IASB Projects A pocketbook guide. As at 31 December 2011

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1 A pocketbook guide As at 31 December 2011

2 In this edition... Introduction 2 Timeline 3 IASB projects 4 Consolidation 4 Financial instruments 7 Leases 13 Revenue recognition 15 Insurance contracts 17 Annual improvements 19 Amendments to IFRS 1 20 Agenda consultation 21 Post implementation reviews 22 1

3 Introduction Ernst & Young s pocketbook guide summarises the key features of active projects of the International Accounting Standards Board (IASB or the Board). This publication also includes potential financial and business implications of the proposed standards, along with our views on the respective projects that have been shared with the Board. We hope you have found the previous editions of this pocketbook guide helpful. In previous editions, we highlighted a number of standards and amendments that the IASB finalised in 2010 and Details of these new and amended standards can be found in our publication, IFRS Update for the financial year ending 31 December This edition of the pocketbook guide provides updates on the IASB s active projects, incorporating activities and tentative decisions made up to 31 December We highlight the Board s proposals for consolidation of investment entities and the re-exposure of the proposal on revenue recognition. Other significant updates from our June 2011 edition include tentative decisions on significant aspects of the leases, financial instruments and insurance contracts projects. The IASB updated its work plan on 20 December 2011 to reflect the amended timetable for its projects. Highlights of the current IASB s work plan are provided in this publication. In addition to re-exposing the revenue recognition proposal, the IASB and FASB also decided to formally expose their joint lease proposal for a second time because they have made significant changes to the model they proposed last year. A second exposure draft is expected in the first half of The decision to re-expose the leases and revenue recognition proposals will allow constituents an opportunity to provide further feedback. We also refer you to our Joint Project Watch IASB/FASB joint projects from an IFRS perspective for additional details of projects discussed in this pocketbook guide that have been undertaken jointly by the Boards. We trust that you will find this guide, as well as the Joint Project Watch, useful. Yours sincerely, Ruth Picker Global Leader IFRS Services Global Professional Practice December

4 Project timeline Ongoing projects First half Second half First half Second half Consolidation Transitional guidance for IFRS 10 Investment entities Financial Instruments 1 Impairment SD General hedge accounting RD 2, Macro hedge accounting Asset and liability offsetting Leases Revenue recognition Insurance contracts 3 Annual improvements Amendments to IFRS 1 5 Agenda consultation Agenda decision Post implementation reviews IFRS 8 Operating Segments IR TC IFRS 3 Business Combinations IR Exposure draft (including re-exposure) Roundtable discussions Final standard SD Supplementary document RD Review draft IR Initiate review TC Target Completion 1 The IASB addressed this project in stages. Final IFRSs for classification and measurement-assets and liabilities were issued in Q and Q4 2010, respectively. 2 An RD of the general hedge accounting proposals is expected to be made available on the IASB website for a period of 90 days. 3 Re-exposure or RD. 4 Annual improvements is expected to be completed in the first half of 2012; separate EDs on annual improvements and are expected to be issued in Q1 and Q3 2012, respectively. 5 The Board will decide whether to proceed with the amendments based on comments received on the ED. 3

5 Consolidation overview Background: Consolidation IFRS 10 Consolidated Financial Statements was published in Q and replaces portions of IAS 27 Consolidated and Separate Financial Statements and the interpretation SIC-12 Consolidation Special Purpose Entities. In December 2011, the IASB issued an ED that proposed clarifications to the transitional guidance in IFRS 10. The proposals are aimed at addressing constituent concerns that the transitional provisions of IFRS 10 were more burdensome than originally intended by the IASB. Comments on the ED are due 21 March 2012 and a final IFRS is targeted for Q Investment entities A separate ED of proposed amendments to consolidation requirements for investment entities was issued in Q Splitting the project into parts allowed the IASB to publish IFRS 10, while allowing time for due process regarding the proposed changes in the accounting by investment entities. 4

