Background

In October 2012, the IFRS Interpretations Committee received a request for guidance on the determination of the rate used to discount post-employment obligations. In particular, the submitter asked the Interpretations Committee whether corporate bonds with an internationally recognised rating lower than “AA” can be considered to be high quality corporate bonds (HQCB).

In its November meeting, the Interpretations Committee noted that:

1. The predominant past practice has been to consider corporate bonds to be high quality if they receive one of the two highest ratings given by an internationally recognised rating agency (i.e. “AAA” and “AA”)
2. IAS 19 does not specify how to determine the market yields on HQCB, and in particular it does not specify what grade of bonds should be designated as high quality
3. An entity shall apply judgement in determining what the current market yields on HQCB are, taking into account the guidance in paragraphs 84 and 85 of IAS 19 Employee Benefits (2011)
4. An entity’s policy for determining the discount rate should be applied consistently over time.

In December 2012, the Interpretations Committee received a comment letter on this issue. The sender asked the Interpretation Committee to clarify whether:

• the basket of HQCB should be determined at the Eurozone level or at country level
• whether the characteristics of the assets in which an entity is allowed to invest should be taken into account to decide which bonds should be used in determining the discount rate.

The Staff noted that the discount rate was an important assumption used in measuring the defined benefit obligation.  The Staff also noted that IAS 19 required that the discount rate be determined by reference to market yields on high quality corporate bonds (HQCB) and in countries where there is no deep market in such bonds the standard requires the market yields on government bonds to be used.

The Staff noted that the concern of the submitter was that although IAS 19 requires the use of HQCB it does not specify which bonds qualify as HQCB and that in practice HQCB were those that received ratings of “AAA”/”AA” given by a recognised rating agency.  In light of the financial crisis, the submitter asked whether corporate bonds with a lower rating than “AAA”/”AA” could be considered HQCB.

The Staff proposed that the Interpretations Committee should develop Implementation Guidance on the determination of the discount rate.  They noted that it was their view that when the volume of HQCB decreases and an entity concludes that these bonds are no longer deep, the bonds population should be expanded to include corporate bonds with a lower rating in order to calculate a more reliable estimate of the HQCB rate but still ensuring that the discount rate continues to reflect a HQCB rate.  The Staff noted that this could be achieved by the entity adjusting the market yields on corporate bonds with a lower rating in order to remove the market premium for the additional credit risk.

The Staff noted therefore, that in determining the discount rate using HQCB the entity should first use the corporate bonds with minimal or low credit risk.  If the population is insufficient to enable the discount rate required by IAS 19 to be determined, then the discount rate should be determined using corporate bonds with higher credit risk adjusted to remove the market premium for the additional credit risk.  The Staff then noted that if expanding the population is still insufficient, government bonds would be used.

The Staff noted that, in their view, the basket of HQCB could be determined at a Eurozone level.

The Staff recommended that:

• the Interpretations Committee develop guidance that helps entities understand and implement the current requirements of IAS 19
• the guidance should follow a hierarchical approach
• the guidance should permit an entity to use HQCB issued in another country that has the same currency

The Staff asked the Interpretations Committee whether they agreed with the Staff recommendations

One of the Committee disagreed with the Staff recommendations.  She disagreed with the hierarchy proposed and also disagreed that guidance in this area should be developed.  She noted that the Staff guidance had actually created a set of rules and some of these went against the guidance in IAS 19 that says to use government bonds in the absence of a deep market.  This Committee member argued that instead of the Staff’s set of rules a set of principles should be developed defining such things as “deep market”, “High quality” and “risk free”.  Preparers could then use these principles and their judgement.  This view was not shared by another Committee member who was supportive of the Staff trying to provide guidance.  Another Committee member also shared the view that the Staff should not be trying to create rules.

Another member was of a similar view and was of the view that the answer in the Implementation Guidance was that you needed “AA” rated corporate bonds and asked the Staff to clarify this .  He reiterated the question as to whether “AA” was required for the corporate bonds to be considered high quality.  The member noted that the standard requires the preparer to use a government bond where there is not a deep market for HQCB.  However in today’s markets, this would lead to government bonds being used which are not deemed high quality and hence the standard is “broken” in today’s market.  He noted that the current situation was not short term and would be a real situation for a number of years.  The Committee member also raised the question as to whether government bonds could therefore be lower than “AA” and be considered high quality.

Another member mentioned that he did not think that IAS 19 necessarily required “AA” rated corporate bonds to be used although he mentioned that he thought that this is what the Staff were trying to conclude with their notion of adjusting lower corporate bonds for credit risk.  The Staff noted that it is their intention that “AA” bonds should be used and in estimating a discount rate lower rated bonds can be used but are adjusted for credit risk.  However if there is still no deep market for “AA” corporate bonds then government bonds should be used.  Another member noted questioned whether the high quality notion in IAS 19 was relative and hence if there are no “AA” bonds one would select the next tier and they would assume to be high quality.  She also questioned how one would assess whether there is a deep market for the purposes of applying IAS 19 and hence when one would use government bonds.  This Committee member found some merits in some of what the Staff were proposing.

One member was also of the view that the hierarchy in the Implementation Guidance was suggesting that preparers could have a free choice between using the government bond in their country or at a Eurozone level where there was no deep market for HQCB and a high quality discount rate could not be estimated.  He was specifically referring to IG 6 – the Staff noted that this was not a free choice as the IG6 (c) should state that “the entity should include bonds…”.  .

The Chairman also disagreed with the Staff.  He noted that the principle of IAS 19 is that the discount rate should be risk free (although some Committee members disagreed) and in the current climate the linear nature of the guidance (i.e. step one is to determine the discount rate on HQCB and if no deep market step 2 is to use market yields on government bonds) in the standard leads one to results that are not consistent with the principle.  This view was shared by a number of Committee members.  These members agreed with starting at the “principle” of IAS 19.  Another member noted that although IAS 19 does not mention “risk free” (i.e. it mentions high quality) it was taken to believe that “AA” and above was risk free.  He noted that an annual improvement may be required to IAS 19 to amend the part of the standard that says that you should go to government bonds where there are no HQCB regardless of what the rating of the government bonds are.  Implementation Guidance could not amend this problem – he mentions that the standard should mention that you should only go to government bonds if they are high quality.

Another Committee member noted the practical difficulties of adjusting the lower rated bonds for the credit risk (i.e. finding the credit risk in a “A” curve that will move one to “AA”) and how companies will achieve consistency in their approach.  Also noted were other practical difficulties in implementing the guidance.  One Committee member noted that IG 7 was not consistent with IAS 19.  He noted that IG 7 tried to create a “synthetic” market in HQCB rather than use an actual deep market where there is not a deep market for HQCB.  He was of the opinion that this was not a requirement of the standard as the standard notes that where there is not a deep market you use government bonds rather than create a synthetic deep market of HQCB.

The Chair brought the discussion to a close.  He noted that there was not a lot of support for the Staff proposal.  He also noted that it was also not clear what Committee members were agreeing to.  The Chair noted that this was a live issue on a live standard and this would be taken to the Board in the hope of a fast resolution.  The Chair noted that no conclusions had been reached in the meeting.

The majority of Committee members tentatively agreed with the proposed course of action.  There were only two Committee members that did not agree.