IFRS outlook. In this issue... Insights on International GAAP. Feature 2

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1 August 2008 Insights on International GAAP IFRS outlook In this issue... Feature 2 Consolidations... a new approach is on the horizon Technical focus 4 Shedding light on accounting for alternative energy Financial reporting developments 8 Resources 14 Consolidations... a new approach is on the horizon Prior to the credit crunch, many economies around the world enjoyed periods of exceptional growth, which in turn drove the development of new and complex off balance sheet financing structures. Not surprisingly, all this has forced the IASB to think very carefully about its consolidation project. Find out more about their plans and how they will impact you. Shedding light on accounting for alternative energy The growing demand for environmentally friendly energy production has resulted in increased investment and new government incentive programmes. Ernst and Young s Power & Utilities IFRS group discusses some of the significant accounting issues that alternative energy businesses face in their quest to be green. Financial reporting developments Learn about tentative decisions reached by the IASB regarding revenue recognition, income taxes and IFRS for private entities, that could significantly affect your business. We welcome your feedback on IFRS outlook. Please contact us at ifrs@uk.ey.com. The next issue will be published in September Will Rainey Global Director of IFRS Services

2 Consolidations a new approach is on the horizon Just over a year ago, turmoil broke out in the world s financial system, following an exceptional boom in credit growth and leverage. During this boom, many new and complex financing structures were developed, essentially providing credit and liquidity facilities through new types of funding and investment vehicles many of which may have been off-balance sheet, particularly in the financial services sector. Whilst these off-balance sheet vehicles are not the reason for the turmoil, their use has raised questions about the adequacy of the consolidation accounting standards. Are they robust enough? Do they adequately disclose the complete picture of an entity s risks? The Financial Stability Forum (FSF) recommended in April 2008 that the IASB should improve the accounting and disclosure standards for off-balance sheet vehicles on an accelerated basis A sentiment echoed by the Finance Ministers of the G8 countries in June The IASB has responded by revisiting its consolidations project (which began in 2003), resulting in a staff draft of a revised standard ( draft paper ) that was discussed at the IASB Board meeting last month. Any revised standard would replace the existing IAS 27 Consolidated and Separate Financial Statements and SIC 12 Special Purpose Entities. However, the project is not limited solely to these off-balance sheet vehicles. It is wider than that, with consequences for all businesses not just those in the financial services sector. In this article, we take a look at the pivotal decisions made in the preparation of the draft paper and some of its implications, to prepare you for the roundtables the Board expects to hold in September IAS 27 is based on the premise that consolidated financial statements should include all entities that are under the control of a parent. The IASB does not intend to change this concept. SIC 12, however, gives guidance as to how this control concept is applied to an entity that has been established for a specific purpose. In doing so, SIC 12 uses a risk and rewards model. The IASB intends to change this principle so that one control model will apply in all situations. Therefore, a key aspect of the Board s proposals is the change in the definition of control. Currently, control focuses on the power to govern the financial and operating policies of another entity to obtain benefits from it. It therefore looks at how control is achieved by an entity, through the financial and operating policies. The draft paper, on the other hand, focuses on what is being controlled the assets and liabilities of the other entity. The proposed new definition of control is that there is current power sufficient to use or manage the assets and liabilities of that entity so as to benefit from them, as if they are its own. The power to govern the financial and operating policies is then just one of the ways a parent can use or manage the assets and liabilities of another entity. It therefore appears to be a broader definition than we have today, potentially bringing more entities into the consolidated financial statements. And it certainly achieves the objective of removing inconsistency between IAS 27 and SIC 12. The definition of control proposed in the draft paper is the current power sufficient to use or manage the assets and liabilities of that entity so as to benefit from them as if they are its own. The Board has, however, raised concerns about the inclusion of as if they are its own. Many jurisdictions have restrictions on another entity s ability to use its own assets, even if it is the single or majority shareholder. Indeed the mere existence of a minority interest holding in an entity can restrict the ability of a majority shareholder using the assets and liabilities of that entity. Therefore, this element of the definition would appear to be narrowing the composition of a group. The Board has indicated it does not intend to do this and will be revisiting this concept as it finalises the definition. Elements of control The draft paper considers control to have two elements power and benefits. Both of these elements must exist they cannot be traded off against each other, nor exist independently of each other. Power is the ability to participate in the management of (or the decision-making relating to) the assets and liabilities, so as to affect the performance of the entity. This ability can be evidenced in many ways, for example, participation in the governing body, electing directors onto the governing body, appointing members of management, dominating decisions about major contracts, entering into contracts to service the assets or liabilities. These powers may be in place to protect the investment made, such as limiting the exposure to lower than expected returns or to allow the parent to participate in the activities. In either case, it is not necessary for power to be absolute. Benefits are the returns from involvement with the entity, which vary with the performance of the entity. There are three important concepts relating to benefits: Benefits must vary they cannot be a fixed return to reflect the risk assumed. However, receiving a variable return is not sufficient on its own the variability needs to be assessed 2 IFRS outlook August 2008

