Wider corporate reporting – Cover note – Agenda paper 28

In order to stay at the forefront of the corporate reporting arena, the Board had asked the Staff to research into the role that the Board should play in this area. This session marked the first Board discussion of the initial survey results. The topics for this meeting were as follows:

• An initial survey of the landscape and implications for the Board (AP 28A); and
• Implications for the Board: options for the Work Plan (AP 28B).

Wider corporate reporting - An initial survey of the landscape and implications for the Board - Agenda paper 10A

Initial survey results

The Staff’s research thus far indicated that wider corporate reporting (which is a broad term used to refer to any reporting by companies that falls outside the primary financial statements and the notes, and includes integrated reporting, sustainability reporting, MD&A etc.) was growing in prominence and importance, although much of it was prepared on a voluntary basis. There was also general consensus among the various stakeholders (including regulators, policy-makers and investors) that companies should report on a broader range of factors beyond purely financial results. Moreover, it was clear that there was an appetite for greater standardisation and a consistent global reporting framework among the current plethora of codes and guidelines.

Staff recommendation

The Staff recommended that the Board play a more active role in wider corporate reporting than its current stance of co-operation and co-ordination with other bodies in this area.

Discussion

The Board generally agreed that they should be playing a more active role in wider corporate reporting. The Chairman in particular believed that the Board has a vested interest in this area because all corporate reporting links to the financial statements. Having said that, some members cautioned against creating more guidance without fully understanding its purpose and what problem it is trying to solve, as they believed that this would just add to the existing confusion and would render the guidance meaningless. In response, other members emphasised the need for the guidance to identify its target audience (i.e. investors as opposed to other stakeholder groups), and to have a clear focus and objective (e.g. how the corporate reporting interacts with financial statements, and how it could be disclosed so as to fairly present information to investors). Specifically, one member suggested that the Staff think of defining ‘sustainability’ for the Board’s purpose to distinguish it from its use in other contexts by other bodies that have also published corporate reporting guidance. Another member believed that the guidance should be generic and flexible enough to keep up with changes over time.

Wider corporate reporting - Implications for the Board: options for the Work Plan -Agenda paper 10B

In this paper, the Staff considered a couple of alternatives of how the Board could take on a more active role in wider corporate reporting. On balance, the Staff believed that there would be merit to update the Management Commentary Practice Statement (PS) for developments that had taken place since its publication. If the Board supports this course of action, the Staff will perform further preparatory work before submitting a formal proposal to add a project to the active research agenda to revise the PS.

Discussion

The Board asked the Staff to do more exploratory work to see whether the Management Commentary PS is the best place to incorporate its work on corporate reporting. Some Board members were sceptical of the need to improve the PS when there were no requests for it from two rounds of agenda consultation. They also asked the Staff to assess whether and to what extent preparers are using the existing guidance.

The Chairman reiterated his belief that the Board must do something in this area, and that the Board’s work should not intrude into other bodies’ (e.g. IOSCO) governing realm.

Goodwill and Impairment - Agenda paper 18

Background

This project was undertaken as a result of the feedback received on the post-implementation review of IFRS 3. The purpose of this session was to recap the approaches developed so far in relation to how changes could be made to the existing impairment model in IAS 36 as well as the subsequent accounting of goodwill, and the progress made by the FASB on a similar project since June 2016 when the two Boards last discussed this topic.

See the October 2015 to June 2016 Agenda Paper 18 series for details of these approaches.

Recap

This project focuses on the following areas:

• (a) whether changes should be made to the existing impairment testing requirements in IAS 36;
• (b) subsequent accounting for goodwill (including the relative merits of an impairment-only approach and an amortisation and impairment approach); and
• (c) whether any intangible assets currently required by IFRS 3 to be separately identified could be subsumed into goodwill for cost/benefit reasons.

