19-21 July 2005, London

Tuesday 19 July 2005

Accounting Standards for Small and Medium-sized Entities – Educational Session

The Board held an educational session on two issues relevant to the project on financial reporting by small and medium-sized entities (SMEs):

1. Bank lending to SMEs

The SME Research Director and Chief Economist of a major United Kingdom bank explained his bank's approach to initial lending decisions and subsequent loan monitoring for borrowings by various size categories of SMEs. He discussed when and how financial statements are used in lending and loan monitoring, including whether adjustments are made to the data in the financial statements; which information is not found to be useful, and why; and which information is missing that lenders would like to have.

The Board was informed of the general credit sanctioning process, which differs depending on turnover levels as well as other factors. Regarding the general process of credit sanctioning, the following was noted and discussed:

• Pre-scoring / approval is generally used to approve loans to borrowers with a turnover of up to £500,000. This process involves using the account data of the individual borrowing. Borrowing levels tend to be up to about £50,000. For 'start up' entities, behavioural scoring is used.
• Up to two-thirds of lending is unsecured, although any collateral offered is priced into the interest rate.
• For borrowers with turnover approximately in the region of £0.5m and £1m the approval process for loans tends to become more complicated. Typically, this group borrows between £50,000 and £100,000.

As regards the financial information needs of lenders, the following was noted and discussed:

• Most of the information required for credit sanctioning as well as ongoing monitoring of borrowers is standardised by individual financial institutions to their information needs and systems and will vary across the banking industry. Information required for such standardised systems is generally obtained from management reports. The requirement of most loan agreements is the furnishing of timely management reports to the lender and such reports are generally viewed as the primary source of information. The frequency with which management reports are required by lenders depends on circumstances and will range from periods of less than one month to six-monthly reports.
• Annual financial statements are used as a 'cross check' of the information contained in management accounts. It was pointed out that the income statement is particularly useful in the credit sanctioning process and that, on the whole, lenders are satisfied by the structure and content of the income statement and balance sheet as currently presented. Those statements provide the minimum information required by lenders. Lenders do not insist that annual financial statements must comply with the FRSSE (see below) or any particular accounting framework. Any changes proposed by the IASB to other aspects of the financial statements would not impact lenders significantly as access to management accounts is generally unrestricted.
• The point was made that consolidated cash flow statements are generally not used by lenders as these are derived by lenders themselves based on the income statement and balance sheet.

It was noted that the above issues may not necessarily be similar to how lending activities are conducted elsewhere in Europe or other parts of the world. Much of the discussion revolved around credit sanction which is distinct from ongoing control and monitoring of borrowers, which was not discussed.

2. UK's Financial Reporting Standard for Small Entities (FRSSE) issued by the UK Accounting Standards Board (ASB)

The chair of the committee of the ASB responsible for developing and maintaining the FRSSE discussed the features of the FRSSE, implementation of the FRSSE by UK SMEs, and acceptance of the resulting financial statements by users. She explain the criteria the ASB has used to make simplifications in the areas of disclosure, presentation, recognition, and measurement and what is required of an SME when the FRSSE does not address a particular accounting issue.

The following issues were discussed and noted:

• The criteria set for entities to qualify to use the FRSSE is based on EU legislation and is as follows:
  • Turnover £5.6m
  • Balance sheet total £2.8m
  • Average number of employees 50

  An entity broadly has to meet two out of the three criteria.

• Certain companies are excluded from the 'small company' criteria for reasons of public interest. These are any entity that is, or is in a group that includes:
  • a public company;
  • a banking or insurance company;
  • a body corporate that (not being a company) has the power to offer its shares or debentures to the public and may lawfully exercise that power;
  • an authorised institution under the Banking Act 1987;
  • an insurance company to which Part II of the Insurance Companies Act 1982 applies; or
  • an authorised person under Part IV of the Financial Services and Markets Act 2000.

  It was noted that, to date, the above criteria had not been problematic. After discussing the requirements to lodge financial statements in jurisdictions including the UK, Australia and Canada, the Board indicated that the requirement to lodge annual financial statements is one of public policy that is not for the IASB to decide.

• Whilst the FRSSE is now in its fifth edition, it was pointed out that the amendments, which occur on average every two years, are not of a minor nature. The changes have emanated mainly from changes to UK GAAP, and the FRSSE tends to lag behind by between one and two years in this regard. The time lag is intentional as this allows the ASB to gather information about the changed requirements as they affect SMEs and experience, before making amendments to the FRSSE.

