Financial Instruments – Classification of Instruments Denominated in a Foreign Currency

IAS 32 Financial Instruments: Disclosure and Presentation establishes principles for classifying financial instruments. IAS 32.22 states that a contract that will be settled by the entity by delivering a fixed number of its own equity instruments in exchange for a fixed amount of cash or another financial asset is an equity instrument. On the other hand, IAS 32.24 states that a contract that will be settled by the entity delivering or receiving a fixed number of its own equity instruments in exchange for a variable amount of cash or another financial asset is a financial asset or financial liability.

The issue discussed by the Board concerns the classification of the written option in a convertible bond denominated in a foreign currency (that is, a currency other than the functional currency of the entity issuing the bond). Such a bond allows the holder to convert the bond into a fixed number of the entity's equity instruments in exchange for a fixed amount of foreign currency.

Although the issue has been raised in the context of a convertible bond it applies equally to freestanding instruments i.e. to all contracts entered into by an entity to exchange a fixed number of own shares for a fixed amount of cash that is denominated in a foreign currency. Such contracts can be simple forward agreements or options on own equity. Consequently, the implications of the issue go beyond just convertible bonds.

The majority of Board members were sympathetic to the fact that convertible bonds that are 'genuinely' issued in a foreign currency because investors operate in that foreign currency should be allowed the equity treatment. The Board was however, concerned about providing an exception as this would have to be restricted sufficiently in order to avoid structuring opportunities. Board members also indicated that the question of whether equity has a currency (that is, as equity is a residual item, is it subject to normal functional currency considerations) should be answered but that this would be addressed in the Liability / Equity project. The Board agreed to explore an amendment to IAS 32 but wanted to understand better the potential structuring opportunities that could arise before proceeding.

The Board indicated that should it decide to allow equity classification that it should be made clear that the foreign currency exposure could not be hedged under IAS 39 as there is no profit or loss impact on the equity item.

Performance Reporting (Comprehensive Income)

The Board was updated on the work of the Joint International Group on Performance Reporting (JIG). After discussing the structure of the project (the issues within Segments A and B) in the context of how to proceed, the Board tentatively decided that the staff should commence work on an exposure draft dealing with Segment A issues only. That exposure draft would consist of a detailed preamble designed to communicate clearly, the intentions of the Board on issues such as the single statement and the fact that there would be no emphasis placed on the comprehensive income amount in Segment A (as opposed to net profit). While preparing the exposure draft, the FASB would be consulted about how best to proceed and if it is decided that a discussion paper is necessary, the exposure draft would be converted into a discussion paper format.

IASB Technical Corrections Policy

The IASB has identified a need for a policy to deal with certain practice problems that require changes to Standards. These are issues that:

• are not consequential amendments arising from other projects,
• could not be solved through interpretation by the IFRIC, and
• require a relatively quick answer.

Generally, such issues arise when it is clear that the words in a Standard are not properly conveying the Board's intentions (even when considered with the Basis for Conclusions and any related guidance).

The Board discussed whether the IFRIC Agenda Committee should be involved in assessing such issues before they are presented to the Board. This did not seem to receive much support, as others believed that once the issue is identified based on the above criteria, the involvement of IFRIC is unnecessary.

The following is an extract from the Observer Notes which may be similar to the policy that will be published by the IASB on its website:

IAS 21 – Net Investment in a Foreign Operation – Paragraph 32 of IAS 21

The Board discussed whether different accounting treatments should apply to exchange differences on monetary items denominated in different currencies. The Board also discussed whether funding provided to a foreign operation by a group entity that is not the reporting entity may be considered to be part of the reporting entity's net investment in that foreign operation in the context of paragraph 32 of IAS 21.

The Board agreed that the intention should be to treat third-currency denominated monetary items that form a part of the net investment in a foreign operation similar to when the monetary item is denominated in the functional currency of either the reporting entity or the foreign operation.

The staff proposed to delete paragraph 33 of IAS 21 in order to remove the inconsistency. However the Board indicated a preference to delete only the last two sentences of that paragraph and include additional guidance. The sentences that may be deleted are as follows:

The Board agreed that the ability to account for exchange differences in equity as provided for by paragraph 32 of IAS 21 should only be available where the lender is in a control relationship (i.e. parent or subsidiary lends to a foreign operation). Monetary amounts outstanding between fellow subsidiaries would qualify for equity treatment, but this would not extend to trade receivables or trade payables. The Staff proposed amending paragraph 15 of IAS 21 as follows:

Some Board members expressed concern whether the above amendment is not sufficiently restrictive to limit its application to a situation where the lender is in a control relationship.

