Tuesday 23 May 2006 (afternoon only)

Service Concession Arrangements [Education Session]

IFRIC staff conducted an educational session to:

• explain the economics of service concession arrangements; and
• update the Board on IFRIC's deliberations, including the tentative decisions made at the May IFRIC meeting.

No decisions were made during this session.

The IFRIC has focused its deliberations on accounting by the service provider, and especially accounting for:

• Operation and maintenance-type concessions: Where a private entity takes on responsibility to operate and maintain an already existing government asset for a given period during which it also assumes significant risk.
• Build and operate-type concessions: Where the private sector undertakes investments, and both operating and investment risks are substantially transferred to the private firm.

The IFRIC is focussing on these types of arrangements because the responsibilities between the service provider and the grantor are most intertwined and the accounting complexity is the greatest.

The IFRIC has tentatively concluded that two models apply under service concessions for the rights received by the service operator:

• The financial asset model - the operator recognises a financial asset
• The intangible asset model - the operator recognises an intangible asset

The discussion focused on the dividing line between the two models. The Board discussed this at length as they wanted to understand the criteria that determined the model a service provider should apply.

At the end of the session, IFRIC staff noted that the Board appeared to agree that the amendments made by IFRIC to the exposure drafts based on comments had not changed the fact that the draft interpretations are still consistent with IFRSs. The staff indicated that IFRIC intends to combine the original three drafts into one interpretation.

The IFRIC has not concluded its redeliberations and will therefore be discussing service concessions at its July and September meetings. The staff noted that the IFRIC will be discussing whether to re-expose the draft interpretations as a single interpretation where the material in all three previous draft interpretations is covered in one.

Wednesday 24 May 2006

Insurance Contracts - Phase 2

The IASB continued its discussion of various aspects of accounting for insurance contracts, the output of which will be a Preliminary Views discussion document (the PV document). This meeting discussed the following topics, some of which were carried forward from the April 2006 meeting:

• Universal life contracts
• Unit-linked and index-linked payments (the Board had a brief discussion of this paper in April 2006, but did not complete its deliberations)
• Credit characteristics of insurance liabilities
• Overview of relevant FASB projects
• Reinsurance
• Salvage and subrogation
• Business combinations and portfolio transfers

The Board was scheduled to discuss, but did not have time to address the following:

• Policyholder participation rights
• Changes in insurance liabilities

The Board noted the most recent project timetable, which includes a meeting with the Insurance Working Group in late June 2006 and a full schedule of topics for discussion at the July IASB meeting. If all topics to be included in the PV document are discussed by the end of that meeting, a first pre-ballot draft of the PV document could be ready in July or early August, with the intention of publishing the document by December 2006.

The IASB staff noted, as a procedural point, that the usual drafting procedures would be followed, with the exception that the threshold for publishing the PV document would be eight positive votes, rather than nine as would be necessary for an exposure draft or IFRS.

Universal life contracts

The Board discussed the appropriate accounting for 'universal life contracts', which is a type of permanent life insurance that allows the policyholder, after their initial payment, to pay premiums at any time, in virtually any amount, subject to certain minimums and maximums. Such a policy also permits the policyholder to reduce or increase the death benefit more easily than under a traditional whole life policy. To increase the death benefit, the insurance company usually requires the policyholder to furnish satisfactory evidence of continued good health.

The staff suggested that there were two possible accounting approaches, called for convenience the 'components approach' and the 'integrated prospective approach.' The staff introduced the benefits and limitations of each approach.

The Board had an inconclusive debate, but it was evident that Board members were uncertain of the real distinction between the two approaches. Some expressed concern about how the integrated prospective approach was being modelled, commenting that too many things hinged on issues surrounding the model. Several Board members noted that the component approach was more transparent than the integrated prospective approach.

Board members commented that resolving the issues surrounding the two accounting approaches would be assisted by a comprehensive numerical example.

The Board agreed to suspend discussion of these issues until the next meeting.

Unit-linked and index-linked payments

The staff introduced the topic by explaining that the staff were seeking to address a perceived accounting mismatch when an insurance fund is essentially a closed-end fund and all cash flows will ultimately be distributed to the policyholders. The staff proposed that if the assets of the unit-linked fund cannot (even using all available accounting options) be recognised and measured at fair value (for example, treasury shares), the carrying amount of the liabilities should exclude the portion of the benefit that depends directly on the difference between the carrying amount of the assets and their fair value.

Some Board members challenged the premise of the proposed presentation, noting that the mismatch was caused not by accounting but by the definitions of assets, liability and equity, under which treasury shares were not assets of the issuer.