  IASB members indicated their intention to have the IFRS standard running parallel to other IFRSs as this would be a standard applicable on a global scale.

• The only area where the FRSSE is more detailed than UK GAAP is in the area of related party disclosures.
• There is no mandatory fall back to UK GAAP where the FRSSE contains no guidance on a particular issue. Instead, the FRSSE guides preparers as follows:
  • first, the financial statements must give a true and fair view;
  • accounting policies and estimation techniques must be consistent with the requirements of the FRSSE and of company's legislation. Where a choice is permitted, "an entity shall select the policies and techniques most appropriate to its particular circumstances for the purpose of giving a true and fair view, taking account of the objectives of relevance, reliability, comparability and understandability;"
  • paragraph 2.5 of the FRSSE then acts as a 'catch all' by requiring "where there is doubt whether applying provisions of the FRSSE would be sufficient to give a true and fair view, adequate explanation shall be given in the notes to the accounts of the transaction or arrangement concerned and the treatment adopted."

• In addition, the introductory remarks on the status of the FRSSE state that "financial statements will generally be prepared using accepted practice and, accordingly, for transactions or events not dealt with in the FRSSE, smaller entities should have regard to other accounting standards and UITF Abstracts, not as mandatory documents, but as a means of establishing current practice."

  There was some discussion about what constitutes 'established practice' when an SME is seeking to establish accounting policies for transactions that are not specifically dealt with by the FRSSE. Some believed this would involve determining the requirements in UK GAAP for such transactions as they apply to other entities (a type of indirect fall back to UK GAAP) as there could be no established practice amongst SME's as the transactions are neither common nor is there any accounting guidance for that section of preparers (not included in the FRSSE). It was pointed out that when looking for established practice, this involved surveying SME's to assess prevalence of the transactions as well as the treatment adopted. Consequently, only when SME's are generally issuing share-based payment transactions will this type of transaction be dealt with by the FRSSE.

  Some IASB members indicated that they had been unaware that the requirements of the FRSSE were not as comprehensive as they had thought, given that the FRSSE did not prescribe the accounting for derivatives and share-based payment transactions, and that there was no fall-back to full UK GAAP should these transactions occur. IASB members stated a concern about issuing a standard that omits guidance on important transactions given the fact that the IASB's standard would be applied globally. It was pointed out that the FRSSE included guidance on transactions that were expected to occur within the target group of entities. Some Board members certain concerned that some small entities enter into derivatives and share-based payment transactions that would not be accounted for if the FRSSE was applied. Instead some disclosures of the transaction would be required together with the accounting treatment adopted, if any.

  In addition, some IASB members expressed concern about the basis for assessing a 'true and fair view' if the standard does not prescribe guidance on the accounting for derivatives and share-based payment transactions. Other Board members drew the Board's attention to the fact that the UK had no standard dealing with financial instruments until very recently, but this did not affect the assessment of 'true and fair view', therefore the Board should not seek to provide guidance in the SME standard for every conceivable transaction.

• The FRSSE is based on objectives for financial statements that primarily focus on stewardship of the entity's management and secondarily for making economic decisions. Some IASB members expressed their concern on this issue as they believe financial statements should be 'forward looking' by providing information with predictive value.

Insurance Contracts Phase II – Educational Session

This education session was led by the FASB staff and focussed on how to determine when significant insurance risk is transferred. This impacts the accounting for the contract, either as an insurance contract or as a financial contract (deposit or derivative).

No decisions were made during this session.

Financial Instruments – Update on July 2005 Financial Instruments Working Group Meeting

The Board was updated on the recent meeting of the financial instruments working group. The update included the following:

• Board members in attendance at those meetings had re-iterated that the working group was intended to assist the Board with work on financial instrument accounting that would ultimately replace IAS 39. It was pointed out that there should be no tinkering with the standard, instead only improvements should be explored and put through as a way of improving the Standard unless some direction is determined that could lead to a full review of the entire standard.
• Members of the working group had indicated concern about moving to a full fair value basis of accounting given where accounting is at present.

Control (including Special Purpose Entities) (Consolidation)

The Board has begun using 'Control', rather than 'Consolidation', as the name of this project. The last time the Board discussed the project was at its November 2004 meeting. At that time the Board asked the staff to proceed with preparing an exposure draft to incorporate into IAS 27, sooner rather than later, the considerable material and guidance the Board has developed on the concept of control as it would apply generally.

