IFRS News. IFRIC 4 frequently asked questions. Shedding light on the IASB s activities* In this issue. *connectedthinking. Issue of the month

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1 *connectedthinking Shedding light on the IASB s activities* Issue 46 In this issue 1 Issue of the month IFRIC 4 frequently asked questions 3 Extractive industries Project update 4 Industry issues Automotive sector 6 IFRS diary Contacts Issue of the month IFRIC 4 frequently asked questions IFRIC 4, Determining whether an Arrangement contains a Lease, was published on 2 December 2004 and applies to annual periods beginning on or after 1 January Jan Buisman and Kevin Klein look at some of the common issues arising from practical application of the interpretation. Many arrangements that are not leases in legal form convey the right to use an asset for an agreed period of time. IFRIC 4 provides guidance for determining whether these arrangements contain a lease. The interpretation specifies that an arrangement contains a lease if it depends on the use of a specific asset and conveys a right to control the use of that asset. Current experiences indicate that companies do not realise the broad impact of IFRIC 4, and the transition guidance is not straight forward. Which types of arrangements frequently contain a right of use? The interpretation is relevant to various types of arrangement, including outsourcing (such as IT, logistics and catering), purchase/sale, franchise and retail agreements. Many arrangements require the use of assets to deliver a specific level of service or product. Such arrangements must be reviewed in detail to determine whether specific assets are utilised to deliver the required level of service or produce, and which party to the arrangement controls the assets. Application of the transition guidance An entity adopting the interpretation may either apply it (IFRIC4.17): (a) retrospectively in full; or (b) only to arrangements existing at the start of the earliest period for which comparative information is presented on the basis of facts and circumstances existing at the start of that period. An arrangement that contains a lease is accounted for under the guidance in IAS 17. IAS 17 requires retrospective application back to the inception of the lease. The following is an example of the application of option (b) in practice: An entity with a year end of 31 December 2006 has an arrangement that has been in existence since It may apply IFRIC 4 s criteria in determining whether that arrangement contained a lease on the basis of facts and circumstances at 1 January 2005 (the beginning PRINT CONTINUED 1

2 IFRIC 4 frequently asked questions Issue 46 of the comparative year). Where the entity concludes that the arrangement contains a lease, the classification of the lease is based on the facts and circumstances in 1990; the transition adjustments recorded at 1 January 2005 are based on the application of IAS 17 since the inception of the lease in IFRIC 4 frequently asked questions Solutions to some of the more frequently asked questions arising from applying the interpretation are outlined below. Specific asset Is a specific asset the same as a uniquely identifiable asset? No. A uniquely identifiable asset is a specific asset in terms of IFRIC 4, but an asset does not need to be uniquely identifiable in order to qualify as specific under IFRIC 4. Can fulfilment of an arrangement be dependent on the use of a specific asset if the supplier/service provider has the right to substitute another asset when the specified asset is not operating properly? Yes. A warranty obligation that permits or requires the substitution of the same or similar asset when the specific asset is not operating properly does not provide relief from lease treatment. For example, entity A leases aircraft 101 to entity B for a period of five years. Entity A has the right to provide entity B an identical substitute aircraft from its fleet in the event aircraft 101 is not operating properly. This clause does not provide relief from lease treatment. Does the fact that an asset is explicitly mentioned in an agreement make fulfilment of the arrangement dependent on a specific asset? Not necessarily, if the fulfilment of the agreement is not dependent on the use of that asset. If, for example, the supplier has the right and the ability to use a different asset not specified in the agreement for providing the services, the arrangement would not be dependent on a specific asset. An arrangement is not dependent on the use of a specific asset if the supplier can use a different asset. Does this mean that it must be probable that the supplier will use a different asset? No. The supplier must have the right and the ability to use a different asset. The supplier has the ability to use a different asset if it is commercially feasible and practical to use a different asset. Ability or right to operate the asset or direct others to operate the asset IFRIC 4.9(a) refers to the purchaser s ability or right to operate the asset or direct others to operate the asset. How can the purchaser direct others to operate the asset? The ability or right to direct others to operate a specific asset