There was no real support for the staff position with respect to unit-linked payments, and the staff will return with other proposals. The Board did raise the question whether a fair value option approach might be possible, but there was significant concern about defining the boundaries for such an option. Board members were concerned that such an option would result in 'do what you like' accounting for unit-linked insurance contracts.

No formal votes were taken on these issues, although it was evident that Board members were satisfied that index-linked insurance contracts would likely be accounted for as derivatives.

Credit characteristics of insurance contracts

The Board discussed whether the credit characteristics of an insurance liability should affect its measurement. Board members stressed that the credit risk being addressed was that of the insurance contract, not the insurer. However, the risks attaching to an individual insurance contract would have an effect on the credit risk of the insurer. After a short debate, the Board agreed:

• For the following reasons, the current exit value of a liability is, conceptually, the price for a transfer that neither improves nor impairs the credit characteristics of the liability:
  • The transferor would not willingly pay the price that a willing transferee would require for a transfer that improves those characteristics.
  • The policyholder (and regulator, if any) would not consent to a transfer that impairs those characteristics.
• At inception, the credit characteristics of an insurance liability are unlikely to have a material effect on either premium rates or the current exit value. A policyholder is unlikely to buy insurance if the policyholder thinks the insurer may not satisfy its obligations in full. If the credit characteristics affect the initial measurement materially, the insurer should disclose the effect.
• Conceptually, the subsequent measurement of an insurance liability at current exit value should reflect changes in the effect of its credit characteristics (ie changes in the probability of default or changes in the price for possible default).
• If the margin is calibrated initially to the premium and that margin is frozen at inception, it could be argued that the margin would incorporate the effect of credit characteristics at inception (argued above to be negligible) and would not reflect subsequent changes in the effect of those credit characteristics.
• If the measurement of an insurance liability does incorporate the effect of a change in its credit characteristics, the effect should be disclosed. (In developing the improvements to IAS 39 and the amendments to the fair value option, the Board noted that it may be difficult to identify the portion of a change in fair values that relates to a change in the effect of credit characteristics. However, this problem should not arise for insurance liabilities, because the effect would need to be included explicitly in a measurement model, rather than estimated from observable market prices).

Update on relevant FASB projects

The Board received a brief summary of developments in FASB projects relating to various aspects of accounting for insurance contracts.

Some Board members were concerned about not including the conclusions of the FASB's work on risk transfer in the PV document. However, it was noted that the FASB was using the IASB's definition of an insurance contract and that any differences should be minor.

The Board agreed with a staff recommendation that the PV document should not address accounting by policyholders for interests in and obligations under insurance contracts. However, several Board members asked the staff to explore ways raising the awareness of this issue among constituents.

Reinsurance

After a brief debate, the Board agreed that:

• The measurement attribute for reinsurance assumed (inwards reinsurance) should be current exit value.
• The measurement attribute for reinsurance assets (outwards reinsurance) should be current exit value.
• For risks associated with the underlying insurance contract, a risk adjustment typically:
  • increases the measurement of the reinsurance asset.
  • is equal in amount to the risk adjustment for the corresponding portion of the underlying insurance contract.
• The conclusion on risk adjustments for reinsurance assets may also be relevant for policyholder accounting. The Board will consider policyholder accounting after the discussion paper stage.
• The carrying amount of reinsurance assets should be reduced by the expected (probability-weighted) present value of losses from default or disputes, with a further reduction for the margin that market participants would require to compensate them for bearing the risk that defaults or disputes exceed expected value (expected loss model).
• Given the Board's tentative decision to use current exit value as the measurement attribute for insurance contracts, there is no need for specific restrictions to prevent the recognition of misleading gains or losses when an insurer buys reinsurance.
• A cedant should recognise at current exit value its contractual right, if any, to obtain reinsurance for contracts that it has not yet issued. In practice, that current exit value may not be material in many cases.

Salvage and subrogation

The Board agreed that:

• Insurance liabilities should be measured net of the impact of related salvage and subrogation rights that the insurer would acquire on paying a claim.
• Once an insurer acquires salvage or subrogation rights (generally by paying a claim under the insurance contract), the insurer has an asset. The insurer should measure that asset initially at current exit value.
• Until the Board has discussed reimbursement rights in the project to amend IAS 37, the Board should not conclude on how an insurer should measure salvage and subrogation rights after initial measurement.

Business combinations and portfolio transfers

The Board agreed that

• IFRS 4 permits an expanded presentation for insurance contracts acquired in a business combination or portfolio transfer. When it completes phase II of the insurance contracts project, if any significant differences remain between current exit value and fair value, it might be necessary to consider retaining the expanded presentation. If no significant differences remain, the expanded presentation would be redundant.
• When an entity takes over a portfolio of insurance contracts in a portfolio transfer, the current exit value of the portfolio at that date is likely to equal the consideration received, less the fair value of any other assets received (e.g. investments or recognisable intangible assets relating to customer relationships). If the current exit value is a different amount, the transferee should recognise the difference as income or expense.