The objectives of the project are to simplify the impairment testing model to reduce the cost of applying it without making it less robust, and to make it more effective by recognising impairment losses at the appropriate time and amounts, supplemented by appropriate disclosures. Preliminarily approaches considered by the Staff in achieving these objectives include the following:

• (a) Using a single method to determine the recoverable amount: to use either fair value less costs of disposal, value-in-use (VIU), or a method that reflects how the entity expects to recover the asset.
• (b) Relief from annual testing: to test only when there is an indication of impairment.
• (c) Changes to the VIU methodology: reconsidering whether it is still appropriate to use a pre-tax discount rate and to exclude the estimated future cash flows expected to arise from improving the asset’s performance from the VIU calculation.
• (d) To include a pre-acquisition headroom amount in the recoverable amount of a CGU to prevent any downward movements in acquired goodwill being absorbed by unrecognised internally generated goodwill, resulting in acquired goodwill not being impaired appropriately.

Next steps

The Staff plans to present further analysis on each of the proposed approaches for discussion by the Board in 2017.

Discussion

There was not any significant technical debate in the session. As previously agreed by the Board, the Staff reconfirmed that they will not be performing any further analysis on the amortisation of goodwill approach, and will instead focus on how to improve the effectiveness of the existing impairment model and the related disclosures. A couple of Board members noted that the Staff will have to do a lot more analysis on the pre-acquisition headroom concept to see whether it is workable, and cautioned against creating more complexity with this approach when one of the objectives of the project is to simplify the impairment assessment.

One Board member in particular believed that the Staff’s work plan is unnecessarily drawn out with lots of analyses and consultations when he doesn’t believe that they would result in any ground breaking improvements to how one assesses impairment.

Discount rates - Agenda paper 17

Background

The purpose of this session was to ask the Board whether any further work was needed to conclude the research project on discount rates. AP 17A summarises the research findings that were presented in detail to the Board in the January 2016 meeting. It also lists various matters for the Staff to consider in future standard-setting activities relating to discount rates and present value measurement, which are incorporated in AP 17B in which the Staff discusses how they aim to make use of the research findings.

This project started in June 2014 with the Board discussing the research findings from September 2015 to April 2016. In light of the input received on the 2015 Agenda Consultation and the Board’s then review of its priorities, the Board expected that the project would conclude without any further significant work.

Staff recommendation

The Staff recommended that the Board:

• (a) not seek feedback from the public on the research outputs; and
• (b) conclude the research project with no further work.

Next steps

The Staff plans to hold an educational session with the Board in the next few months on low and negative discount rates.

Discussion

The Board approved the Staff recommendations without any technical debate. The discussion centred on how to communicate the research findings internally and how to make sure the Staff use it in future activities, as well as to highlight the fact that the discount rate is not an island but interacts inextricably with measurement considerations.

Discussion

The Staff indicated that the final ballot draft of all parts of IFRS 17 have been circulated to the Board and expect to publish IFRS 17 in the second half of May 2017. The Staff will also send out a public call for nominations to the transition resource group around the time of publication.

Primary Financial Statements – Cover note – Agenda paper 21

Background

The IASB continued its discussion on the Primary Financial Statements (PFS) project. The topics for this meeting were as follows:

• Earnings before interest and taxes (EBIT) (AP 21A)
• Management operating performance measure (Management OPM) (AP 21B)
• General guidance on classification, aggregation and disaggregation (AP 21C)

APs 21A and 21B complement each other and discuss whether additional subtotals should be introduced in the Statement of Financial Performance (SOCI). The Staff recommended that the Board require the presentation of EBIT (to be defined by the Board) and permit the presentation of a Management OPM (to be defined by management) as subtotals in the SOCI in order to balance users’ needs for having a subtotal that allows for comparison across entities and one that allows management the flexibility to tell their own story.

The Staff plans to discuss the following topics at future Board meetings: (a) adjusted basic earnings per share; (b) better ways to communicate information about OCI; (c) targeted improvements in the statement of cash flows; and (d) development of illustrative examples for the PFS.

Primary Financial Statements – Earnings before interest and tax (EBIT) – Agenda paper 21A

Background

In this paper, the Staff analysed how the Board could define EBIT so that it could be calculated in a consistent manner across entities in order to satisfy users’ need for a subtotal in the SOCI that provides a comparable starting point for valuation and ratio analysis across entities.