3 The Financial Stability Forum (FSF) recommended in April 2008 that the IASB should improve the accounting and disclosure standards for off-balance sheet vehicles on an accelerated basis relative to the other investors. The larger the proportion of variability relative to other investors, the more likely the benefits are evidence of control. Benefits are not limited to returns from the investment they also include returns that the investor may be able to generate directly from the investment that are not available to other investors. For example, economies of scale. Benefits must have the potential to be favourable they cannot be limited to only bearing losses, for example, through a guarantee arrangement. In this context, favourability is assessed relative to the expected returns, which could be both higher than, or lower than expected. Relationship between power and benefits Once the benefits and power have been identified, judgement will be required to determine whether power is proportionate to the benefits that flow from the investment, ie, is power sufficient to provide adequate compensation for, or benefits from, the investment. This provides a basis for distinguishing investments held in a fiduciary capacity. For example, a trustee has the power to make decisions about the assets and liabilities in a trust to generate returns for the beneficiaries. If the trustee receives a variable fee based on the performance of the trust, a comparison between the level of the fee received and the amount of power held by the trustee is required, in order to assess whether the fee is compensation for the agency services it provides or a return on the investment. This may also require comparison to a normal market return for such services. However, the paper currently does not provide sufficient guidance to assess some of the more difficult scenarios that are often faced in practice, such as where a fund manager holds investments in a dual capacity one as a direct investment that generates returns for itself, and one as an agent for the beneficiaries. This assessment becomes more complex as the direct investment can range from being quite small (5%) up to 40%. Additional complexity also arises where fund managers may be locked in with or without a direct investment. This is an area that the staff will continue to work on. In many special purpose entities, the decision-making powers are often limited by the entity s constituting document or contractual arrangements. Therefore, the focus is on benefits that the investor receives and whether they have the power to make the decisions that affect those benefits. For example, when an entity is set up to operate on auto pilot there are no financial and strategic decisions to be made. Instead, the decisions that affect the benefits are often operational in nature and based on the level of interaction between the SPE and the entity. In such cases, it is the entity that receives the benefits receiving the output or synergies while other investors may have returns linked to performance or, in some cases, a fixed fee with no decision making power. The other important aspect of the definition of control is the requirement that it is current power not future power. For example, an option that may be exercised in the future isn t sufficient on its own to evidence control. Rather it must be exercised, or other rights given along with the option to give current power. Nor is it a potential power. For example, merely holding the largest single voting interest, without having a majority interest, is not sufficient on its own to evidence control. The entity must use that dominant voting position to gain control (often referred to as de facto control ). Both of these concepts will need further work before the draft is finalised. The impact of these proposals is likely to result in more entities being consolidated rather than remaining off-balance sheet. This is particularly so as the proposals clarify that the assessment of whether or not control exists is continual. During the Board s deliberations, it was also acknowledged, that in some cases, this continual assessment and the application of de facto control may result in an entity flipping in and out of the group from one period to the next. Hence, many entities will need to put additional procedures in place to make this reassessment and respond to changes in circumstances including the need to fair value the underlying net assets when gaining control and to fair value the investment when losing control. Increased disclosures The decision as to whether one entity controls another in many cases will require a significant level of judgement to be exercised. Responding to the calls for increased disclosures, the draft paper proposes additional disclosures about an investment and its risks when the decision has been difficult and the entity has significant involvement instead of control. While the final definition of significant involvement is yet to be determined, it is expected to result in an increase in a greater level of disclosure than currently. Conclusion While further clarification is needed in a number of areas, the general direction of the Board is clear there must be power and benefits that are proportionate to each other. Their proposals have the potential to change existing practice in many areas not just in the financial services sector where we have seen the current turmoil. It is therefore vital that companies track the progress of this project over the coming months and are ready to respond quickly to the IASB as to its impact. IFRS outlook August