Pension Accounting

The Board considered a proposal from the staff to consult the SAC and the IASC Foundation Trustees on adding a project to its agenda on pensions. The draft proposal was not available to observers.

The Board was asked for their preliminary views on which of the following possible project plans should be prepared and presented to SAC and the IASC Foundation:

• Option A. A long-term project, with targeted set of amendments to pensions, which in the first phase would be constrained by what the Board could finalise within a four-year period. It was explained that this would be the timeframe because of the due process, but also because this would open up for a finalisation of this part of the project within the timeframe of most of today's Board members.

• Option B. A limited-scope project, very similar to phase 1 of the project the FASB has addressed. Phase 1 of the FASB project is however limited, as it only addresses accounting in the balance sheet, while the income statement would remain untouched. The FASB currently expects to have its project finished by the end of 2006.

The discussion highlighted that Board members had more appetite for option A as an approach. However, the Board pointed out that if they were to take on a project, constituents must be informed that the project will address all issues on pensions, and that would end up in a new standard. The project would then be split into different phases where the Board would pick some issues that would be dealt specifically in during the first phase.

The Board decided that the staff should write a proposal for a long-term project. This proposal, which would be addressed for SAC and the IASC Foundation for an approval to be taken on the Boards agenda, should also include what the Board think should be dealt with within the different phases of the project.

Related Party Disclosures

The Board considered a staff proposal to consult the SAC and the IASC Foundation Trustees on adding a project to its agenda to update and clarify the requirements in IAS 24 Related Party Disclosures. The draft proposal was not available to observers.

It was explained that the main objectives of such a project would be to address:

• a. The requirements in IAS 24 for entities with significant state ownership when they transact with similar entities; and
• b. Whether, when an associate of an entity is preparing its own financial statements, the requirements of IAS 24 should include as related party transactions, transactions between the associate and a subsidiary of the associate's significant investor.

The Board discussed the issues set out in the agenda paper. Board members said that disclosure of transactions between entities with significant common ownership is both useful and important information.

The Board approved the staff proposal to consult with the SAC and the IASC Foundation in June regarding adding this project to the IASB's agenda.

Thursday 25 May 2006

Accounting Standards for Small and Medium-sized Entities

The Board considered a marked version of the revised draft ED International Financial Reporting Standard for Small and Medium-sized Entities. In addition, the Board began deliberations of some specific issues identified by the staff. The Board started by discussing the notion of 'mandatory fallback' to the full text of IFRSs. The Board agreed that this phrase had raised undue alarm amongst constituents and indicated its intention that the draft ED should clearly state that:

• The SME standard is intended to be a stand-alone document for a typical entity with about 50 employees.
• Where IFRSs provide an accounting policy choice, the Board has concluded that SMEs should have the same options. The simpler option is set out in he IFRS for SMEs, and the other option or options are permitted by cross reference to IFRSs.
• The IFRS for SMEs omits some accounting topics that are addressed in full IFRSs, because the Board believes that the typical SME is not likely to encounter such transactions. However the IFRS for SMEs has an explicit cross-reference telling an SME that happens to encounter such a transaction to look to a particular IFRS.
• The SME standard states that if the IFRS for SMEs does not address a transaction, event, or condition or provide an explicit cross-reference back to an IFRS, an SME should select an accounting policy that results in relevant and reliable information.
  • In making this judgement, an SME should consider, first, whether appropriate accounting can be determined by analogising from the principles in the IFRS for SMEs.
  • Only if no analogies can be derived, the full text of IFRS should be consulted as a 'fallback'. The Board considered whether the second tier of the hierarchy would be operational as auditors are likely to force preparers to apply the full IFRS guidance if no specific guidance exists in the SME Standard.
  • The Board voted and agreed that the approach they were taking could result in different accounting for similar transactions if entered into by entities following the SME Standard and those following the full IFRSs.
• In adopting the IFRS for SMEs, a jurisdiction could elect to add, as an appendix to the IFRS for SMEs, the full text of an IFRS that they deem especially relevant to SMEs in that jurisdiction, even though in the IFRS for SMEs itself that IFRS is cross-referenced rather than included. For example, in hyperinflationary economies, the full text of IAS 29 may be incorporated into the SME Standard for such jurisdictions.
• The Board will seek views from constituents about whether all of the options in full IFRS should be available to SMEs or, if not, which option(s) should be retained.