Staff analysis

The Staff assessed the pros and cons of EBIT against other subtotals as follows:

Operating profit – There is no consensus among users as to what this subtotal constitutes. There have also been various failed attempts in the past to define operating activities and operating profit.

EBITDA – There is concern that this is often used as a measure of cash generation (for which it is a poor proxy) and the Staff thought that the Board may not want to encourage its use. Furthermore, as discussed in the Principles of Disclosures DP, the presentation of EBITDA would be incompatible with the classification of expenses by function in the SOCI. In addition, if a standardised EBIT subtotal is introduced, users can simply add back depreciation and amortisation to arrive at EBITDA.

EBIT – This is already widely used in practice and there is reasonable consensus on what this subtotal comprises – earnings before finance income/expense and tax. Nevertheless, there is diversity in practice as to what constitutes finance income/expense. As EBIT inherently removes the financial effects of differences in capital structure, the Staff believes that finance income/expense should be described as income/expenses relating to an entity’s capital structure, which includes cash and short-term investments. This is because how an entity manages its cash and short-term investments is interrelated with an entity’s decisions on debt and equity financing. This treatment would also be consistent with current practice. As to whether something constitutes short-term or long-term investments, and whether long-term investments form part of the entity’s capital structure, it is a matter of management judgement.

Staff recommendations

The Staff recommends that the Board:

• (a) require EBIT to be presented as a subtotal in the SOCI;
• (b) define EBIT as profit before finance income/expenses and tax;
• (c) describe finance income/expenses as income/expenses related to the entity’s capital structure (which includes cash held and short-term investments); and
• (d) provide guidance on whether certain items are finance income/expenses, e.g. net interest on the net defined benefit liability and income/expenses from long-term investments.

Next steps

The Staff plans to discuss the following issues in relation to EBIT at future Board meetings:

• (a) whether an EBIT subtotal is relevant for entities whose ordinary activities are primarily financing activities (e.g. financial institutions);
• (b) how to classify finance income/expense arising from an entity’s ordinary activities; and
• (c) how the share of results of associates and joint ventures affects the EBIT calculation.

Discussion

The Board generally supported including an EBIT subtotal and acknowledged that the biggest challenge would be to define what constitutes the capital structure. The Board also asked the Staff to consider and develop the following points further:

• EBIT seemed to have been selected by the Staff because it is commonly used. The Staff should explore further whether there are any conceptual reasons for choosing EBIT as the comparability anchor and what is the purpose of the subtotal (e.g. how will it assist with ratio analysis?), which may in turn provide the Board with a framework to define ‘capital structure’.
• Where does one draw the line between short-term and long-term investments? Are long-term investments anything that exceeds one year? How does that notion interact with investments accounted for under IFRS 9? This also touches on what is meant by an entity’s cash management activities. The Board also noted that they have eschewed defining long-term investments as it is a difficult category to define, and cautioned the Staff that the discussions in this project should be consistent with the Board’s past decisions.
• What is net debt? The Board had several failed attempts at defining this term and cautioned the Staff from re-treading the same path.
• How would the following affect the EBIT calculation:
  • (a) IAS 37 accretion expense,
  • (b) interest arising from an IFRS 15 contract asset/liability,
  • (c) finance income and expenses of insurers, banks, conglomerates,
  • (d) net interest expense on defined benefit plans – some Board members disagreed with the Staff’s view that this should be treated as a finance expense. This is because the net defined benefit obligation and its related expense are presented on the statement of financial position and in profit or loss as a single amount, and that many entities view this as operating staff expense (i.e. not split between operating and financing),
  • (e) fair value changes of investment properties, returns on equity securities, share of results of associates (the question is are these assets part of an entity’s long-term investments?)

The Staff pointed out that the eventual guidance will lay out the principles but it will also have some rules, as this is the most pragmatic way to establish a comparable subtotal.