4 Shedding light on accounting for alternative energy Increased awareness of climate change among the wider population, concerns about the sustainability of non-renewable energy sources and the desire of consumers and corporate entities to be green have created a demand for environmentally friendly energy production. Governments in many countries are providing incentives for companies to develop alternative energy projects in recognition of the high cost involved. Whilst this has led to significant investment in alternative energy, it has created some new challenges in financial reporting. Recently, we brought 18 of the key European players in the power and utilities industry together to discuss their financial reporting issues. In this article, we provide an overview of some of the more significant challenges companies face, whether or not they are already applying IFRS, or will do so in the future. Box 1: European Power & Utilities IFRS Alternative Energy roundtable On 28 May 2008, Ernst & Young s Global Power & Utilities IFRS group, led by Gerd Lützeler, hosted its third annual IFRS roundtable in Düsseldorf, Germany. The following topics related to alternative energy were discussed: A view of alternative energy from the industry presented by Craig Coburn, CFO of BP Alternative Energy Emission Rights: The IASB s agenda presented by Henry Rees and Nikolaus Starbatty from the IASB Impairment of assets: key considerations for alternative energy assets Is that wind farm a lease? Accounting for wind farm development costs Customer contributions in the power & utilities industry Business combinations and asset acquisitions Decommissioning costs: challenges and uncertainties Incentives for alternative energy in Europe The future of the alternative energy market If you wish to receive information about future IFRS Power & Utilities roundtables or about the other activities of the group, please contact Gerd Lützeler, Chairman of the Global IFRS Power & Utilities Group. (Gerd.Luetzeler@de.ey.com) Accounting for different incentive schemes Currently, there is no specific guidance in IFRS to address schemes that encourage investment in alternative energy, including the reduction of emissions from existing technology. Governments are not acting together to develop a consistent global scheme to provide incentives for the development of alternative energy. Consequently, there are a range of schemes which seek to achieve the same goal - the development of alternative energy. This means that each scheme may be accounted for in different ways. Some of the more common schemes are summarised in Box 2. In April 2008, we discussed the Clean Development Mechanism (CDM) and the accounting for Certified Emission Rights (CERs) arising from it. We discuss below the accounting for green certificates and projects on the IASB s agenda directly related to alternative energy. Green certificates Generator with no distribution or retail activities Green certificates are usually granted by a government body to a generator. There are varying views as to the exact nature of the certificate held by the generator. We believe that they should be accounted for as government grants in accordance with IAS 20 Accounting for Government Grants and Disclosure of Government Assistance. A grant is recognised when there is reasonable assurance that the entity will comply with the conditions attached to it and the green certificates become receivable. This requirement will generally be met when energy is produced. As IAS 20 provides some optional accounting, varying practices will develop. We believe that the grant should be recognised as an intangible asset. IAS 20 permits the grant to be measured on initial recognition at either its nominal value or its fair value. The market for green certificates is usually local (and therefore limited) and fair value may be difficult to determine. If the grant is recorded at fair value, we believe that it should be recognised in the income statement either as a reduction of costs incurred for the period or as other income. As electricity cannot be stored, we expect that all associated costs of production will be expensed during the period. Hence, any reduction of costs incurred will be recognised in the period in which the electricity is generated. Revenue then arises when the generator sells the certificates to distributors either directly or on the open market. 4 IFRS outlook August 2008