Conceptual Framework – Qualitative Characteristics

The Board discussed the second of three expected papers considering issues related to qualitative characteristics. In May, the Boards considered the qualitative characteristics of relevance and reliability (faithful representation). The Board discussed qualitative characteristics other than relevance and faithful representation.

Comparability

The staff made the following recommendations:

• Comparability is an important characteristic of decision-useful information and should be included as a qualitative characteristic in the converged conceptual framework.

The Board deferred a decision on this issue to the next meeting.

• Comparability and consistency should be separately defined.

The Board agreed.

• Relevance and faithful representation should have primacy compared to comparability and consistency.

The Board asked the Staff to rephrase this issue so that relevance and faithful representation would not be seen as 'trumping' comparability.

• Disclosures can help to compensate when comparability or consistency is overridden by a greater need for relevance or faithful representation.

The Board agreed.

In addition to the above, Board members made the following points:

• In practice, too much emphasis is placed on comparability, sometimes leading to incorrect accounting for the sake of comparability. In Japan, comparability is subsumed with faithful representation so as to de-emphasis it. Consequently, care should be taken to avoid 'contrived uniformity' as this is not comparability.
• The staff were asked to strengthen the wording around comparability to bring a focus on structuring schemes. The message would be that, regardless of how transactions are designed, if the economic phenomenon is the same, the accounting should be comparable.
• Consistency will be subsumed within comparability.

Understandability

The staff made the following recommendations:

• Users (including non-professionals as well as professionals) are assumed to have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence.

While the Board agreed, the staff was asked to further explain who the intended user of IFRS is meant to be as this would assist the Board in determining the detail and sophistication of its literature.

• Understandability is the quality of information that enables users to perceive its significance.

The Board agreed and added that information should be "capable of being understood."

• Relevant information should not be excluded because it is too complex or difficult for certain users to understand.

The Board agreed.

• Understandability is enhanced by the characterisation, aggregation, classification and presentation of financial information.

The Board agreed.

Materiality

The staff made the following recommendations, which the Board agreed with:

• Materiality relates to faithful representation, in addition to relevance.

• Materiality should be considered as a screen or filter to determine whether information is sufficiently significant to influence decisions of users in the context of the entity, rather than a qualitative characteristic itself.

Other candidates for qualitative characteristics

Having discussed the qualitative characteristics that presently exist in the IASB and FASB frameworks, the Board discussed whether other characteristics should be added. Two characteristics were identified by the Staff and discussed by the Board:

Transparency

In spite of its high profile use, the term transparent, is not a qualitative characteristic presently used or defined in any major accounting framework. The Board discussed this characteristic using the word 'succinctness' and concluded that this is subsumed within representational faithfulness therefore should not be a separate characteristic in itself.

True and fair

The staff recommended that true and fair should be considered as a component of representational faithfulness. The Board agreed.

Revenue Recognition – Project strategy

The objective of the Board's discussion was to decide whether it shares the FASB's views about the way in which the project should proceed.

The FASB had reconsidered the objective and scope of the joint project on revenue recognition. It decided that its preference would be to:

• continue the joint project, with the same goals and scope as before, ie to develop a conceptual framework for revenue recognition and a general standard derived from that framework; but
• at the standard level, use a different measurement attribute for performance obligations than has been proposed up until now. The FASB reaffirmed its past decision that the general standard for revenue recognition should require revenue to be recognised on the basis of changes in assets and liabilities (without consideration of additional recognition criteria, such as earning or realisation).

However, the FASB decided to pursue an approach in which not all assets and liabilities in revenue arrangements would be measured at fair value. Instead, performance obligations would be measured at 'performance value', that is, the amount at which the good or service could be sold to a customer. In practice, performance value would normally equal the consideration received or receivable from the customer.

The majority of IASB members indicated that their preference would be to continue with the joint project, with the same goals and scope as before but would be willing to compromise and explore the performance value measurement approach.

Thursday 23 June 2005

Management Commentary

Management commentaries are also called Management's Discussion and Analysis or Operating and Financial Review.