Primary Financial Statements – Management operating performance measure – Agenda paper 21B

Background

In this paper, the Staff analysed whether entities should be permitted to present an OPM – to be defined by management and not by the Board – in the SOCI to supplement the proposed presentation of EBIT in the SOCI (See AP 21A). The Staff further considered what constraints should be imposed on the OPM calculation in order to reduce the risk of their being misleading (e.g. should there be any prohibition on the exclusion of infrequently occurring items and/or of other items such as amortisation and share-based payment expenses?), given the amount of relative freedom that management will have with regard to how they are calculated.

Staff analysis

The Staff believed that it is beneficial for management to define their own OPMs as this would allow them the flexibility to ‘tell their own story’ and it would also save the Board a major challenge (as indicated by past unsuccessful attempts) to try to define what such an OPM should encompass. With regard to what constraints should be imposed, the Staff reasoned that not only will it be difficult to define what items should be allowed to be excluded from the OPM, it may also lead to entities presenting another OPM outside the financial statements if the restrictions do not suit their needs, which undermines the whole purpose of this project. A potential solution is to require transparent disclosures about the OPMs (see recommendations below).

Staff recommendations

The Staff recommended that the Board:

• (a) allow the presentation of a Management OPM in the SOCI;
• (b) allow items to be excluded from the Management OPM as long as it meets the requirements for subtotals in IAS 1.85, 85A and 85B; and
• (c) require additional disclosures on the Management OPM to enhance transparency, including:
  • (i) appropriate labelling of the subtotal;
  • (ii) a requirement to describe and explain the OPM (including an explanation of why any items have been excluded from the OPM, and why management believes it reflects the entity’s performance);
  • (iii) a requirement to disclose whether the entity uses the same OPM outside the financial statements; and
  • (iv) a historical summary of items excluded from the OPM.

Discussion

The Board asked the Staff to explore further whether they should require or allow the presentation of a Management OPM in the SOCI. They supported not imposing any more constraints on the Management OPM beyond what is required by IAS 1.85-85B. There was hardly any appetite to explore defining ‘operating profit’ which would entail presenting a section relating to investment activities in the SOCI in addition to EBIT and the Management OPM. Lastly, the Board agreed with the Staff’s proposals on additional disclosures regarding Management OPM presented in the SOCI.

Disclosure of a Management OPM in the SOCI

The Board was undecided on this issue (which is separate from the discussion on requiring versus allowing such a disclosure). One Board member did not see how this adds to the existing IAS 1 guidance which allows an entity to disclose additional information in the SOCI if it is relevant to an understanding of the entity’s financial performance. Another Board member asked the Staff to consider the possibility of including the Management OPM in a separate statement that reconciles to the SOCI (he was concerned that including the OPM in the SOCI would destroy the structure of the SOCI), and others suggested presenting it as part of segment information. Some Board members also believed that some parameters should be set on what is meant by operating performance measurement instead of allowing a free choice (because some entities might regard net profit after tax as their Management OPM which is not a measure of operating performance).

Requiring versus allowing

Most Board members preferred requiring the presentation of Management OPM as opposed to merely allowing it. One Board member believed that whatever OPM is disclosed outside the financial statements should be disclosed in the financial statements, because if given a choice, an entity would not disclose it in the financial statements due to all the disclosure requirements. Nevertheless, the Board noted that they do not have the authority to impose such a requirement and asked the Staff to liaise with regulators and find a way to implement this. Another Board member believed that having it as a requirement would elicit more response from the stakeholders than a permission to disclose.

Defining operating profit

One Board member lobbied at length for the inclusion of operating profit as a subtotal in the SOCI. He believed that it is important to distinguish operating profit from income/expenses from investing activities. There were however not much support from the other Board members: some were not clear about what purpose this subtotal will serve, and others believed that it is sufficient to disclose EBIT and/or the Management OPM. Despite this, the Staff will bring back a paper illustrating the Board member’s suggestions and how it interacts with EBIT and the Management OPM for discussion at a future meeting.

Primary Financial Statements – General guidance on classification, aggregation and disaggregation – Agenda paper 21C

Background

In this paper, the Staff drew together relevant guidance in IAS 1 and the Conceptual Framework ED to come up with three basic principles (which are self-explanatory) that could guide the aggregation and disaggregation of information in the financial statements. The Staff also described the notions of ‘classification’, ‘aggregation’ and ‘disaggregation’ and how they interact with one another. Furthermore, the paper includes a brief outline of various possible aggregation characteristics, e.g. by an item’s nature, function, or measurement basis.