5 Box 2: Alternative energy and emission reduction incentive schemes Existing schemes can be categorised broadly into three types: those focused on financing the cost of a renewable energy generation asset; those to encourage production from renewable sources; and those to cut carbon emissions overall. Schemes financing the cost of a renewable energy generation asset The CDM Promotes the development of cleaner energy production technology. The CDM scheme achieves this through the issuance of CERs. Government grant subsidies Subsidies provided to fund an alternative energy project. Schemes to encourage production from renewable sources Regulated tariffs A predetermined amount receivable per megawatt hour of electricity generated. The rate is set by a government or regulatory body for a stipulated period of time. Green certificates Certificates are granted to generators based on the volume of electricity produced from renewable sources. The generator may then sell these to distributors or retailers separately or together with electricity sold. Normally, there is a requirement for electricity distributors or retailers to source a set portion of energy sold from renewable sources. The relevant number of green certificates must be remitted for this mandated portion and a penalty is paid for any shortfall. In some countries, the penalty is put into a pot. The amount in the pot is redistributed to the holders of green certificates. The distribution of the proceeds in the pot is effectively a further incentive to develop renewable energy. Final amounts to be redistributed are unknown for sometime after the certificates are remitted. Distributors and retailers must either purchase these certificates from generators or from a market, if one exists. Schemes to decrease overall carbon emissions European Union Emissions Trading Schemes (EU ETS) In response to the Kyoto Protocol to reduce greenhouse gas emissions, the European Parliament introduced the EU ETS. In this scheme, limits are imposed on carbon emissions through the issuance of tradable emission rights. To the extent carbon emissions exceed the rights held, further rights must be purchased on the market. As some companies received rights greater than their emissions, they are able to sell these rights through the trading schemes. IFRS outlook August

6 Shedding light on accounting for alternative energy continued Distributor or retailer with no generation activities Green certificates must be purchased by a distributor directly from the generator or from the market - and, as such, are not within the scope of IAS 20. Any green certificates purchased are recognised as intangible assets and initially measured at cost. These intangible assets may be revalued, but only if there is an active market in accordance with IAS 38 Intangible Assets. As electricity is sold, a provision is recognised for the obligation to deliver green certificates to the government. This provision is measured at the fair value of green certificates to be remitted and re-measured at each balance sheet date. However, there are some alternative methods of accounting for the asset/liability. The entity may elect to classify the green certificates purchased as reimbursement rights in respect of the provision (rather than a separate intangible asset). This means that the green certificates held to match an existing liability can be remeasured to fair value (to match the liability), even if there is no active market. Alternatively, the entity may measure the provision, to the extent that it holds green certificates, based on the carrying value of the green certificates it holds. The provision in excess of the certificates held is measured at fair value to reflect its obligation to purchase further certificates. Both methods have the same impact on the income statement. If an entity is both a generator and distributor, or retailer, further accounting challenges arise. The IASB s agenda The IASB has recently added the Emission Trading Schemes project to its agenda. At its May 2008 meeting, the Board tentatively decided that the scope of the project will address the accounting for all tradable emission rights and obligations, and for activities to receive tradeable rights in the future, e.g., CERs. The staff plan to present alternative accounting models to the Board in the third quarter of 2008 and anticipates that an Exposure Draft will be released in the second half of We are supportive of the IASB s decision to pursue this project. A key concern is that the scope of the project is limited to tradable emission rights and obligations, and to activities to receive tradable rights in the future. This avoids the requirement to address the accounting for all government grants, and therefore, helps to finalise a standard more quickly. However, this means that other schemes to encourage investment in alternative energy, such as green certificates, will not necessarily be addressed by the project. However, if the project is principles-based to account for the activities within its scope, the industry may need to consider how applicable these principles are to other schemes. Acquisitions of wind farms Significant judgment is required to decide whether an acquisition of a wind farm is a business combination or merely the acquisition of a collection of assets, as acquisitions are made at various points in the development of a wind farm. Box 3 contains examples from both ends of the spectrum. 6 IFRS outlook August 2008