6 Consolidation investment entities Joint project (ED issued August 2011) Background: The IASB issued a new consolidation standard in May 2011 that establishes a single control model applicable to all entities. The IASB, jointly with the US Financial Accounting Standards Board (FASB), is continuing to consider issues relating to consolidation accounting for investment entities. Scope: The proposals would be applicable to all controlled investments held by a reporting entity that meet the definition of an investment entity. Key features: To qualify as an investment entity, an entity would be required to meet several criteria. An investment entity would be prohibited from consolidating investments in entities that it controls, and could not account for joint ventures or associates using the equity method. Instead, an investment entity would measure those investments at fair value. A parent of an investment entity that is not an investment entity itself would be required to consolidate any controlled investees held by the investment entity (i.e., fair value is not allowed at the parent entity level). This would be a significant change for investment entities, which are currently required to consolidate investees that they control. 5

7 Consolidation - investment entities cont d Entities that do not meet the criteria to be an investment entity would be prohibited from measuring investments in joint ventures and associates at fair value. This is currently permitted, but not required, for certain entities, such as investment-linked insurance funds. Transition: If an entity meets the definition of an investment entity, an adjustment to opening retained earnings would be made. The adjustment would be for the difference between the previous carrying amount of the net assets of the controlled investee and the fair value of the investee as of the date of first applying the proposed amendment. An effective date of 1 January 2013 was proposed during deliberations, which coincides with the effective date of IFRS 10 Consolidated Financial Statements. Some constituents (including the FASB) consider it appropriate that an entity should be able to retain, in its consolidated financial statements, the fair value accounting applied by its subsidiary in the parent s consolidated financial statements. Proponents of this view generally believe that if fair value provides the most decision-useful information in the financial statements of the investment entity, it also provides the most decisionuseful information in the group s financial statements. 6

8 Financial instruments (IAS 39 replacement) - overview Background: The IASB separated the financial instruments project into several phases: Classification and measurement IFRS 9 Financial Instruments for financial assets was first published in November 2009 and updated in October 2010 for financial liabilities. Refer to IFRS Update for the financial year ending 31 December 2011 for details of the new requirements of IFRS 9. Amendments issued in December 2011 revised the effective date of IFRS 9 to annual periods beginning on or after 1 January Further, these amendments no longer require entities to restate comparative figures. Instead, entities would either be required or permitted to provide additional disclosures on the basis of the entity s date of transition. The IASB tentatively decided at its November 2011 meetings to initiate a limited scope review of IFRS 9 and, in particular, to consider the interaction with the insurance contracts project and the differences with US GAAP. The IASB and FASB have divergent views on several areas, particularly on the extent of use of fair value. The limited scope review of IFRS 9 creates uncertainty as to what IFRS 9, if amended, will require. This could be of concern to entities that have already adopted IFRS 9. 7

9 Financial instruments (IAS 39 replacement) - overview cont d Balance sheet offsetting Amendments to IFRS 7 Financial Instruments: Disclosures and IAS 32 Financial Instruments: Presentation were issued in December Hedge accounting A final standard is expected to be issued in the first half of 2012 on general hedge accounting. Proposals on macro hedge accounting are being considered separately and an ED is expected in the first half of Impairment of financial assets The IASB and FASB (the Boards) are jointly working on an approach for impairment of financial assets. This approach is based on variations of proposals that were previously issued in 2009 and 2011 and is expected to take into account constituents feedback received on the previous proposals. An ED is expected in the first half of We fully support the deferral of the effective date of IFRS 9. We also fully support the IASB s decision to continue to permit earlier application of IFRS 9, particularly as it would allow first-time adopters to apply only one set of financial instruments requirements. Relief from restating comparatives addresses constituents concerns about the original IFRS 9 requirements. 8