Staff recommendations

The Staff recommended that the Board include the following principles in the Standards:

• (1) Items that share similar characteristics should be classified and aggregated together.
• (2) Items that are dissimilar should not be combined and should be disaggregated.
• (3) Aggregation and disaggregation in the financial statements should not obscure relevant information or reduce the understandability of the information presented. They should also contribute to a faithful representation of the items presented.

The Staff also recommended that the Board define the notions of ‘classification’, ‘aggregation’ and ‘disaggregation’, including how they interact with one another, in the Standards.

Furthermore, the Staff asked the Board whether they should explore the possible aggregation characteristics in more detail.

Discussion

The Board agreed with the Staff’s recommendations. The discussion focused on how to refine these principles.

Conceptual Framework - Agenda paper 10

The discussion of the Conceptual Framework exposure draft (the ‘CF ED’) is nearing the final stages. The topics for this meeting were as follows:

• Applying the amendment to paragraph 11 of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors to rate-regulated activities (AP 10B); and
• Due process summary for References to the Conceptual Framework (AP 10C).

In addition, the tentative decisions made to date are summarised in AP 10A.

Conceptual Framework - Applying the amendment to paragraph 11 of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors to rate-regulated activities - Agenda paper 10B

Background

The Board issued the Exposure Draft Updating References to the Conceptual Framework ('Updating References ED') in May 2015, which proposed to replace references to the Framework in IAS 8 and other affected Standards with references to the Conceptual Framework. Nevertheless, feedback on the ED indicated that the proposal could lead to diversity in practice for entities that conduct rate-regulated activities because the revised definitions and concepts in the CF will not definitively answer:

• (a) whether regulatory account balances meet the definitions of assets and liabilities;
• (b) whether those balances should be recognised; and
• (c) how those balances should be measured and presented.

This is especially problematic for entities that developed accounting policies by reference to the Framework in accordance with IAS 8.11 as they do not recognise any regulatory account balances as assets or liabilities. Furthermore, the proposed amendment could also lead to two rounds of accounting changes in a short period of time: 1) on application of the revised concepts and definitions of the CF, and 2) on application of the future Standard on rate-regulated activities.

Staff recommendation

In view of the above, the Staff recommended that:

• (a) entities be prohibited from applying the amendment to IAS 8.11 to accounting policies for regulatory account balances that were developed by reference to the Framework. The Staff recommends a prohibition as opposed to a choice of non-application as they believed this would improve comparability across entities and within an entity over time, as well as avoid disruption for both users and preparers of financial statements;
• (b) the prohibition apply to both existing and new accounting policies for the same reasons as above;
• (c) entities that develop accounting policies for regulatory account balances by reference to the Framework be required to continue doing so until they apply the future Standard on rate-regulated activities; and
• (d) a regulatory account balance be defined as the balance of any expense (or income) account that is not recognised as an asset or a liability in accordance with the Standards and is included, or is expected to be included, by the rate regulator in establishing the rate(s) that can be charged to customers.

Discussion

The Board approved the Staff’s recommendations subject to drafting changes.

One Board member asked the Staff to redraft so as not to imply that the Board has confirmed that there is no Standard that applies to rate regulated activities (RRA), as might be misconstrued from the agenda paper. This is because in applying the IAS 8 hierarchy, an entity may conclude that IAS 39/IFRS 9 or IAS 38 (or another Standard) is applicable in accounting for the regulatory account balances. Another Board member understood the Staff’s intention to be to the extent that an entity has applied the existing Framework to develop an accounting policy for RRA, that entity does not need to reassess its position in terms of the revised CF. The Staff agreed with the latter interpretation and will redraft accordingly.

Another Board member was concerned that the Staff’s rationale for prohibiting an entity from using the revised CF to develop new accounting policies might imply that the old and new frameworks would result in significantly different accounting outcomes for RRA, which might not be true given that the revised CF does not fundamentally change the existing one. The Staff confirmed that this was not their intention – they simply did not want entities to have to engage in a new analysis based on the revised CF when that might result in the same outcome as the existing Framework.