is distinct from adherence to agreed supply terms and goes further than that. Examples of situations where the ability or right to direct the operations of an asset is conveyed are: the purchaser has the ability to hire, fire or replace the operator; the purchaser has the ability to specify significant operating policies and procedures in the arrangement (as opposed to the right to monitor the supplier s activities) with the supplier having no ability to change such policies and procedures; and just-in-time delivery and the purchaser has the right to manage and change deliveries on a very short-term basis (for example, daily or hourly). Pricing IFRIC 4.9(c) does not consider that an arrangement contains a lease if the price paid is contractually fixed per unit of output. How is a take-or-pay contract (ie, where a fixed amount is payable each period irrespective of the output taken) treated under IFRIC 4? The price per unit of output in a take or pay contract is variable, because the fixed amount is divided by a variable amount of output. Can a price that is based on a formula where all the parameters are outside the control of the contracting parties be treated as contractually fixed per unit of output? Is a price fixed for the purpose of IFRIC 4 if it is escalated with a fixed increment or determinable based on a fixed formula? No. Contractually fixed per unit of output is interpreted literally ie, as a fixed monetary amount per unit of output that does not change during the contract period. A price based on a formula such as a fixed increment is not contractually fixed per unit of output if the volume taken is not fixed. For example, a price escalation clause based on inflation would not meet the requirement for a contractually fixed price per unit of output. IFRIC 4.9(c) does not consider that an arrangement contains a lease if the price paid is equal to the current market price per unit of output at the time of delivery. If the arrangement provides for pricing equal to the current market price but is subject to a minimum (floor) or a maximum (cap), would the pricing be considered to be current market price? No. Pricing arrangements including caps/floors would not be considered to reflect the current market price at the time of delivery, because the price at delivery might be different from the spot market price. Portions of an asset, unit of account A supply contract where one entity takes all of the output of an asset is in the scope of IFRIC 4.9(c), provided that the price is not fixed per unit of output or current market price. 2

3 Extractive industries Issue 46 What happens if two parties take together all of the output, 50% each? IFRIC 4 does not address the issue of portions; it has been deliberately excluded from the scope of IFRIC 4. The above situation does not necessarily constitute a lease, unless the contract is caught under IFRIC4.9(a) or IFRIC4.9(b). However, IFRIC 4.9(c) should be applied to arrangements in which the underlying asset would represent a unit of account in either IAS 16 or IAS 38. Example A power plant has two turbines and two customers. Each customer enters into an arrangement whereby it will take all of the output of a specified turbine. Would both customers have a lease under IFRIC 4.9(c)? Yes. Each of the two arrangements contains a lease. The situation is different if each customer has an undivided interest in the whole power plant. Final thoughts These frequently asked questions demonstrate that a detailed analysis of a company s arrangements against the criteria in IFRIC 4 is necessary in order to conclude whether an arrangement conveys the right to use an asset that is accounted for as a lease under IAS 17. Although there has been an increase in IFRIC 4 activity, there appear to be arrangements in various industries waiting their turn to be analysed. Extractive industries project: news so far Michael Stewart, looks at progress on the Board s extractive industries project. The IASB s research project on the accounting by the extractive industries began soon after the publication of IFRS 6, Exploration for and Evaluation of Mineral Resources, in December The extractive industries project is designed to lead to a new standard that will provide guidance on the accounting for exploration, development and production costs and will replace IFRS 6. The challenge faced by the IASB is that significant costs are incurred in the exploration phase, much of which is incurred before the exploration can be assessed as having probable future economic benefits. These costs should consequently be expensed by companies following the historical cost model because the IASB Framework definition of an asset is not met until there are probable future economic benefits. IFRS 6 was published to provide temporary relief from the Framework requirement of probable future economic benefits. It allows the capitalisation of the costs of exploration after an exploration licence has been acquired, until such time as the exploration is evaluated for commercial viability. One of the objectives of the extractive industries project is to find a basis of accounting for exploration costs that is consistent with the Framework and can replace