The purpose of this session was to:

• outline the issues the staff view as critical in determining the timing and development of a revised standard on control;
• review the decisions to date and identify those matters on which the staff intend to bring additional analysis to the Board;
• present a project plan for the Control Project.

The following issues were discussed:

The Board pointed out that this is not a convergence project at present, but at some point it will become so. Given the differences between IFRSs and US GAAP in this area, the IASB had decided to continue working on IAS 27 and then the FASB would consider converging at a later point in time.

It was clarified that the Board would not seek to revisit IAS 28 and IAS 31 as part of this project but would merely ensure consistency between the notion of control and that of joint control and significant influence.

Some Board members indicated their intention to consider potential issues regarding the control notion as it applies to individual assets versus the application to entities. Furthermore, the issue of whether an SPE is really an entity should be explored or whether it is merely a group of individual assets.

Concern was expressed about the tentative definition of control which some members believed would not capture certain SPEs. The tentative definition (as per the observer notes) is as follows:

It was agreed that a flow chart would not be incorporated into the standard, as this would result in a 'checklist' approach to the assessment of control.

Regarding options, one Board member indicated that the right to exercise an option does not necessarily give control over the underlying entity. The current holder of the actual controlling interest is to be viewed as presently in control. Therefore, control over the option instrument does not translate to control over the underlying entity / asset. Some Board members indicated their intention to explore whether the 'benefits' requirement is fulfilled where an option has a strike price that is relatively high to the extent that the total return to the option holder is adversely affected.

The staff intends to make the disclosures consistent between investments in subsidiaries falling within the scope of IAS 27 and those that are accounted for in terms of IAS 39.

The Board noted that certain issues related to the control notion had been brought to the attention of some Board members (such as controlling minority shareholders) and directed that where these can be easily dealt with by IFRIC for the sake of timely guidance, this should be the route taken for those issues.

No decisions were made during this session.

Wednesday 20 July 2005

Extractive Industries – Educational Session This education session involved a question and answer session with minerals and oil and gas industry experts focussing on reserve definitions. No decisions were made during this session.

The purpose of the July 2005 public education session for the extractive activities research project was to:

• expand Board members' understanding of:
  • the key elements of the existing reserve and resource definitions for minerals and oil and gas;
  • the similarities and differences between those definitions - and the two industries more generally; and
• provide Board members with a further opportunity to ask mineral and oil and gas technical experts questions about reserves and resources; and
• seek the Board's initial reaction to the possible directions for defining reserves and resources for financial reporting purposes.

Much of the discussion was centred on the different definitions of reserves and resources including that of the SEC. The Board indicated its intention to reach one generic definition for financial reporting purposes and to then take into account some of the differences in the current definitions, probability assessments etc into the measurement and disclosure provisions of the Standard.

Insurance Contracts Phase II – Educational Session: Life insurance.

Two life insurance industry experts gave a presentation on aspects of life insurance accounting, concentrating on product features. Their presentation (141 slides) is available on the IASB Website www.iasb.org. There were no decisions taken and very little discussion of the matters by Board members, other than items of clarification.

Conceptual Framework

The Board was joined in London by a member of the FASB staff and a member of the Canadian AcSB staff, and via video link by several members of the FASB staff team.

Objectives of Financial Reporting – Stewardship and Accountability

The discussion was in response to a request made in April 2005 by both the IASB and the FASB that the staff investigate the meaning of the terms stewardship and accountability and the implications of having such objectives in the IASB and FASB conceptual frameworks. The IASB discussed these objectives within the context of providing decision-useful information. Most members agreed with the staff recommendation that providing the information needed to assess stewardship or accountability should not be added as an explicit objective of financial reporting by business entities (11 in favour; 3 opposed).

In reaching that determination, one Board member expressed a strongly-held view that stewardship remains an objective of financial reporting, especially in separate financial statements. While admitting that there was overlap, those who supported having stewardship as a separate objective did not want to see the concept subsumed in 'useful for economic decision-making.' Some also mentioned stewardship in relation to small and medium-sized entities, but it was noted that in many circumstances this would not be the case since management and owners were the same. Accountability was also defended, particularly as the concept was interrelated to reporting performance. There needed to be a way of holding management accountable for growing the business at a rate faster than the cost of capital. Analysts expected this, but preparers were less accepting of this.