Conceptual Framework - Due process summary for References to the Conceptual Framework - Agenda paper 10C

Background

The Board discussed the feedback on the Exposure Draft Updating References to the Conceptual Framework in 2016 and most recently in January 2017. See APs 10E and 10F to the January 2017 Board meeting for details.

The Staff will ask the Board for permission to begin the balloting process for the amendments to update references to, and quotations from, the Framework without re-exposure.

Discussion

The Board granted permission to ballot without re-exposure. One Board member voiced her intention to dissent for the reasons discussed in AP 10B.

Dynamic Risk Management - Background and Proposed Approach - Agenda paper 4

Background

This was an educational session that provided the Board with the project history and discussed the Staff’s approach to developing the dynamic risk management model.

Dynamic risk management (DRM) refers to a situation where the risk position being hedged experiences frequent changes. In April 2014, the Board published the Discussion Paper Accounting for Dynamic Risk Management: A Portfolio Revaluation Approach to Macro Hedging. Overall, the respondents agreed that the DP captured the critical elements of DRM; however, they objected to the proposed solutions, mainly on grounds that revaluing residual risk does not necessarily reflect DRM and will lead to profit or loss volatility, and that some of the proposals may be inconsistent with the Conceptual Framework.

The Staff plans to develop the DRM model in the following stages:

1. Develop the foundational knowledge of what is DRM, including an understanding of how DRM activities are currently reflected in the financial statements.
2. Develop guiding principles to account for DRM. This includes an understanding of what the users’ needs are and whether the proposed model would faithfully reflect risk management, as well as the cost of implementation.
3. Evaluate the merits and shortcomings of each proposed model and select the preferred approach for further development and discussion.

The Staff plans to complete these three stages by October 2017, before developing the preferred model further.

Discussion

The Board reconfirmed the following as previously discussed:

• The IAS 39 hedge accounting will be grandfathered until the completion of the DRM project;
• The Board will focus on developing an accounting model for net interest rate exposures and will consider extending that model to other sectors that are also subject to dynamic risks, e.g. the energy and commodities sector, at the end;
• The Board will consider the feedback received on the DP in modifying the portfolio revaluation approach (PRA) which may end up being a new model given the shortcomings of the PRA as noted by the respondents. In other words, the Board will not start with a clean sheet of paper in developing the proposed model.

The Board also raised the following points:

• What is the objective of this project? What is the scope of what the Board is trying to solve? Is there a gap in the hedge accounting requirements in IFRS 9 and if so, what is it? This will necessitate an understanding of what IFRS 9 allows entities to do and what the revised IFRS 7 requires entities to disclose regarding risk management. In order to start with a full picture when developing the proposed DRM model, the Board asked the Staff to review the detailed discussions relating to the grandfathering of IAS 39 and the related proxy hedging issue, which the Board consider to be compatible with IFRS 9. Those discussions contain a lot of information as to what IFRS 9 allows entities to do. The Board also asked the Staff to review the Board’s intention as regards the requirements of IFRS 7 and IFRS 9. All these matters are unlikely to be apparent from current financial statements, not only because IFRS 9 and the revised IFRS 7 are not yet effective, but also because entities are allowed to continue using the IAS 39 hedge accounting guidance. One Board member noted that Brazil is considering whether to prohibit the grandfathering of IAS 39 as they believed that the hedge accounting requirements of IFRS 9 alone are sufficient.
• The potential to split the project into two parts: one part dealing with interest rate risks relating to core demand deposits (which mainly affects financial institutions), and another dealing with dynamic open portfolios (which is also applicable to energy companies).
• To work with the Primary Financial Statements project team to see whether and how the presentation of alternative performance measures could satisfy some of the users’ needs for information regarding an entity’s profile of interest rate risk exposure, how the entity has managed that risk and whether it is working well.
• Whether and how the current low interest rate environment affects the effectiveness of disclosures on risk exposure.
• How will the proposed model help users understand how a bank stabilises its net interest margin over a period of time? Put very simply, how does a bank manage the variability of the net interest margin between fixed-rate demand deposits and the variable-rate assets that are funded by those deposits?
• Whether application of the DRM model should be mandatory or voluntary. Feedback received indicated that preparers prefer voluntary application on a sub-portfolio basis. One Board member, however, favoured mandatory application as the Board is creating a specialised model to deal with a very specific risk. She also believes that mandatory application would elicit more involvement from the relevant stakeholder groups.