the guidance in IFRS 6. The extractive industries project team has explored the possibilities of using a fair value basis of accounting for exploration, development and production as well as the use of a historical cost basis. The advantage of a fair value model is that the probability of future economic benefits is reflected in the valuation, and hence a suspension of the requirements of the Framework would not be required. The project team recently reported the results of their preliminary work on the use of fair values to the IASB. The project team identified a number of concerns with the use of fair values for recognising mineral reserves on the balance sheet. The principal concern relates to the reliability of the measurement of volumes of minerals in an exploration area. The processes applied by geologists and engineers to assess the volumes of mineral resources require the use of many estimates. The data used by the geologists and engineers may include a significant amount of indirect, rather than direct, evidence of the quantities of resources present. This increases the uncertainty of estimates. These estimates are constantly revised as more data is obtained by further test drilling, seismic surveys, etc. The use of a fair value model for measuring the mineral reserves and resources would, as a result, lead to constant revisions to recognised assets as more geological and engineering data becomes available. A number of IASB Board members expressed continued support for finding a solution that uses fair values as the measurement basis. The benefit of a fair value-based accounting model for mineral resources is that it reflects information about what has been found rather than focusing on what has been spent. The information is therefore considered more relevant to the needs of the reader of the financial statements. A consequence of following a fair value model for recognition of reserves is that the basis of income recognition is likely to need to change. IAS 41, Agriculture, uses a fair value approach for measuring 3

4 Automotive sector Issue 46 crops, livestock and other growing biological assets. Income is recognised for the increases in value of the biological assets, and so no gross profit is recognised on sale of the harvested agricultural produce. A similar basis for income recognition may be required for the extractive industries if a fair value recognition model is adopted. The project team has been asked to do further work exploring how a fair valuebased model could be developed and to compare this with a historical cost model. The project team will meet the IASB periodically over the next 12 months to discuss progress; a preliminary views paper is expected to be published in Concurrently the Society of Petroleum Engineers and the Combined Reserves International Reporting Standards Committee are working to develop an agreed definition of reserves and resources that can be used for IFRS reporting by both oil and gas and mining entities. Further news on the progress of this project is expected in the next six months. IFRS in the automotive sector PwC s Automotive group has developed guidance for industry-specific IFRS financial reporting issues. Partner in PwC s Automotive group in France, Philippe Vincent, and partner in PwC s Global Accounting Consulting Services group, Oliver Scherer, explain some of the areas that have proved complex in the first year of reporting under IFRS. Companies in the automotive industry face their own set of challenges in applying IFRS. A number of financial reporting issues require judgments by CEOs and CFOs when applying the standards, and explanations of these judgments for investors. Some of the industry-specific characteristics that complicate financial reporting for companies in the sector are listed below: The automotive industry requires significant upfront investment, often with uncertainty about expected returns; The commercial success of a vehicle depends on a car maker s ability to match customers needs worldwide and requires standardised production platforms to maximise margins; The cost of raw materials is rising in an industry that is a heavy consumer of commodities; and Complex production arrangements exist between original equipment manufacturers and their suppliers. Key areas that had an impact on firsttime adopters financial statements are development costs, tooling, fixed assets and goodwill impairment, buyback arrangements and commodity hedging. We look at each of these below. Development costs Development costs were expensed as they were incurred under many entities previous GAAP. Under IFRS, those that meet the criteria of IAS 38 are capitalised. Management has to demonstrate: the technical feasibility of completing the intangible asset so that it will be available for use or sale; the intention to complete the intangible asset and use or sell it; the ability to use or sell the intangible asset; the ability of the intangible asset to generate probable future economic benefits; the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and the ability to measure reliably the expenditure attributable to the intangible asset during its development. It has been simple to demonstrate