7 Box 3: Examples of wind farm acquisition 1. A suitable site to build a wind farm has been identified, but no lease over the site has been obtained. The only information that exists is the identification of a suitable site and studies showing that there is enough wind, and that there is an ability to connect to an electricity grid. There may or may not be legal permission to build a wind farm on the site at this stage. 2. The wind farm is fully constructed and operational, connected to the grid and generating revenue from electricity generated. A business is defined in IFRS 3 Business Combinations as generally consisting of inputs, processes applied to those inputs, and resulting outputs that are, or will be, used to generate revenues. It is clear that example 1 in Box 3 above does not meet the definition of a business. At this stage of development, there are no inputs, processes or outputs. Equally, it is evident that example 2 above does meet the definition of a business. Obvious inputs, processes and outputs exist. Applying the definition of a business to the acquisition at a stage in between the examples provided requires judgment and consideration of the individual facts and circumstances, such as existing policies and procedures that will be transferred, activities the employees perform, existing contracts and anything else required in order to begin production. The revised IFRS 3 (effective for annual periods beginning on or after 1 July 2009) (IFRS 3R) redefines a business and states that it is not necessary for outputs to be present in order for the acquired set of assets to qualify as a business. It is only necessary that the inputs and processes are, or will be, used to create outputs. All of the inputs and processes need not exist if the acquirer can produce output from the assets, for example, by integrating them with their own inputs and processes. It, therefore, appears that the IASB has broadened the definition of a business such that more transactions will qualify as a business acquisition. We are not entirely sure that it was the intention of the Board to capture a greater number of transactions within the scope of IFRS 3R, and it will be interesting to see how the Board reacts as the standard is applied in practice. Careful judgment must be applied and we expect that this will remain an area of uncertainty in the industry. Conclusion The application of existing IFRS has already presented the industry with significant challenges and we expect these to increase. The IASB has launched projects to reconsider aspects fundamental to financial reporting, such as the definition of assets and liabilities, revenue recognition and the definition of the reporting entity. As other areas of alternative energy, such as solar and biofuels, are expected to grow, it is critical that the industry continues to debate these financial reporting issues to promote a consistent approach to reporting. In response to the continued positive feedback from participants, the Global IFRS Power & Utilities roundtable is held annually. The next roundtable will be held in May IFRS outlook August

8 Financial reporting developments The IASB (the Board) met in London on July 2008 and the IFRIC met on July The table below summarises the main issues discussed. On the following pages, you will find more detailed information and insights about the shaded items in the table. Projects Key discussion points Status Consolidation Proposed ED Revenue recognition Management commentary IFRS 5 Discontinued Operations: Proposed ED Income Taxes Proposed ED IFRIC D23 Distribution of Non-cash Assets to Owners IFRS for private entities Leases IFRIC D24 Customer Contributions The staff presented a draft of an ED to replace IAS 27 Consolidated and Separate Financial Statements and SIC 12 Consolidation Special Purpose Entities. The Board did not make any decisions. An analysis of some of the definitions proposed e.g., significant involvement and its relationship to significant influence the disclosure requirements, reputational risk and agency relationships is still to be undertaken. See our feature article on page 2 for more details. The Board confirmed that the DP will focus on the customer consideration model, and would include a brief discussion on why the current exit price model was considered but determined impractical. The Board continued discussions on the DP issued in 2005, Management Commentary, and made several tentative decisions relating to its relationship to the conceptual framework. The IASB tentatively decided that: the definition of discontinued operations will include businesses, as defined in IFRS 3, which meet the requirements to be presented as held for sale upon acquisition, but will provide some exemptions from disclosures. entities will be required required to provide note disclosure on significant income, expense, assets and liabilities and reconcile them to the statements of comprehensive income and financial position. The Board reviewed a pre-ballot draft of the ED amending IAS 12 Income Taxes and made several tentative decisions. The IFRIC discussed comment letters received and made several tentative decisions regarding the scope of the interpretation, and accounting for distributions of non-cash assets to owners. The Board continued its redeliberations of proposals, including accounting for associates, jointly controlled entities, investment property, intangible assets, business combinations, equity, borrowing costs, impairment of non-financial assets and post-employment benefits. The Board discussed several issues and made several tentative decisions regarding accounting by lessees. The IFRIC discussed situations where all customers are treated equally regardless of whether or not they have made a contribution. It concluded that if all customers pay a fee for ongoing access, this may indicate that the initial contribution is for initial access only and not for ongoing access. In these circumstances, the ongoing performance obligation is an executory contract. For the next meeting staff will develop a set of indicators, based on IAS 18, to help identify whether a performance obligation arises from a customer contribution. ED expected in Q DP expected in Q ED expected in Q ED expected in Q ED expected in Q Final standard expected in H DP expected in Q IFRS outlook August 2008