Financial Instruments with Characteristics of Equity research project - Agenda paper 5

This session marked the end of the technical deliberations of the Financial Instruments with Characteristics of Equity (FICE) project. The staff presented the following agenda papers:

• (a) Summary of discussions to date - Agenda paper 5A
• (b) Application of the Gamma approach to derivatives on ‘own equity’ – derivatives in foreign currency – Agenda paper 5B
• (c) Summary of interactions with other IFRS Standards – Agenda paper 5C
• (d) Due process and permission to ballot – Agenda paper 5D

The Board was asked to comment on the staff analysis and their recommendations.

Financial Instruments with Characteristics of Equity research project - Summary of discussions to date- Agenda paper 5A

Recap

The research phase of this project involves evaluating potential ways to improve the classification of liabilities and equity, and the related presentation and disclosure requirements.

The Board has explored the features to distinguish liabilities and equity: (i) the type of economic resources required to settle the claim; (ii) the timing of the transfer; (iii) the amount required to be transferred; and (iv) the priority of the claim relative to other claims.

The Board has been developing an approach (labelled Gamma, see discussion in February 2016), which distinguishes claims based on a combination of these features and would lead to outcomes broadly aligned with IAS 32. In February 2017, the Board tentatively decided to limit the equity/liability classification assessment to a consideration of the contractual terms of the financial instrument consistently with IAS 32 (i.e. non-contractual terms, e.g. legal and regulatory requirements, would not be considered in the classification assessment).

Appendix A summarises three approaches and Appendix B summarises classification outcomes for some simple instruments under the proposed approaches.

Financial Instruments with Characteristics of Equity research project - Application of the Gamma approach to derivatives on ‘own equity’ – derivatives in foreign currency - Agenda paper 5B

Background

This was a follow-up of the questions raised by the Board in its December 2016 meeting with regard to the classification of derivatives over own equity in a group scenario where the functional currency of the parent differs from that of the subsidiary. The Staff analysed two scenarios in this paper:

1. A subsidiary issues a derivative on its own equity in its functional currency that is classified as equity in its own financial statements. Does the classification change on consolidation when the functional currency of the parent differs from that of the subsidiary?
2. If one entity in a group (e.g. a parent) issues a derivative on equity instruments of another group entity (e.g. a subsidiary), then which entity’s functional currency should be the reference point in determining whether the derivative is denominated in a foreign currency for the purposes of classification in the consolidated financial statements?

Staff analysis

The Staff believed that the relevant functional currency is the functional currency of the entity whose equity instruments are being delivered for the purposes of classification in the consolidated financial statements (note that the analysis is based on the receipt of cash for the delivery of equity instruments, but it also applies to the opposite scenario). The Staff reasoned as follows:

• The value of a derivative is the net of two amounts – the receivable leg (the cash/financial assets receivable) and the payable leg (the equity instruments to be delivered).
• Under the Gamma approach, one of the criteria for classifying derivatives on own equity instruments as equity is that the value of the derivative must depend solely on the residual amount of the entity – this being the entity that will be issuing the equity instruments as they represent a claim on the residual amount of that specific entity.
• Since the residual amount of an entity is measured in the functional currency of that entity, the cash receivable must also be in that same currency for the derivative to be solely dependent on the residual amount and not be subject to foreign currency fluctuations.

The above answers question 2. Applying this logic consistently to question 1, the Staff believed that the debt/equity classification would not change on consolidation regardless of the functional or presentation currency of the parent.

Discussion

All Board members agreed with the Staff’s analysis.

One member asked the Staff to remove the reference to presentation currency as that has no relation to the functional currency and confuses the discussion. She also suggested more linkage between the functional currency, the primary economic environment and the entity’s residual value to strengthen the analysis.