the fulfilment of some of these criteria, as they correspond to specific and documented milestones in the development process. However, demonstrating the ability of the intangible assets to generate probable future economic benefits has proven more complex, as it has required many companies to prepare formal cashflow projections, project by project. Management faces a challenge going forward in monitoring the profitability of recognised intangibles, particularly when such intangibles serve different platforms with different rates of return. Tooling arrangements The development of tooling in the automotive industry often exceeds 12 months. How should costs and revenues be recognised over time? When a tool is considered to be sold by a supplier to an original equipment manufacturer (OEM). Tooling contracts tend to be part of a broader production agreement. This raises the question of whether profits or losses on the sale of a tool by a supplier to an OEM should be recognised immediately or deferred over the life of the underlying platform. Certain legal conditions surrounding the tooling arrangements make it difficult to assess whether the supplier or the OEM bears the risks and rewards associated with the tool. This assessment is crucial in determining whether the tool can be considered as sold to an OEM after its production period. The adoption of IFRS led many automotive companies to do in-depth analyses of the legal terms and conditions of their tooling arrangements. Management has amended some of these contracts to ensure they better reflect the underlying economics of such arrangements. Companies are currently reviewing their accounting policies in light of IFRIC 4, which is effective from 1 January

5 Automotive sector Issue 46 Fixed assets and goodwill impairment Fixed assets and goodwill are exposed to impairment risks in the automotive sector because the industry is highly capitalised, know-how intensive and exposed to the macro-economic cycle. This can lead to a significant number of assets being impaired if a car model performs poorly. IFRS requires companies to develop cash flow projections for each cash-generating unit where indicators of impairment exist. Many entities reorganised their reporting processes as a result of this requirement. Some of the projections have also required the involvement of CEOs and CFOs, as such projections reflect management s opinions about the probable outcome of its actions. Complications can arise when applying IAS 36, which defines the recoverable value of a given asset for which indications of impairment have been identified. IAS 36 restricts the extent to which value-in-use calculations can reflect future capital expenditures and cost savings. The future cash flows should be calculated for the asset in its current condition; future improvements in asset performance should not be taken into account except where they are necessary to make the asset ready for use. These requirements can be difficult to apply in the automotive industry, as restructuring activity is almost continuous given the ongoing need to upgrade production facilities. It is not always easy to distinguish cost savings from future operational improvements. Such difficulties may mean that automotive companies will not regard value-in-use calculations prepared under IAS 36 as an appropriate basis for determining impairment provisions. Instead companies may consider adopting the fair-value-less-costs-to-sell model. Buyback arrangements Buyback arrangements are a common way for companies to drive sales of new vehicles. Manufacturers sell new cars to fleets (often businesses that provide company cars), rental companies and individuals with a commitment to buy them back after a period of time, usually two to three years. Revenue is recognised under IAS 18 when the following conditions have been satisfied: The entity has transferred to the buyer the significant risks and rewards of ownership; The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the cars sold; The amount of revenue can be measured reliably; It is probable that the economic benefits associated with the transaction will flow to the entity; and The costs incurred or to be incurred in respect of the transaction can be measured reliably. The transfer of legal ownership is not sufficient to determine whether the seller has transferred most of the risks and rewards. The automaker may retain the risk related to the residual value of the cars bought back that is, the risk that the fair value of the used car will be lower than the contracted buyback price. IAS 18 provides little application guidance on how to assess the transfer of risks and rewards or to define significant residual risk. Some OEMs have elected, under IAS 18, to present as fixed assets the cars sold under buyback agreements for which the OEM is deemed to retain the significant risks and rewards; others have elected to present such cars as inventory. Clear disclosure of the policy followed is crucial for users of the financial statements. Commodity hedging The cost of raw materials has increased substantially in recent years. There is an increasing need for protective mechanisms given the level of consumption