It was accepted that part of the problem was that there were different notions of stewardship and accountability embedded in financial reporting. What was accepted by all was that the conceptual frameworks needed a better discussion of the two notions, probably in the Basis for Conclusions. It was suggested that this discussion might differentiate the two, perhaps relating stewardship as reporting to owners and accountability as reporting to a wider constituency.

One Board member noted the link between these concepts and the notion of 'chief economic decision-maker' in IAS 14. The Board agreed a staff recommendation that the conceptual frameworks should retain a discussion that acknowledges that financial information is useful for other purposes, which include assessing management's stewardship and compliance with laws, regulations, and contractual provisions. Specifically:

• (a) Information about the economic resources of an entity, the claims to those resources, and the changes in them also is useful for purposes other than making investment, credit, or similar resource allocation decisions.
• (b) Financial reporting information may be useful in assessing how management of an entity has discharged its stewardship responsibility to owners (stockholders) for the use of resources entrusted to it.
• (c) Financial reporting information may be useful in assessing management's performance. However, financial reporting usually cannot and does not separate management performance from entity performance.
• (d) Financial reporting information may be useful in assessing an entity's compliance with laws, regulations, and contractual provisions.

Several Board members wanted to see stronger language in (b) and (c), while another cautioned that (d) needed to be rephrased so that expectations were not raised unduly. In particular without qualification, 'compliance with laws…' could be read to include 'did my delivery drivers always obey the speed limit?', etc!

Conceptual Framework – relationships between the qualitative characteristics

The Board discussed an approach to describing the relationship between qualitative characteristics, basing their discussion on the flowchart reproduced in the Observer notes. Board members generally supported the flowchart (or schematic, as one preferred to call it) but raised concerns about the placement of timeliness and materiality. For example, the fact that financial information is 'stale' would not be a reason for not reporting it, as was suggested by the schematic. This led to the realisation that the flowchart used the same terms to communicate different things.

Board members seemed to think that the schematic was preferable to the hierarchy currently contained in the FASB Statement of Financial Accounting Concepts. However, the schematic needed further work to show that the characteristics were inter-related rather than linear. In addition, the operation of the characteristics of comparability ('to what?') and consistency (across items within the entity? or across entities?) needed to be resolved.

The Board agreed that the schematic was worth developing and asked the staff to do so, taking into account their comments.

Definitions of 'understandability' and 'materiality'

The Board approved definitions of understandability and materiality as follows:

Report on IASB European 'Roadshows'

The Board received an interim report of the results of the first 14 of 18 presentations involving IASB members and staff taking place in Europe during June and July 2005. Although a common presentation had been prepared, the meetings themselves had been quite different, with some involving active participation of the audience and others less so. A full debrief would be provided once all the visits had been completed, but the following points were noted:

• The opportunity to speak with Board members and staff on 'home ground' was appreciated.
• The benefits of switching to IFRS were beginning to be noticed, including better information than under previous GAAP; the need for IFRS to address complex issues (such as concessions) to avoid a loss of comparability; and better disclosure.
• Obviously, there were some concerns, too, including the pace of change (but some wanted projects completed soon (e.g., segments); the volume and complexity of the standards; the degree of linkage (or lack of it) between management (internal) and external reporting; and local problems with separate financial statements.
• Users were finding the switch to IFRS very beneficial, with improved comparability and better disclosure.
• There were concerns expressed over the interpretation and enforcement of IFRS.
• The push for convergence, in the light of talk of 'equivalence' was questioned.
• There were often specific comments on Board projects, including the Framework, reporting performance and financial instruments.

The Board discussed how to build on the experience gained from the roadshows in all aspects of its operations, including the IASB Website, improvements to the Board's basis for conclusions and considering future focus meetings such as these.

Thursday 21 July 2005 (afternoon only)

Short-term Convergence – Income Taxes

Commenting on the project timetable, the staff indicated their intention to have a pre-ballot draft exposure draft by the time of the October meeting.

At this meeting, the Board was asked to consider and confirm a summary of its decisions as well as to indicate any alternative views. Three Board members noted that they would like to read the draft before indicating whether they would dissent or provide alternative views. The main issue that would affect the Board member's position would be whether an overall improvement is made to IAS 12 by this project given that the Board has dealt with only some issues in the Standard. The Board also discussed whether IAS 12 should be re-written at this point and issued as an IFRS. Some Board members disagreed with this suggestion as they had not reconsidered all of the principles in IAS 12 as part of this project. Nevertheless, the staff was asked to consider ways of improving the layout and structure of IAS 12 during the drafting process.