Another member asked how the proposed attribution of profit or loss and OCI to equity derivative instruments would affect whether the translation difference is recognised in P/L or OCI. The Staff responded that the translation would not be affected and where the translation difference is recognised would simply follow the existing guidance in IAS 21.

Another Board member agreed with the Staff’s technical analysis but struggled with its interaction with the group being viewed as a single reporting entity and how to justify the change in classification of the instrument upon consolidation.

Financial Instruments with Characteristics of Equity research project - Summary of interactions with other IFRS Standards – Agenda paper 5C

Background and Staff analysis

This paper discussed the potential implications of the Gamma approach on other Standards and research projects. The major implications identified by the Staff were as follows:

• The revised Conceptual Framework (CF). The most significant difference between the Gamma approach and the CF is that the former considers one additional feature for equity/liability classification purposes: whether the amount of the claim is independent of the entity’s economic resources. The CF also requires reclassification of OCI to P/L if this enhances the relevance or faithful representation of the information in the statement of profit or loss; however, the Gamma approach proposes no recycling of amounts recorded in OCI arising from the separate presentation of income and expenses that depend on the residual amount on the basis that this provides more relevant information.
• IFRS 2, with regard to the classification of share-based payment transactions as equity-settled or cash-settled, as the distinction between equity and liability in IFRS 2 is consistent with that in the revised CF. Furthermore, the Gamma approach’s proposed attribution of total P/L and OCI to derivatives classified as equity (see AP 5C to the February 2017 Board meeting for illustrative examples) may be considered applicable to equity-settled share-based payments.
• IAS 33. The biggest impact comes from the Gamma approach requiring an entity to 1) present separately income and expenses arising from obligations that are classified as liabilities but which depend solely on the residual amount; and 2) attribute total P/L and OCI to some classes of equity other than ordinary shares. These requirements will affect the numerator of the EPS and/or diluted EPS calculations.

The Staff intends to include a brief discussion of these impacts in the forthcoming discussion paper and will consider the next steps based on feedback on the DP.

Discussion

The Board suggested adding the following points for discussion in the DP:

• Revised CF: how the ‘having no practical ability to avoid the transfer of an economic resource’ notion in the revised CF’s definition of a liability interacts with the equity/liability classification under the Gamma approach;
• IFRS 9: the scope of equity instruments eligible for having their fair value changes recognised in OCI is driven directly by the classification of the instrument under IAS 32. Any changes in classification from applying the Gamma approach will therefore have a knock-on effect.
• IAS 33 basic EPS: to include a discussion and worked examples on whether and how attribution of P/L and OCI to equity derivatives would affect the calculation of basic EPS. A number of Board members thought that it would reduce the numerator in a way similar to the attribution of P/L to NCI; however, the Staff disagreed but wavered upon further elaboration. One Board member suggested that the DP clarify that any potential consequences would be dealt with as a consequential amendment to IAS 33 rather than as a fundamental standalone review of IAS 33 to pre-empt respondents from commenting on other IAS 33 issues.

One Board member also questioned at length as to whether the OCI arising from net investment hedges should not be subsequently reclassified to P/L in order to be consistent with the Gamma approach. The Gamma approach proposes no recycling of amounts recorded in OCI arising from the separate presentation of income and expenses that depend on the residual amount. In both cases, the OCI arises from an equity item. There was no appetite around the table to engage in the debate and the Staff and the Vice-Chair believed that this is out of the scope of the FICE project.

Financial Instruments with Characteristics of Equity research project - Due process and permission to ballot - Agenda paper 5D

The Staff sought the Board’s permission to ballot a discussion paper that will set out the Board’s preliminary views on the following, with a 180-day comment period:

• (a) the challenges identified with regard to the classification of a financial instrument as equity or liability;
• (b) the possible approaches to addressing those challenges; and
• (c) the possible approach that can be selected and developed into a Standard-level solution.

The Staff expects to publish the DP towards the end of 2017.

Discussion

The Board granted permission to ballot with a 180-day comment period.