion, some Board members expressed their concern at the lack of clarity of the bank regulators' concerns as regards the fair value option, and underscored that there was a possibility that there might in fact, be nothing wrong with the fair value option. Some Board members pointed out that the 'roundtable discussions' should be replaced by a public education session at which the bank regulators, particularly the European Central Bank, would be provided the opportunity to put forward their concerns to the full Board.

A general concern was raised regarding the reason why a particular constituency's concerns, which appeared contrary to the majority's view, were being considered so extensively by the Board. It was also pointed out that an overwhelming majority of respondents disagreed with the 'possible new approach' and fully supported IAS 39 with the unrestricted fair value option.

The issues raised by the bank regulators at the round-table discussions were noted as follows:

• The fair value option introduced risks in situations where internal controls, systems etc are not operating adequately, leading to an incorrect application of the fair value option.
• Certain instruments which could only be measured by valuation models would present an opportunity for entities to manage earnings by 'cherry picking' those instruments that would give the desired outcome.
• The inadvertent measurement at fair value of only one side of the balance sheet, thereby creating a mismatch in measurement basis across the balance sheet.

Responses to these concerns by Board members highlighted the following:

• Application guidance is already in place that addresses the criteria and circumstances under which valuation models can be used under IAS 39.
• Disclosure requirements already in place address the earnings management concerns.
• The risks that the bank regulators are trying to manage do not arise from the accounting, but rather the terms and conditions of the contracts entered into by management.
• The fair value option is an irrevocable choice at the point of initial recognition; therefore, there is no risk of cherry picking as the future performance is unknown at that point in time.

The point was made, that it appeared as though the concerns raised by the bank regulators were in fact issues that they themselves, could manage given their mandate and that the debate around the fair value option was not really an accounting debate, but possibly something else.

It was pointed out that another paper would be considered at the February meeting which would incorporate the reactions received to date on the proposed new approach.

ED 7 – Financial Instruments

Capital disclosures

The proposed requirements in ED 7 would result in entities providing disclosures that are intended to enable users to evaluate the entity's capital. Those provisions in ED 7 attracted the most criticism of any of the proposals in the ED. Of the 95 respondents that commented on the capital disclosures, 85 (89%) disagreed with some aspect of them.

The staff recommended that the Board:

a. confirms its proposal to require disclosure of a description of what the entity regards as capital;

The Board agreed but asked the Staff to clarify that this disclosure requirement pertains to capital that an entity manages as opposed to what that entity 'regards' as capital. In addition, clarification should be made that capital and equity are not references to the concept.

b. does not require the proposed disclosure of whether the entity has complied with the capital targets set by management, or the consequences of any non-compliance.

The Board agreed, after much debate, to remove the requirement (consistent with the Staff proposal) on the basis that it would not be operational. The original intention of this requirement was to act as an early warning mechanism of possible breaches in the future.

c. confirms the proposals in ED 7 to require disclosure of qualitative information about the entity's objectives, policies and processes for managing capital;

The Board agreed.

d. does not make a distinction between the disclosures required from regulated entities compared to non-regulated entities;

It was not clear whether the Board agreed or disagreed with this recommendation.

e. confirms the proposals in ED 7 not to require disclosure of the actual level of any externally imposed capital requirements; and

The Board agreed.

f. confirms the proposals in ED 7 to disclose compliance with externally imposed capital requirements.

The Board agreed.

The Board considered the above recommendations as a package and agreed that the proposals achieved their intention.

Overall, the Staff recommended that any disclosure requirements about capital should be in the form of an amendment to IAS 1, rather than within the new IFRS. The Board agreed.

Disclosure of the fair value of collateral and other credit enhancements

Regarding the disclosure of the fair value of collateral and other credit enhancements, the Staff recommended that the Board:

a. replace the disclosure of fair value of collateral pledged as security and other credit enhancements proposed in paragraph 39(b) of ED 7 with the requirement to disclose, by class of financial instrument with credit risk, the amount of exposure to credit risk at the reporting date after taking into account any collateral or other credit enhancements, unless such disclosures would be impracticable, in which case the entity shall state that fact.

The Board agreed.

b. clarify that 'other credit enhancements' include master netting agreements.

The Board agreed but asked the Staff to delete the word 'master' and refer to 'netting agreements'.

c. retain the 'impracticable' exemption. Thus, where an entity has financial instruments with credit risk that are mitigated by collateral whose fair value cannot be practicably determined, the entity shall disclose the maximum exposure to credit risk without taking account of any collateral pledged, describe any collateral pledged as security and state that it is not practicable to determine the fair value of this collateral.

Concerns were expressed regarding the 'impracticable' notion and the Board discussed this issue at length.

Proposals to amend paragraph 39 of the ED as depicted below (credit risk) were rejected by the Board, other than the insertion to 39(a) except that the word 'master' would be deleted to leave a reference to 'netting agreements':

Credit risk 39. An entity shall disclose by class of financial instrument with credit risk: a. the amount that best represents its maximum exposure to credit risk at the reporting date without taking account of any collateral pledged or other credit enhancements (eg master netting agreements); b. in respect of the amount disclosed in (a), a description of collateral pledged as security and other credit enhancements and, unless impracticable, their fair value; and c. the amount of exposure to credit risk at the reporting date after taking into account any collateral or other credit enhancements, unless such disclosures would be impracticable, in which case the entity shall state that fact; and d. information about the credit quality of financial assets with credit risk that are neither past due nor impaired.

Disclosures regarding the allowance account

The staff recommended that the Board retain the requirement to disclose a reconciliation of changes in the allowance account, and not to extend the requirement to the provision of equivalent information if an allowance account is not used.

The Board made the point that IAS 39 requires an allowance account due to the collective impairment test and that any requirement in this area should be for all entities and not just financial institutions. Regarding the situation where an allowance account is not used, Board members appeared to support the disclosure of similar information as in the situation where an allowance account is in use, as this provides useful information regarding losses.

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