The Board's decisions were grouped into the following topics, and details pertaining to each of these are available in the observer notes. Only the issues discussed by the Board at this meeting are detailed below:

Definition of tax base

The Board agreed to the following definition of tax base:

Exceptions from the temporary difference approach

Investment in subsidiaries, branches and associates, and interests in joint ventures

The Board decided that an entity should recognise the income tax consequences of all temporary differences arising in the consolidated financial statements. An implication of this decision is that an entity should take into account any taxes payable by a subsidiary on the distribution of earnings to the parent in determining the tax rate to be used to measure its consolidated deferred tax liability. The practical difficulties of doing this for foreign subsidiaries are addressed below. In addition, the Board decided to eliminate from IAS 12 the notion of 'branches'.

At the joint meeting in October 2004, the boards decided to retain the exceptions in and IAS 12 and SFAS 109 for the recognition of deferred tax liabilities for certain investments in foreign subsidiaries (or foreign corporate joint ventures) because of the practical difficulties in measuring the liabilities. The IASB agreed to move to the SFAS 109 wording for the exception.

The Board asked the staff not to characterise this issue as an exception, but rather to include this guidance in the application guidance of the Standard. Some Board members asked the Examples to be clarified regarding whether certain information was assumptions or derivations.

The Board appeared to agree with the rest of the summary.

Guidance on tax bases

At its June 2004 meeting, the Board decided to amend the definitions of tax base and temporary difference in IAS 12 Income Taxes. As a result of the amendments to these definitions, the Board also decided to include additional guidance and examples of tax base in IAS 12. The Board considered a paper dealing with guidance on tax bases. In that paper, the staff recommended the following:

• An introductory discussion on how to derive a tax balance sheet. This would be implementation guidance.
• Guidance on the tax base when different deductions are available depending on whether an asset is used or sold. The principle would be in the standard, with illustrative examples in implementation guidance.
• Guidance on the tax rate to use when different rates are applicable depending on whether an asset is used or sold. The principle would be in the standard, with illustrative examples in implementation guidance.
• Guidance on the tax base when different deductions are available depending on whether an asset is sold individually or as a single-asset entity. The principle would be in the standard, with illustrative examples in implementation guidance.
• Procedures for the computation of deferred taxes. This would be implementation guidance.

The staff also recommended that the descriptions of cost and fair value in IAS 16, IAS 38 and IAS 40 be amended to clarify that cost (on initial recognition) means fair value assuming full deductibility for tax purposes.

The Board generally agreed with the staff recommendations. After some discussion around the issue of which tax rate to use for an asset that may be sold separately or when the entity itself is sold, the Board asked for additional guidance covering jurisdictions that are taxed on a consolidated basis.

Regarding Example 3 dealing with assets and liabilities arising from finance leases, the Board decided to make it clear that deferred tax arises on these transactions. This is consistent with the removal of the initial recognition exclusion.

Special deductions

At its March 2005 meeting, the Board considered whether to include guidance in IAS 12 that is already included in SFAS 109. One of the areas discussed related to special deductions. The Board concluded that IAS 12 could not converge with the wording of SFAS 109 on special deductions as it would be inappropriate for IAS 12 to include a list of jurisdiction-specific special deductions, as is included in SFAS 109. The Board decided that a general principle for special deductions that is consistent with the requirements of SFAS 109 should be developed and agreed with the FASB staff.

The Board considered a paper that discusses the principle that could be developed for special deductions. Board members indicated that a principle could not easily be developed as the underlying issue was specific to one jurisdiction only. Consequently, the Board decided not to develop a principle at this time but to consider the issue again once the issue of 'uncertain tax positions' had been looked at.

Agenda Plan

The staff indicated that this session was the Board's annual review of the Agenda Plan and that no decisions were going to be taken. Decisions on the Agenda will be taken at the September and October meetings.

The staff indicated that the SEC was willing to recognise IFRSs as a high quality and comprehensive set of global accounting standards and will consider scrapping the requirement for a reconciliation between IFRSs and US GAAP provided certain differences are dealt with in the short-term convergence project.

In addition, the staff pointed out that the IASB is short of staff to deal with the current work load but plans were underway to increase the staff complement through a recruitment drive as well as asking for Practice Fellows from the major accounting firms.

The meeting in September will involve a more detailed discussion of projects.

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