9 Projects Key discussion points Status IFRS 2 Share-based Payment and IFRIC 11 IFRS 2 Group and Treasury Share Transactions - Group cash-settled sharebased payment transactions Compliance costs for REACH Agenda decision The Board agreed that the final amendment to IFRS 2 would incorporate all of the relevant interpretations. However, before the amendment is finalised, the IFRIC will reconsider all significant proposals made in the ED. The IFRIC concluded that the proposals in the ED did not completely achieve its objective, and concluded amendments that it would recommend to the Board. The IFRIC agreed to add to its agenda a project on the treatment of costs incurred to comply with the requirements of the European Regulation concerning the Registration, Evaluation, Authorisation and Restriction of Chemicals (REACH). The regulation came into force on 1 June Financial instruments: Agenda decision Financial instruments: Liabilities and equity Financial instruments: IAS 32 Financial Instruments: Presentation - transaction costs Financial instruments: Valuing financial instruments in markets that are no longer active Fair Value Measurement The Board agreed to add two projects to its agenda related to financial instruments: Financial instruments with the characteristics of equity. Derecognition of financial instruments. The distinction between when a financial instrument is classified as equity or liability is not always clear and the derecognition model is both difficult to apply and understand. We applaud the Board for its commitment to repair IFRS in this regard. The European Financial Reporting Advisory Group (EFRAG) held an educational session with the IASB on the loss absorption approach. The loss absorption approach is presented in the EFRAG discussion paper, Distinguishing Between Liabilities and Equity, as an alternative to the approaches outlined in the FASB Preliminary Views document. The IFRIC received a request for guidance on the meaning of the terms incremental and directly in the context of transaction costs on equity transactions. In particular, the question is how to allocate costs that relate jointly to more than one transaction, such as when an entity issues new shares at the same time as listing existing shares. The IFRIC confirmed that costs related to the listing of existing shares were distinct from costs relating to issuing new shares, and that the only incremental direct costs directly attributable to the latter activity qualified to be recognised in equity. It therefore decided not to add this issue to its agenda. However, the IFRIC has recommended to the Board that definitions of such terms should be developed and included and included in the glossary as they are terms used in other Standards and Interpretations. An expert advisory panel was established to discuss the valuation of financial instruments in markets that are no longer active. A sub group of the panel (preparers and auditors) met and discussed how financial instrument measurement issues are being resolved in practice. In particular, this covered new approaches that have developed for establishing fair value when there are no longer observable market prices and dealing with forced transactions such as liquidation and distressed sales what these are and when they may be ignored. A draft document summarising the issues and how they were addressed will be issued. The Board tentatively decided to define fair value as the current exit price and will determine at future meetings which markets should be considered in determining this value. The Board recognises that Standards currently use fair value in a broader context. Future meetings will also consider how this applies to liabilities and where current references to fair value in IFRS do not meet the objective for using current exit price. Tentative decision to be confirmed at the September IFRIC meeting Draft paper to be posted to IASB website for feedback ED expected in H ED = Exposure Draft, DP = Discussion Paper, FI = Final Interpretation, Q = First quarter of 2008, H = First half of 2008 IFRS outlook August

10 Financial reporting developments continued IFRIC agenda decisions items not taken on to the IFRIC agenda IAS 39 effective interest rate method IFRIC was requested to provide guidance on the application of the effective interest method for financial instruments with cash flows linked to an inflation index. The Committee noted that paragraphs AG6 AG8 of IAS 39 provide relevant guidance and that judgment is required to determine whether such an instrument is within the scope of paragraph AG7 or paragraph AG8. Accordingly, IFRIC decided not to add this item to its agenda, but did refer this issue to the IASB recommending it to clarify the requirements and expand existing application guidance. Revenue recognition Both the IASB and the FASB previously expressed a tentative preliminary view in favour of the customer consideration approach. The Board confirmed its earlier decision, and concluded that the DP should include a brief discussion on the current exit price model and why it was not selected. The Board tentatively decided that, for multiple element arrangements, the total transaction price should be allocated to individual performance obligations based on the entity s observed or estimated stand-alone sales price for each element. The calculation would be done on a pro-rata basis. For example, if an entity sold hardware and software together for a total price of 400,000, and sold the hardware separately for 300,000 and the software separately for 200,000, the allocation would be as follows: Stand alone price Percentage Hardware 300,000 60% 240,000 Software 200,000 40% 160,000 Total 500, % 400,000 Measurement of performance obligation However, if the fair value for a component (based on unadjusted quoted prices in an active market) was determinable at contract inception, then that value should be used. To qualify as a quoted price in an active market there must be transactions of sufficient volume and frequency in identical assets or liabilities, and the entity has the ability to access that market. A number of issues are outstanding. The more significant of these include: Should selected industries, or types of contracts, be excluded from this general standard? Currently, insurance, leases and financial instruments are likely to be excluded. How are obligations such as a right of return, guarantees (such as performance, residual value, minimum revenue, etc.) and promotional promises to be treated? Other than when the contract is determined to be onerous, when should the performance obligation be remeasured? The proposed standard will affect all industries, particularly those with multiple element arrangements and those that recognise revenue based on percentage of completion. Entities with multiple element arrangements where the individual elements are not sold separately by the entity or there is no market, may need to revert to other measures for allocation, such as labour input hours or cost plus a reasonable margin. Businesses following IAS 11 Construction Contracts will also likely see significant changes to their revenue recognition as the model focuses on satisfying obligations, not necessarily the level of economic activity. All entities should carefully follow the discussions by the Boards to assess the impact of these proposals. 10 IFRS outlook August 2008