The Board commenced deliberations of specific sections of the draft ED and will continue tomorrow. During today's discussion, the Board asked the staff to perform an exercise of checking that the simplifications and cross-references made in the draft ED and its accompanying glossary are faithful to the meanings intended in the full text of IFRS so as to avoid unintentional differences in meaning.

Based on progress made to date, it was noted that an exposure draft is likely to be released for public comment in September or October 2006.

Fair Value Measurement

Principles of the fair value measurement project

The following principles were put to the Board as those forming the foundation of the fair value measurement project:

• The objective of a fair value measurement is to determine the price that would be received for an asset or paid to transfer a liability in a transaction between market participants at the measurement date.
• The definition of fair value and its measurement objective should be consistent for all fair value measurements required by IFRS.
• A fair value measurement should reflect market views of the attributes of the asset or liability being measured and should not include views of the reporting entity that differ from market expectations.
• A fair value measurement should consider the utility of the asset or liability being measured. As such, the fair value measurement should consider the location and the condition of the asset or liability at its measurement date.

The Board concurred with the staff that the above principles form the foundation of the fair value measurement project.

Revised definition of fair value

In the staff's view, the FASB's revised definition of fair value is substantively similar to the one tentatively approved by the IASB in December 2005. Based on that, the IASB agreed that the revised definition is consistent with the measurement objective.

However, some Board members expressed concern about the change to a 'price' rather than 'amount'. In addition, the revised definition is based on an exit price notion that does not consider prices that exist other than the exit price. As a consequence, other Board members noted that the current definition will require measurement based on a hypothetical market that, for some types of assets and liabilities, cannot be calibrated with reality and in most cases will result in day 1 gains or losses, which constituents are uncomfortable with.

Revised fair value hierarchy

The draft fair value measurement statement indicates that valuation techniques used to measure fair value shall maximise the use of observable inputs and minimize the use of unobservable inputs. The hierarchy prioritises the inputs to valuation techniques used to measure fair value based on their observable or unobservable nature.

The revised three-level hierarchy is summarised as follows:

• Level 1 inputs are observable inputs that reflect quoted prices for identical assets or liabilities in active markets the reporting entity has the ability to access at the measurement date.
• Level 2 inputs are observable inputs other than quoted prices for identical assets or liabilities in active markets at the measurement date.
• Level 3 inputs are unobservable inputs, for example, inputs derived through extrapolation or interpolation that cannot be corroborated by observable data. However, the fair value measurement objective remains the same. Therefore, unobservable inputs should be adjusted for entity information that is inconsistent with market expectations. Unobservable inputs should also consider the risk premium a market participant (buyer) would demand to assume the inherent uncertainty in the unobservable input.

IFRSs currently does not have a single hierarchy that applies to all fair value measures. Instead individual standards indicate preferences for certain inputs and measures of fair value over others, but this guidance is not consistent among all IFRSs.

The Board agreed with the staff's conclusion that the revised hierarchy in the draft fair value measurement statement is consistent with the principles discussed above and that the hierarchy in the draft fair value measurement statement represents an improvement over the disparate and inconsistent guidance currently in IFRSs.

Unit of account and fair value measurements

The Board agreed that it is not appropriate or practical to provide detailed guidance on the unit of account within the fair value measurement project. Determining the appropriate unit of account is a critical element of accounting and is not always consistent from one asset or liability to another or from one type of transaction to another.

Determination of which market

The Board agreed with the FASB's conclusion to adopt the 'principal market' view. While this will result in a change from the 'most advantageous' view currently in IFRS, the 'principal market' view more accurately reflects the fair value measurement objective and provides a more representative measure of fair value by giving preference to highly liquid markets over less liquid markets.

Transaction price presumption

At the December 2005 meeting, the IASB tentatively agreed the fair value measurement objective was an exit price. The December discussion highlighted the conceptual difference between transaction price (what an entity would pay to buy an asset or receive to assume a liability) and an exit price objective (what an entity would receive to sell an asset or pay to transfer a liability). The staff concluded that an entity cannot presume an entry price to be equal to an exit price without considering factors specific to the transaction and the asset or liability. As a consequence, the staff plans to bring a separate discussion of day 1 gains or losses to the Board at a future meeting.

The Board shared the concerns of the staff that if a transaction price were presumed to be fair value on initial measurement, entities might not sufficiently consider the differences between an entry transaction price and an exit fair value. As such, IFRSs should require an entity to consider factors specific to the transaction and the asset or liability in assessing if the transaction price represents fair value.