10 9 Financial instruments impairment Joint project (Re-exposure expected first half 2012) Scope: The proposals are applicable to all financial assets recorded at amortised cost under IFRS 9 (e.g., loans held by financial institutions and investments in debt securities). Key features: The Boards have agreed to pursue a three-bucket approach. Under this approach, all financial assets are initially placed into Bucket 1 and subsequently moved to Bucket 2 and 3 as credit deteriorates. An impairment allowance would be recorded based on the lifetime expected losses for the portion of assets expected to move to Buckets 2 or 3 over the next 12 months. Assets would move into Bucket 2 when (1) there has been a more than insignificant deterioration in credit quality and (2) the likelihood of default is such that it is at least reasonably possible that the contractual cash flows may not be recoverable. The Boards agreed to avoid bright lines indicating when lifetime expected losses should be recorded when applying the three-bucket approach to debt securities and consumer and commercial loans. The Boards have yet to discuss the disclosure requirements and application of the new impairment approach to purchased financial assets, trade receivables and lease receivables. Transition: The expected effective date for IFRS 9 impairment is 1 January 2015, unless there are further delays in the impairment project. We support the Boards efforts to arrive at a converged solution to accounting for credit impairment under IFRS and US GAAP.

11 Financial instruments asset and liability offsetting (Amendments to IFRS issued December 2011 Scope: The amendments are applicable to offsetting financial assets and financial liabilities. Key features: IFRS 7 amendments require additional disclosures for financial instruments entered into under an enforceable master netting agreement (or other similar agreement). IAS 32 amendments provide application guidance for offsetting financial instruments in the statement of financial position as follows: The right of set-off must be legally enforceable in both the normal course of business and in the event of default, bankruptcy and insolvency of either of the counterparties Only gross settlement systems with certain features would be considered equivalent to net settlement Transition: The amendments to IAS 32 are applied retrospectively to annual and interim periods beginning on or after 1 January The new disclosures in IFRS 7 are applied retrospectively and are effective for annual and interim periods beginning on or after 1 January Earlier application is permitted. Although a fully converged framework for balance sheet offsetting between IFRS and US GAAP has not been achieved by these changes to IFRS, the amendments to IFRS 7 will enable a reconciliation of the effect of the IFRS and US GAAP difference. The amendments will not have a major effect on accounting practice, but the new disclosure requirements may result in system modification. 10

12 Financial instruments general hedge accounting (IFRS expected first half of 2012) Scope: An entity may choose to designate a hedging relationship between a hedging instrument and a hedged item as defined in the proposed standard. Key features: Hedge accounting would be permitted for risk components of financial and, for the first time, non-financial items, provided the risk components can be separately identified and reliably measured. There would be no arbitrary bright line tests for hedge effectiveness assessment. Instead, there must be an economic relationship between the hedged item and the hedging instrument, and the effect of credit risk must not dominate the value changes that would result from that relationship. Qualitative testing would be possible, when appropriate. A principles-based approach is proposed, which is consistent with the IASB s objective to reduce complexity. Under the propsed model, there would be a better link between an entity s risk management strategy, the rationale for hedging and the impact of hedging on the financial statements. For entities that already apply IFRS, it is expected that almost all of the previous hedge accounting relationships under IAS 39 would still qualify under the proposed standard. The proposals are likely to have a significant impact on entities that use economic hedging practices, but are currently unable to reflect this in their financial statments. 11

13 Financial instruments general hedge accounting cont d A hedge relationship would be rebalanced after inception when the hedge ratio is adjusted for risk management purposes, rather than being dedesignated and re-designated as currently required under IAS 39. Transition: The proposals are expected to be applicable prospectively for annual periods beginning on or after 1 January Early application would be permitted, but only if the hedge accounting proposals are adopted together with all other IFRS 9 requirements that have been previously finalised. The most significant benefit may be for non-financial services entities, because hedge accounting would be permitted for risk components of non-financial items. 12