11 Management commentary The DP on management commentary was issued in Based on the proposals to revise the Conceptual Framework (see Supplement to IFRS outlook, issue 7) the Board began rediscussing this project and tentatively decided that the objective, users and qualitative characteristics of the information in the management commentary will mirror those included in Phase A of the Conceptual Framework project. While the DP proposed types of content for the management commentary, the Board tentatively decided to develop presentation requirements linked to IFRS 8 and to add the following specific elements: The strategy used for evaluating management, including executive compensation. The strategy for minimising taxes and its integration with any uncertain tax positions. A discussion of key resources and financing obligations. Income taxes The Board decided that the exposure draft expected later this year should take the form of a draft new IFRS, rather than an amendment to IAS 12. The Board confirmed its earlier decision that when temporary differences arise upon initial recognition, entities should: Measure a deferred tax asset or liability in accordance with IAS 12. Separate the asset or liability into: an asset or liability with a tax basis available to market participants for a transaction in that individual asset or liability in that jurisdiction. This would be measured in accordance with IFRS, excluding any entity specific tax effects. A tax advantage or disadvantage based on the difference between the normal jurisdictional tax and the tax basis available to that entity. If, upon initial recognition, the transaction does not affect comprehensive income, equity or taxable profit and is not a business combination, a premium or allowance is included in the deferred tax asset or a liability. This appears to result in an accounting treatment similar to that required by the initial recognition exception currently contained in IAS 12. The Board also confirmed other significant earlier decisions as follows: An entity s expectations about the manner in which an asset or liability will be settled or recovered do not affect the determination of its tax basis, but will affect the determination of whether a temporary difference exists and the rate used to determine that temporary difference. Deferred tax assets would be recognised using a two-step approach: An asset would be recognised for the tax effect of the entire amount that the entity is entitled to receive as a result of future deductions, with the measurement process considering uncertainty for amounts disallowed. A valuation allowance would be recognised to ensure that the asset net of the valuation allowance meets the criterion of being more likely than not to be realised. The ED will include a general prohibition on tracking changes in recognised tax assets and liabilities back to the components of comprehensive income and equity in which the tax was originally recognised. Tax differences arising on investments in foreign subsidiaries and joint ventures should not be recognised if the investment is permanent in nature. IFRS outlook August

12 Financial reporting developments continued The IASB also confirmed that disclosures would focus on the amounts recognised in the financial statements, with no further disclosures relating to the difference between the recognised amount and amounts claimed in the tax return. This appears to mean that no disclosure will be required of the gross amount of uncertain tax positions. IFRIC D23 Distribution of Non-cash Assets to Owners The IFRIC decided that: The scope would clarify that transactions in which the shares of group entities are distributed to shareholders outside of the group do not meet the definition of common control transactions in IFRS 3 Business Combinations, and therefore, such transactions would be within the scope of the draft interpretation. To retain the approach of recognising a liability for the distribution to be made, and that settlement of the liability will give rise to a gain or loss to be recognised in income. Therefore, the alternative approach of recognising a gain on settlement directly in equity was rejected. The dividend liability would be recognised when management declared the payment. However, if the jurisdiction legally requires approval of the payment by the shareholders, the relevant date would be when the formal approval was granted by the shareholders. To recommend to the Board to amend IFRS 5, such that it is applied to assets held for distribution to owners as of the commitment date. The IFRIC recognised that an accounting mismatch may result from measuring the asset to be distributed at cost and the dividend payable at fair value, and will consider how best to eliminate this mismatch in future meetings. IFRS 2 Share based Payments and IFRIC 11 IFRS 2 Group and Treasury Share Transactions The IFRIC decided an amendment should be made to IFRS 2 to clarify that: the receiving entity accounts for the goods and services it receives in accordance with IFRS 2; and the settling entity has to account for the settlement in accordance with IFRS 2. The IFRIC also concluded that in cases where the receiving and settling entity were two different entities, the classification and measurement of the transaction in their separate financial statements should not necessarily be the same. When the receiving entity does not have an obligation to settle the share-based payment transaction, the goods and service would be measured by the requirements for equity-settled transactions. It would also recognise an equivalent contribution in equity, irrespective of how the settling entity calculates the expense or how it is reflected in the consolidated accounts. IFRS for private entities Significant tentative decisions made by the Board included: Associates and Jointly Controlled Entities (JCE) Reconfirmed the proposed approach to allow an entity to use the cost, equity method, or proportionate consolidation for JCEs) or fair value through profit or loss model (with one exception the cost model will be prohibited when there is a published price available for the associate. However, if ED 9 Joint Arrangements is finalised before this standard, proportionate consolidation would not be permitted for investments in a JCE. For equity and proportionately consolidated investments, the most current information must be used. 12 IFRS outlook August 2008