Fair value within the bid-ask spread

Entities often transact somewhere between the bid and ask pricing points, particularly if the entity is a market maker or an influential investor. However, application of the rule in IAS 39 results in consistency across entities without consideration of entity specific factors that may influence where within the bid-ask spread the entity is likely to transact. Further, the rule creates a bright-line in quoted markets, thus limiting the use of judgement and subjectivity in the fair value measurement.

The Board agreed to add a discussion to the invitation to comment that communicates agreement with the principle in the draft fair value measurement statement. The discussion would state that it is not appropriate to use a consistently applied pricing convention as a practical expedient to fair value. This recommendation would result in both a change to existing IFRSs as well as a departure from the FASB's draft fair value measurement statement.

Transaction and transportation costs in measuring fair value

The definitions of transaction type costs vary in IFRSs, though such costs are consistently excluded from fair value measurements. Currently, IFRSs are not clear (with the exception of IAS 41) whether transportation costs are an attribute of the asset or liability, and as such should be included in the fair value measurement.

The draft fair value measurement statement defines transaction costs as the incremental direct costs to transact in the principal or most advantageous market. Incremental direct costs are costs that result directly from, and are essential to, a transaction involving an asset (or liability). Incremental direct costs are costs that would not be incurred by the entity if the decision to sell or dispose of the asset (or transfer the liability) was not made.

In the draft fair value measurement statement, the FASB concluded the fair value measurement of the asset or liability shall include only those costs that are an attribute of the asset or liability. The FASB concluded transaction costs are an attribute of the transaction, not an attribute of the asset or liability. Therefore the fair value measurement of the asset or liability shall not include transaction costs.

The staff agreed with the conclusions in the draft FVM statement regarding transportation and transaction costs. However, the staff concluded that the discussion of what types of costs are attributes of the asset or liability could be more robust as it is difficult to decipher justification for different treatment of transaction costs and transportation costs in the current discussion in the draft FVM statement. As such, the staff recommended, and the Board agreed that the invitation to comment should include a question on the sufficiency of the discussion of costs that are attributes of an asset or liability, such as transportation costs.

Business Combinations Phase 2

Exceptions to the fair value measurement principle - Assets held for sale

The Business Combinations Exposure Draft (BC ED) proposes an exception to the fair value measurement principle for acquired non-current (long-lived) assets that are classified as held for sale as of the acquisition date.

At the January 2006 meeting, The Board asked the staff to bring the proposed accounting for assets held for sale back to the Board because:

• the staff was concerned about the justification for the proposal as an exception to the fair value measurement principle; and
• it was not clear to the staff whether the Boards intended the measurement exception to relate to assets that the acquiree classified as assets held for sale before the acquisition date or whether the Board intended the measurement exception to relate to any assets acquired in the business combination that the acquirer intends to hold for sale.

The Board agreed that the final standard make it clear that the designation by an acquiree of an asset as being held for sale is not relevant when recognising and measuring assets acquired in a business combination. In addition, the Board agreed with the staff view that an acquirer should be allowed to recognise an asset as being held for sale at the date of acquisition if it can meet the criteria in IFRS 5. However, it is unlikely that the acquirer would be able to meet those criteria as of the acquisition date.

The Board agreed to go a step further and amend IFRS 5 to replace 'fair value less cost to sell' with 'fair value'. It was reported that the FASB had indicated its intention to take the same extra step. However, some Board members noted that this extra step should be taken as a separate project as it will involve a fundamental review of impairment accounting.

Accounting for employee benefits in a business combination

The Board affirmed the fair value measurement exception for employee benefit obligations in the scope of IAS 19. Therefore, an acquirer will measure the assets or liabilities of the acquiree that are related to its employee benefit schemes in accordance with IAS 19 rather than at fair value.

Operating leases

The staff believes that without additional guidance, different interpretations of the application of the recognition principle to an acquiree's operating leases might result. For example, constituents might interpret the recognition principle as requiring recognition of an intangible asset (liability) for the acquiree's interest in a net beneficial (onerous) contract and:

• separate recognition of the assets and liabilities related to an acquiree's operating leases. For example, if the acquiree is the lessee of an operating lease, the acquirer would recognise a separate asset for the acquiree's rights to use assets according to the lease agreement, including related renewal options and other rights, and a separate liability for its obligations to make required lease payments.
• no recognition of assets and liabilities related to an acquiree's operating leases because IAS 17 Leases and FASB Statement No. 13 Accounting for Leases do not require separate recognition of assets and liabilities related to operating leases.

Operating leases in which the acquiree is the lessee

The Board affirmed the proposal in the business combinations ED that acquirers only should be required to recognise an intangible asset (liability) for the acquiree's interest in a net beneficial (onerous) contract, rather than being required to recognise separately an asset and related liability.