The meeting was asked to provide 'conditional clearance' on a Preliminary Views Discussion Paper on management commentary (MC), which has been prepared by a working group of staff from standard-setters in Canada, Germany, New Zealand (lead) and the UK. The project staff hopes to have the document issued in September or October 2005.

The project team had prepared the draft discussion paper from the point of view that the annual report was a package containing the financial statements, MC and other material. However, the project team did not think that it was appropriate to include MC within the 'IFRS assertion' that applies to the financial statements. Consequently, the discussion paper is to be silent on the attestation requirements attaching to MC.

The staff noted that the project team had held productive discussions with IOSCO (securities regulators) and IFAC, whose feedback had helped to refine the draft discussion paper. One of the principal sensitivities was the differentiation between items reported in the financial statements (including footnotes) and that reported in MC.

Board Members held a wide-ranging discussion of the draft discussion paper (Observers did not have a copy of this document). One of the concerns expressed was that the project staff had prepared the discussion document from an apparent point of view that MC was 'a good thing' and proceeded to develop something that looked much like an exposure draft. This approach was dissimilar to that in the forthcoming discussion document on measurement, which sets out alternative views. This difference in style should be explained carefully when the document is issued.

Board Members expressed concerns with the project team's use of the IASB Framework's qualitative characteristics in the MC context. They were afraid that using carefully crafted words in a context other than financial reporting was potentially dangerous. For example, MC (being management's self-assessment) could never be 'neutral', since management's bias would be inherent. Similarly, a proper aim in MC would be consistency (as opposed to the Framework's comparability): the MC should address matters on a consistent basis from year to year.

The Board Members reviewed the proposed Questions to Recipients (available in the Observer Notes). The questions will be redrafted and submitted to the July 2005 Board meeting for further discussion.

The Board agreed that the discussion paper should be issued (10 in favour; 3 opposed; 1 abstention). The Board Advisors on the project should be responsible for the detailed review of the text. During that review, they would bear in mind the comments and concerns expressed at this session and would bring any critical matters to a subsequent Board meeting, similar to other 'sweep issues.'

Short-term Convergence – Segment Reporting

The Board considered whether to add guidance similar to that in EIC-115 Segment Disclosures-Application of the Aggregation Criteria in CICA 1701 issued by the Canadian Emerging Issues Committee. This EIC provides guidance on applying the criteria in CICA 1701 (equivalent to FAS 131) when determining whether two segments have 'similar economic characteristics.' The Canadian guidance was prepared at the request of securities regulators.

After discussion, it was agreed not to add similar guidance to the IASB's forthcoming exposure draft. Some Board Members expressed concerns about the approach to measurement in FAS 131 [internal reporting measures], preferring the approach in IAS 14 [IFRS measurement]. There was no conclusion on this point and it may come back to a subsequent meeting.

The Board also decided to ask a question about a potential loss of information between that provided in IAS 14 and FAS 131 in the Invitation to Comment.

Proposed Amendments to IFRS 6 and IFRS 1

The Board approved amendments to IFRS 1 and IFRS 6 as exposed in April 2005. The amendment will clarify that an entity that both (a) adopts IFRSs for the first time before 1 January 2006 and (b) applies IFRS 6 before that date is exempted not only from providing comparative prior-period disclosures but also from applying the recognition and measurement requirements of IFRS 6 in the prior comparative period.

Short-term Convergence – Income Taxes

The Board was informed that the staffs of both the FASB and IASB are working towards a joint exposure draft of amendments to FAS 109 and IAS 12, such that constituents will be able to see where either Board is making amendments to its standards.

Disclosure

(a) Components of income tax expense

The Board agreed to retain the specific example in paragraph 80(b) of IAS 12.

The Board agreed to add to IAS 12 the examples in paragraphs 45(g) and 45(f) of FAS 109

(b) Contingent assets and liabilities

The forthcoming exposure draft of proposed amendments to IAS 37 Provisions, Contingent Liabilities and Contingent Assets contains the following:

The Board agreed to propose deleting this requirement in the Income Taxes ED, noting that IAS 10 would capture this information.