of steel, copper and aluminium. Many automotive companies have long-term commodity hedging contracts. Management should record these derivatives on the balance sheet at fair value, with gains and losses from re-measurement recorded in the income statement, unless they meet the criteria for hedge accounting under IAS 39. This raises a number of challenges. A company that qualifies for hedge accounting should match the hedging instrument s gains or losses against the losses or gains to which they relate, or recognise them in equity until the hedged item affects the income statement. This is only permitted if management complies with strict documentation standards and other requirements. The complexity of these agreements and the level of documentation required to comply with hedge accounting has led many companies to reinforce the processes of collecting and assembling the required data and to ensure consistency of the policies applied across the business. Car makers are often party to complex commercial contracts that can contain embedded derivatives (for example, contracts indexed to market-based variables such as commodity prices or foreign exchange rates). This requires an in-depth analysis of all significant existing agreements. The impact on financial communication Certain items that are significant to the industry such as impairment calculations and the valuation of longterm benefit obligations or stock options are dependent on financial assumptions, particularly discount rates. Such measures may provide investors with useful information as to the value of the business at the balance sheet date, but their volatile nature may not help with understanding the long-term factors driving a business that is focused on long-term investments. Management may want to provide investors with information explaining the volatility in the income statement and provide measures that benchmark performance relative to other companies in the sector. 5

6 Diary/Contacts Issue 46 New challenges ahead Changes are likely in accounting for joint ventures. The IASB in December 2005 proposed a new model consisting mainly of removing, in certain circumstances, the option of proportional consolidation for jointly controlled entities. This would mean only equity accounting would be permitted. If the proportional consolidation option is removed, some companies might decide to withdraw from these kinds of arrangements or provide a more comprehensive view of their sales and margins in the notes to their financial statements. The Board has also issued an exposure draft of a proposed amendment of IAS 14, Segment Reporting. It proposes that financial information should be reported on the basis that it is used internally for evaluating operating segment performance and for deciding how to allocate resources to operating segments. Such revisions may provide more transparency; but management may need to be ready to answer questions if their internal reporting discloses that some activities are highly profitable. Finally, management needs to reinforce processes and controls surrounding the production of financial information complying with IFRS. The automotive industry in the US found, under Sarbanes Oxley, that insufficient documentation of accounting policies IFRS diary Looking forward 2 IFRIC issues interpretation: IFRIC 11, IFRS 2 Group and Treasury Share Transactions. Looking back 29 September 2006 comment deadline expired for IASB exposure draft of Proposed Amendments to IAS 23, Borrowing Costs. 30 September 2006 comment deadline expired for draft IFRIC Due Process Handbook. 23 October 2006 comment deadline expired for IASB exposure draft of Proposed Amendments to IAS 32, Financial Instruments: Presentation ; and IAS 1, and procedures was the single largest cause of material weaknesses. The IFRS standards are principles-based but contain as many complex concepts as US GAAP. Embedding policies and procedures will be crucial to prevent errors and surprises. Presentation of Financial Statements: Financial Instruments Puttable at Fair Value and Obligations Arising on liquidation. 31 October 2006 comment deadline expired for IFRIC draft interpretation: D19, IAS 19 The Asset Ceiling: Availability of Economic Benefits and Minimum Funding Requirements. 3 comment deadline expired for IASB and FASB s discussion paper on joint conceptual framework. 6 comment deadline expired for IFRIC draft interpretation D20, Customer Loyalty Programmes. For further help on IFRS technical issues contact: Global IFRS Leader ian.d.wright@uk.pwc.com: Tel: Business Combinations and Adoption of IFRS mary.dolson@uk.pwc.com: Tel: tony.debell@uk.pwc.com: Tel: olivier.scherer@uk.pwc.com: Tel: shelley.h.so@uk.pwc.com: Tel: caroline.woodward@uk.pwc.com (valuation issues): Tel: Financial Instruments and Financial Services pauline.wallace@uk.pwc.com: Tel: jan.buisman@uk.pwc.com: Tel: kevin.klein@uk.pwc.com: Tel: sandra.thompson@uk.pwc.com: Tel: francesco.nagari@uk.pwc.com (insurance): Tel: Liabilities, Revenue Recognition and Other Areas rich.sharko@uk.pwc.com: Tel: klaus-dieter.x.steinfels@uk.pwc.com: Tel: richard.davis@uk.pwc.com (actuarial issues): Tel: editor joanna.c.malvern@uk.pwc.com: Tel: PRINT HOME 6