Operating leases in which the acquiree is the lessor

The staff proposed that the final business combinations standard should clarify that the fair value of the asset subject to the operating lease is not affected by the terms of the operating lease contract associated with the asset. The fair value of the asset subject to the operating lease will reflect the effects of leasing the asset at market terms at the measurement date. The effects of the terms of the existing operating lease contract should be considered separately from the fair value measurement of the asset subject to the operating lease. If the lease is not at market terms, the lessor would recognise separately an intangible asset (beneficial contract) or liability (onerous contract). The concern is that without this clarification some constituents might believe that the fair value of an asset subject to an onerous operating lease contract is lower than the fair value of the same asset leased at market terms.

Some Board members disagreed with the staff proposal on the basis that a building that is subject to lease agreements is different to one that is not subject to lease agreements. Furthermore, IAS 40 and IAS 41 are inconsistent on this issue. The Board decided to wait for the outcome of the FASB's deliberations before deciding on how to proceed.

Can an operating lease at market terms have a greater net value than zero?

The business combinations ED guidance on operating leases describes only two types of assets and liabilities that might be recognised in relation to operating lease contracts:

• an intangible asset or liability if the terms of the operating lease are favourable or unfavourable relative to market terms; and
• the asset subject to an operating lease in which an acquiree is the lessor.
• The Board agreed with the staff recommendation that the final business combinations standard should clarify, that operating lease contracts at market terms might have value for reasons other than terms that are favourable relative to market prices. For example, an operating lease contract might have value because an entity is willing to pay more than the market rate to gain entry into a market with limited access or to obtain access to existing customer relationships. In such circumstances the intangible asset to which that value is attributable should be recognised separately. That is to say, even if an acquiree's operating lease contract is at market terms, the acquirer still must recognise any intangible assets which create value in the at-market contract.

It was not clear whether the Board decided to characterise the above clarification as an exception to the recognition principle or as additional application / implementation guidance.

Cost of a Subsidiary in the Separate Financial Statements of a Parent on First-time Adoption of IFRSs

At its March 2006 meeting, the Board decided to add a project to its technical agenda to resolve issues in relation to measuring the cost of a subsidiary in the separate financial statements of a parent on first time adoption of IFRSs. Constituents argue that, in some circumstances, it is difficult to determine the cost of an investment in a subsidiary in accordance with IAS 27 Consolidated and Separate Financial Statements on first time adoption of IFRSs.

Three options were considered by the Board:

• 1. Use the previous GAAP cost as deemed cost
• 2. Use the IFRSs carrying value of the net assets of the subsidiary at transition date as deemed cost
• 3. Fair value as deemed cost

Many Board members indicated a preference for option 3 and then 2. However, the Board acknowledged that IFRS 1 is a practical expedient for entities transitioning to IFRS and therefore the exception provided need not be of the highest quality. After some discussion about the exact nature of the problem, which some believe arises only where shares were issued in exchange for an interest in the subsidiary and the value of the business acquired at that date can no longer be determined, compared to a purchase of an interest (for example, by cheque) in which case some Board members believe such records should be retrievable.

It was agreed that the staff should work on developing a model that uses option 2 above to determine the cost of the subsidiary at the date of transition if the information required in IAS 27 cannot be determined. On the issue of determining pre-acquisition profits, the staff would attempt to develop a model that is independent of option 2 but ensuring that the two models are compatible.

Friday 26 May 2006

Amendments to IAS 37 - redeliberation of the ED

Approach to re-deliberating the issues associated with the recognition principle proposed in the ED (agenda paper 10A))

In the February 2006 Board meeting it was agreed that an entity shall recognise a liability when:

• the definition of a liability has been satisfied; and
• the liability can be measured reliably.

Many respondents used litigation as an example to highlight their concerns with the ED. Staff believe that litigation is a problematic area because it often involves multiple points of uncertainty, and so may combine several recognition and measurement issues. As a result, litigation will be discussed as a standalone topic in the June meeting. The following topics will also be discussed in June:

• the Framework's recognition criteria;
• clarity of explanation within the ED;
• elimination of the term 'contingent liability'; and
• the interaction between the recognition principle in the ED and the recognition of liabilities following the guidance in other standards (e.g. business combinations).

From the comment letters on the proposed amendments to IAS 37, staff identified two main sources of uncertainty:

• 1. uncertainty about the outflow of resources embodying economic benefits associated with a present obligation; and
• 2. uncertainty about the existence of a present obligation.

1. Uncertainty about the outflow of resources embodying economic benefits associated with a present obligation

Respondents argued that the ED's proposals are not consistent with the Framework, because the Framework definition of a liability includes the words 'the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits'. Staff believe that the phrase 'expected to' has more than one definition, and has addressed this issue in paper 10B (see below).