13 Investment property and property, plant and equipment (PPE) Decided to retain the options for accounting for investment property and PPE that exist in full IFRS. That is, allowing an entity to choose between the use of cost or fair value. Intangible assets other than goodwill Entities will have an accounting policy choice to expense or capitalise development costs. Business Combinations Retain the same accounting as full IFRS, but include specific requirements on how to account for business combinations where the accounting is only provisional. Equity Leases The Board tentatively decided: To eliminate the requirement to classify a lease as finance or operating and apply the same approach to all leases. Lessees should not recognise options to extend leases for additional periods as separate assets, and that assets and liabilities should be based upon the lease term. Judgment will be required in determining the lease term as entities will have to consider contractual terms and non-contractual and other business factors. A lessee should discount the lease payments using the lessee s incremental borrowing rate for secured borrowings. As required by full IFRS, entities will be required to classify compound financial instruments as financial assets, financial liabilities and equity instruments. Borrowing costs Entities will have an accounting policy choice to either expense or capitalise borrowing costs, despite the recent amendments to IAS 23 Borrowing Costs. Impairment of non-financial assets An entity will be required to perform an impairment test only if indicators suggest an asset may be impaired. Impairment will be determined using the concepts of recoverable amount, value in use and cash-generating unit outlined in IAS 36 Impairment of Assets. Post employment benefits Actuarial gains and losses and past service costs will be recognised in profit or loss immediately, rather than permitting some of this to be outside of the profit or loss as IAS 19 Employee Benefits allows. IFRS outlook August

14 Resources Supplements to IFRS outlook: Issues Issue 11 - Hedging portions of risk This supplement looks at new guidance introduced by the amendment to IAS 39 Financial instruments: Recognition and Measurement: Eligible Hedged Items. This is much narrower in scope than the original rules-based approach, addressing only the designations of a one-sided risk in a hedged item and inflation as a hedged risk in particular situations. Issue Proposed annual improvements This supplement summarises 12 proposed amendments to 8 standards recently issued by the IASB. Other publications Caution: fair values in progress - accounting for investment property under construction This publication discusses the implications of the IASB s decision to require investment property under construction to be accounted for under IAS 40 Investment Property. IFRS 7 for the banking industry This publication provides an analysis of the disclosures made in the first year of mandatory adoption of IFRS 7 Financial Instruments: Disclosures made by the 24 largest European banks by capitalisation. It also contains examples and commentary on the practical difficulties involved in preparing and interpreting this information. IFRS 7 for the insurance industry This publication report is based on an analysis of the IFRS 7-specific disclosures in the annual financial statements of sixteen of the largest insurers reporting under IFRS. It explores how IFRS 7 has been applied in the insurance industry, and highlights some of the challenges faced by insurance companies 14 IFRS outlook April 2008

15 Coming soon Good Group (International) Limited, International GAAP Illustrative Financial Statements for 2008 This updated publication will contain the consolidated financial statements of a fictitious company, Good Group (International) Limited, for the year ending 31 December 2008, based on IFRS in issue as at 30 July The financial statements will be cross-referenced to the source literature and include explanatory notes. Supplement to IFRS outlook Earnings per share This supplement summarises proposed amendments to IAS 33 Earnings per Share recently issued by the IASB. IFRS outlook April

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