Sweep issue on IAS 28 Investments in Associates: Clarification on the partial use of fair value amendment

In February 2010 the Board approved an Annual Improvement amendment to IAS 28 to enable a parent entity to measure part of the investment in an associate at fair value in its consolidated financial statements when that part is designated as at fair value through profit or loss in accordance with the scope exclusion in paragraph 1 of IAS 28 (the 'venture capital organisations' exception). This amendment will be issued as a consequential amendment in the forthcoming IFRS on Joint Arrangements.

As a result of drafting the consequential amendments, the staff noted two related sweep issues, which it presented to the Board. These issues were:

• Is significant influence needed at the level of the venture capital organisation or only at group level in order to qualify for the exception at group level?
• Should the use of fair value through profit or loss be a requirement in the financial statements of the venture capital organisation to retain the use of fair value at group level?

After a short debate, the Board agreed that:

• significant influence over the investee is not required at the level of the venture capital organisation to measure the investment at fair value through profit or loss at group level, and
• it is not necessary that the venture capital organisation account for its investment at fair value through profit or loss in its separate financial statements. In other words, the accounting for the investment in the venture capital organisation does not taint the choice available in the group financial statements.

The exception will be characterised as an exception to the measurement principle in IAS 28, not a scope exception. In addition, the amendment will clarify that the exemption is available based on the business purposes for holding the investment and not restricted by the financial reporting basis used in the venture capital organisation's own financial statements.

Finally, the amendments are likely to use the phrase 'venture capital organisations or mutual funds, unit trusts and similar entities, including investment-linked insurance funds' (or something similar), until such time as the Board's forthcoming exposure draft proposing a definition of an 'investment entity' is issued in a final IFRS.

Participating investment contracts

The Boards discussed whether investment contracts with a discretionary participation feature should be within the scope of a standard on:

• insurance contracts, and so should be measured in the same way as participating insurance contracts, or
• financial instruments, and so should be measured at amortised cost or fair value through profit or loss.

The staff recommended a split approach – that the IASB and FASB agree different positions:

• that the IASB treat investment contracts with discretionary participation features as insurance contracts; and
• that the FASB should treat these items as financial instruments within the scope of their proposed financial instruments standard, currently on exposure for public comment.

The FASB confirmed that such contracts would be within the scope of their proposed financial instruments standard.

IASB members were divided on this issue. Those opposing the staff recommendation were concerned about scoping into a proposed IFRS on insurance contracts things that were explicitly not insurance contracts. This was to create 'industry' standards, something contrary to the IASB's philosophy. In addition, some were concerned about structuring possibilities, for example, that some transactions could avoid financial instrument accounting altogether. Those who supported the staff recommendation acknowledged the opponents' view but were prepared to accept it on mainly pragmatic grounds. Some would support the proposal only in situations in which the investment contracts participated in a pool for which a significant majority of the participating contracts were insurance contracts.

The IASB was evenly split (6/6 of the Board members at the meeting). As a result, the Chairman stated that the IASB ED would expose the staff recommendation (that is, including investment contracts with a discretionary participation feature within the scope of the proposed insurance IFRS), and discuss the treatment of such contracts as financial instruments subject to normal IFRS financial instruments accounting in the basis for conclusions, with a specific question in the Invitation to Comment.

Contract boundary

On a related issue, the IASB agreed that the contract boundary for 'investment contracts with a discretionary participation feature' be defined as the point at which the contract holder no longer has a contractual right to receive benefits arising from a discretionary participation feature.

Risk adjustment techniques

The Boards discussed which techniques should be available for measuring a risk adjustment and, in particular, whether a cost of capital technique would meet the proposed objective for the risk adjustment. This discussion followed on from one on 18 May 2010, when they decided that if the measurement model for insurance contracts were to include a separate risk adjustment, the range of available techniques for measuring that risk adjustment should be limited in some way.

The staff proposed that the techniques be limited to the following, with the technique used being driven by the expected distribution of expected losses:

• a confidence level technique (or value at risk);
• a conditional tail expectation technique (or tail value at risk); or
• a cost of capital technique.

The staff recommendation was not well received. In particular, the cost of capital approach was criticised because it did not meet the Boards' measurement objective, in that it measured what an investor would require to assume a book of business, whereas the Boards are seeking to measure the insurance liability.

Some Board members thought that the only measurement technique that met the Boards' measurement objective was the conditional tail expectation/tail value at risk technique: in particular it addressed the particular challenge of measuring risks with low frequency and high severity, which would have risk adjustments higher than those risks with high frequency and low severity.

A FASB member did not think that the Boards had enough information or analysis about risk valuation methodologies to make an informed decision. In addition, the Board member was concerned that the staff was seeking to accommodate certain regulatory accounting practices within the envelope of investor-focused financial reporting. This was not necessarily the Boards' responsibility.

The Boards could not conclude on this issue. The staff will return during the IASB meeting 15-17 June with another attempt to achieve consensus.