Respondents were also concerned that the probability was only being considered when measuring a liability, whereas the Framework requires a probability assessment to determine whether a liability should be recognised. Staff believed that the only justification for not recognising a liability when there is little or no uncertainty that a present obligation exists is that it is not possible to identify a range of possible outcomes with sufficient reliability. Consequently staff propose to examine whether further guidance is needed in this area.

2. Uncertainty about the existence of a present obligation

Several respondents indicated that there are many situations in which it is not certain that a present obligation exists. This has been referred to by staff as 'element uncertainty'. Whilst this is not a new issue, the ED has highlighted it because it clarifies that an entity must first determine whether a present obligation exists. This issue is addressed in paper 10C (see below).

The meaning of the phrase 'expected to' in the definition of a liability (agenda paper 10B)

Comment letters on the ED indicated that different views exist on the meaning of 'expected to'. In particular, many are interpreting the phrase as meaning 'probable'. The issue arises as 'expected to' is often used in common English to mean more likely than not, or probable. If an outcome is less certain, the word 'possible' is often used. However, staff believe that the phrase 'expected to' in the Framework is not intended to imply a particular degree of certainty. Instead, they believe it is being used to indicate some potential outflow is necessary in order to meet the definition of a liability. The Board acknowledged that there is widespread confusion about the term, and there was comment that the phrase was being used here in more of a statistical context (where the probability of an out come is assessed by adding together all possible outcomes multiplied by their associated probabilities of occurring). It was also mentioned that the history of the phrase being used by the FASB was to avoid the assumption that there must be virtual certainty before a liability exists. The Board generally agreed with the staff conclusion that:

• 'expected to' is not intended to imply that there must be a particular degree of certainty that an outflow of benefits will occur before an item meets the Framework definition of a liability; and
• the Board's interpretation of 'expected to' in the IASB's definition of a liability does not increase divergence with US GAAP.

However, the Board felt this was important enough that this confusion should not simply be addressed in the Basis for Conclusions - it should also be included in the body of the standard.

Determining whether an entity has a liability when the existence of a present obligation is uncertain (agenda paper 10C)

Staff noted that element uncertainty is not a new issue. IAS 37 currently contains limited guidance and states that when uncertainty exists an entity must assess all available evidence to determine whether it is more likely than not that a present obligation exists. If so, a present obligation is deemed to exist, and if not, a contingent liability exists. However, IAS 37 also states that it is only in rare cases that it will not be clear whether a present obligation exists. The ED does not include any reference to 'more likely than not'.

Many respondents disagree with omitting this probability guidance in the ED, and support the Alternative View given. They argue that by omitting this guidance, there is insufficient guidance on what to do in situations where it is unclear whether a present obligation exists.

Staff agreed with respondents that more guidance in this area is necessary. Further, staff believe that element uncertainty arises with sufficient frequency across all industries to justify including additional guidance. Staff proposed five different options which may form the basis of additional guidance on element uncertainty:

• 1. reflect element uncertainty in measurement;
• 2. reinstate the 'more likely than not' guidance in paragraphs 15 and 16 of the current IAS 37;
• 3. reinstate the current probability recognition criterion;
• 4. provide a list of indicators to act as guidance in determining whether a present obligation exists; or
• 5. identify an alternate obligating event.

Staff recommended that option 4 be pursued. The Board agreed that further guidance was needed and justified. There were a variety of views about which of the above options was the best route to follow. There was general agreement that providing a list of indicators as to whether a present obligation exists (that is, option 4) would be useful. Some Board members felt that in addition, the 'more likely than not' guidance should be reinstated. Several Board members stated that it was difficult to judge without seeing the list of indicators. There was some discussion about whether entities would use the 'more likely than not' guidance in practice, even if the words were not reinstated. There was also discussion about whether it is appropriate to use probability to determine whether an event has occurred, as either the event has occurred, or it hasn't. Some Board members stated it might be helpful to also give some examples of situations in which there is no element uncertainty.

Stand ready obligations (agenda paper 10D)

The ED proposes introducing the concept of a stand ready obligation. Many respondents stated that the explanation of what a stand ready obligation is too broad and will result in recognising far more liabilities. Based on an analysis of the comment letters staff believe that there are two potential improvements that could be made:

• improve the explanation of the notion of a stand ready obligation; and
• provide additional examples to illustrate the distinction between scenarios in which there is a stand ready obligation and in where there is just business risk.

The Board agreed with the staff plans for improvement. Staff then asked the Board to consider four examples and to give an indication on whether there is a liability, and if so what is the obligating event. The examples given are duplicated from the observer notes.