(c) Intercompany asset transfers

The Board agreed to include disclosures to address the following matters:

• Expand the disclosure requirements of FAS 109, paragraph 43 to include the component of deferred tax assets and liabilities that represents the impact of an intercompany transfer of an asset between taxing jurisdictions with different effective tax rates.
• Require disclosure of any such impact recognized as part of income tax expense (benefit) in the income statement for interim or annual periods. This could pertain to all transfers or be limited to transfers whose timing or terms are not customary for the consolidated entity.
• Require disclosure of tax effects of any modifications, including unwinding (reversal), of terms of such transfers.

(d) Nature of deferred tax assets

The Board agreed to eliminate the disclosure requirement in IAS 12 paragraph 82.

(e) Public entities not subject to tax

The Board agreed to add to IAS 12 the disclosure requirement in FAS 109 paragraph 43, but to extend this to all companies, not just public ones:

A public enterprise that is not subject to income taxes because its income is taxed directly to its owners shall disclose that fact and the net difference between the tax bases and the reported amounts of the enterprise's assets and liabilities.

(f) Reconciliation between tax expense and pre-tax accounting profit

By a majority (12 in favour; 2 opposed), the Board agreed that the tax rate reconciliation would require the use of the domestic rate of the parent company.

(g) Amounts and expiry dates of operating loss and tax credit carryforwards and deductible temporary differences

The Board agreed to defer their discussion of this topic.

(h) Consolidated tax returns

The Board agreed to add to IAS 12 the disclosure requirements of FAS 109 paragraph 49:

(i) Disclosure of dividends and unremitted earnings

• The Board agreed to retain the disclosures required by IAS 12 paragraphs 82A, 87A, 87B and 87C.
• The Board agreed that when a preparer makes a post balance-sheet disclosure of dividends declared, the tax effects, if any, of that dividend also be disclosed
• The Board decided not to add guidance similar to that in paragraph 44(a) of FAS 109 to IAS 12, which requires an entity to disclose the types of events that would cause temporary differences that have not been recognized to become taxable. This was contrary to the staff recommendation. This matter will be re-debated as a sweep issue.
• The Board (in common with the FASB) did not agree with a staff recommendation to require all entities to disclose a foreign earnings table. Instead, the Board agreed (8 in favour; 6 opposed/ indifferent) to require a continuity schedule for foreign unremitted earnings and to raise a question in the Invitation to Comment about the usefulness of this disclosure.

Uncertain tax positions

The Board agreed that:

• An enterprise must establish that it is probable1 in the Statement 5 context (meaning that "the future event or events are likely to occur") that a position taken (or expected to be taken) regarding a tax deduction, credit, or filing position would be sustained if challenged by taxing authorities prior to the tax benefit from that position being recognised as a benefit or reduction of tax expense in the financial statements.
• An enterprise must presume that a taxing authority will review a tax position when evaluating whether the position is probable of being sustained. Therefore, consideration of the risk of detection is inappropriate.
• The enterprise shall recognise the tax position in any subsequent period that it becomes probable that the tax position will be sustained.

The Board agreed that initial measurement should be based in the entity's best estimate of the settlement amount. The guidance in FASB Concepts Statement 7 would be useful.

After a discussion on derecognition, the Board asked the staff to return to the next meeting with a paper discussing the interaction of IAS 12 and the proposed amendments to IAS 37.

IFRIC 3 Emission Rights

The IFRIC staff introduced the topic by outlining the development of IFRIC 3 and the subsequent developments within the European Union, including the fact that EFRAG had not recommended that IFRIC 3 be endorsed for use in the EU. There followed a long and vigorous debate during which several alternative treatments were proposed.

Board Members acknowledged that IFRIC 3 had expressed a correct and appropriate interpretation of existing standards. Board Members expressed similar reservations over the effects of that Interpretation to those that had been expressed by IFRIC members at the time it was finalised but observed that they, like IFRIC, had been under the impression at the time that an Interpretation was needed urgently because of the imminent start of the EU 'cap and trade' scheme. However, it was apparent that this urgency was no longer there. Consequently, the Board decided to take the time to conduct a broader assessment of the nature of the various volatilities resulting from the application of IFRIC 3 to a 'cap and trade' scheme and to consider whether and how it might be appropriate to amend existing standards to reduce or eliminate some of those volatilities.

The Board voted to withdraw IFRIC 3 with a public explanation of its plans to conduct such wider assessment (12 in favour; 1 opposed; 1 abstained). How this withdrawal is to be effected will be decided at the July IASB meeting.

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