There was general agreement that a liability does exist in example 1, and the obligating event is selling the warranty (rather than selling the CD player and warranty, as proposed by staff). There was some discussion about whether this was consistent with the impairment model in IAS 39 for receivables, where an incurred (rather than expected) model is used. There was also discussion about how in practice some entities link warranty provisions with revenue. For example, if history indicates that warranty claims are made on 5% of sales, the warranty provision is booked when the sales are booked.

Staff put forward two views. The first was that examples 1 and 2 are not different in substance. The second is that they are different, and that in this scenario there is only a liability fro CD players that have faults at the time of sale. The Board debated this example for a while, with most Board members stating the facts were not conclusive and that more information was needed to give a view. For example, the consumer legislation could require the vendor to write an identical warranty to that in example 1. Alternatively, it could require a different warranty, or it could just give protection for CD players with a fault at the point of sale (that is, if a fault developed on day 2, the customer would not be protected by the legislation). The remaining two examples deal with non-contractual situations.

Generally, most Board members agreed with the staff that Y does not have a liability. This is because the available evidence indicates the company has complied with health and safety regulations.. Therefore there is no present obligation and there is no potential outflow of resources.

Staff again put forward two views. View A is that Y has no liability until an accident occurs. As at 30 June 20X1, the available evidence indicates that no accidents have occurred as a result of the hazard and therefore there is no potential outflow of resources.

View B is that Y does have a liability because the existence of a hazard creates a stand ready obligation to accept the financial consequences of the hazard causing an accident. There were a variety of views on this example, although the Board did generally agree that there could never be a stand ready obligation unless there is a breach of the health and safety regulations. It was also generally agreed that the answer might depend on how long it would take to rectify the breach.

Accounting Standards for Small and Medium-sized Entities

The Board continued its discussions of a draft Exposure Draft of an IFRS for Small and Medium-sized Entities (SMEs). The Board had begun its discussion of that topic yesterday. Many of the comments given were drafting comments.

Incorporating changes to IFRSs in the IFRS for SMEs. The Board agreed that generally, the text of the IFRS for SMEs should be based on existing IFRSs and should not reflect changes that have been proposed in Exposure drafts. The Board also agreed that each time an IFRS is exposed, that Exposure Draft should also address how, if at all, the changes would be incorporated into the IFRS for SMEs. This approach would enable SMEs to early adopt standards and would minimise inconsistencies between IFRSs and the IFRS for SMEs.

Definitions. The Board noted that in the Draft ED, some of the definitions in the glossary differ from those in the 2006 Bound Volume of IFRSs. They should be conformed, or the difference should be explained.

Business combinations. Material on business combinations will be removed from the IFRS for SMEs and, instead, will be addressed by cross-reference to IFRS 3 Business Combinations.

Statement of income and retained earnings. Previously, the Board had concluded that if the only changes to an SME's equity during a period arise from profit and loss and payment of dividends, the SME may present a combined statement of income and retained earnings instead of separate income and equity statements. The Board clarified that an SME is eligible to present a combined statement of income and retained earnings if its equity changes due to (a) correction of a prior period error or (b) changes in accounting policy, in addition to changes due to profit and loss and dividends.

Expensing all development cost. The draft ED will include an option for an SME to charge all development cost to expense. An SME that wishes to capitalise development cost would be cross-referred to the requirements of IAS 38 Intangible Assets.

Combined financial statements. A better description of these is needed. Further, clarify that if an entity chooses to present combined financial statements, it must comply in full with the IFRS for SMEs.

Model financial statements. Staff noted that a comprehensive model set of financial statements for SMEs was being developed based on the IFRS for SMEs. Those statements would include actual figures (rather than X's for numbers).

True and fair override. The Board discussed whether a fair presentation override should be permitted for SMEs. The Board concluded that such an override should only be allowed when requirements of the IFRS for SMEs would conflict with local law or regulation.

Financial instruments. Most of the remaining discussion centred around the section dealing with financial assets and financial liabilities. Whilst there was general agreement that the full requirements of IAS 39 should not be included in the SME standard, Board members noted that in simplifying the requirements, there were sometimes unwanted inconsistencies or complications. Areas of particular discussion were:

• which financial assets should be accounted for at fair value, and how to determine fair value; and
• reclassifications of financial assets.

Staff will discuss how this section should be redrafted with particular Board members.

Income taxes. The Board agreed that the exemptions in IAS 12 from recognising the tax effects of certain temporary differences should be included in the IFRS for SMEs. There was also a general discussion about whether to bring in some of the definitions in the proposed amendments to IAS 12, as this might help clarify and simplify certain situations.

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