14 Leases Joint project (Re-exposure expected first half of 2012) Background: Based on feedback from constituents on the ED (issued in August 2010), the Boards identified a number of issues that continue to be discussed during the ongoing redeliberations. Scope: Generally, leases of property, plant and equipment. Key features: Lessee model Lessees would recognise an asset for the right to use the leased item and a corresponding obligation to pay rentals. Current operating lease accounting would be eliminated except for certain short-term leases (i.e., leases with maximum term of 12 months). Amortisation of the right-to-use asset and interest on the lease obligation would be recognised in profit or loss. Reassessment of certain key considerations (e.g., lease term, variable lease payments that depend on an index or rate) would be required throughout the life of the lease. This would be a significant change from existing IFRS. The classification of leases as either finance or operating would cease and be replaced with a right of use approach. As a result, key ratios (e.g., gearing, EBITDA and interest coverage), bank covenants and other key performance metrics are likely to be impacted. Initial and ongoing estimation would require new processes and changes to information systems to capture information required by the proposed standard (e.g., lease term, lease and non-lease components). Entities would need to focus on separating services and executory payments from existing operating leases. Previously these costs may have been split out as the accounting treatment for such payments was often the same as operating lease payments under existing IFRS. 13

15 Leases cont d Lessor model Lessors would apply a single approach, the receivable and residual approach, to all leases, except shortterm leases and leases of investment property. Lessors would apply current operating lease accounting to short-term leases and leases of investment property. Under the receivable and residual approach, the lessor would recognise a lease receivable, allocate the carrying value of the underlying asset being leased between the right of use granted to the lessee and the portion retained by the lessor ( residual asset ), and recognise profit at the commencement of the lease. Over the term of the lease, the lessor would recognise income related to interest on the receivable and accretion of the residual asset. Transition: Lessees and lessors could transition following either a full retrospective approach or a modified retrospective approach (i.e., an approach that allows certain types of relief that the Boards designed to reduce transition costs). The Boards have not concluded on the effective date. We support the Boards decision to re-expose and strongly encourage companies to re-evaluate the proposed revised model and provide feedback to the Boards. 14

16 Revenue recognition Joint project (Re-exposure November 2011) Background: The Boards exposed their joint revenue recognition proposal for a second time in November 2011 as a result of significant changes made to their original proposals. Scope: The proposal would apply to revenue arising from contracts with customers and the sale of some non-financial assets that are not an output of the entity s ordinary activities (i.e., sale of property, plant and equipment or intangibles). Lease contracts, insurance contracts, financial instruments and certain non-monetary transactions are outside the scope of the proposal. Key features: The proposed model is based on the following five steps: 1. Identify the contract with a customer Contracts can be written, verbal or implied. Contracts could be combined, but would not be required to be segmented. 2. Identify the separate performance obligations in the contract A good or service would be distinct (i.e., a separate performance obligation) if either: (i) the entity regularly sells the good or service separately; or (ii) the customer can benefit from the good or service on its own or together with other readily available resources. Accounting for multiple-element deliverables in a contract may impact the timing of revenue recognition. The notion of transfer of control would have a significant impact on revenue recognition, mainly in long-term contracts. This would need to be taken into consideration in existing and forthcoming contracts. No significant impact is expected for normal sales contracts. Revenue and its related key performance indicators may change. For example, the presentation of bad debts expense as a separate line item adjacent to the revenue line instead of part of operating expenses would result in a lower gross margin amount. Among other changes, the proposal would require additional disaggregated disclosures of revenue, reconciliations of contract asset and liability account balances between periods, and disclosure of key estimates. These changes may require significant modifications to existing internal data gathering efforts and processes. 15

17 Revenue recognition cont d 3. Determine the transaction price The transaction price would be the amount of consideration that an entity expects to be entitled to in exchange for transferring promised goods or services to a customer. The transaction price would exclude credit risk. 4. Allocate the transaction price to the separate performance obligations Estimated transaction prices would be allocated based on the stand-alone selling prices. A residual technique could be used for performance obligations with highly variable prices (e.g., software licences). 5. Recognise revenue when (or as) the entity satisfies a performance obligation An entity would satisfy a performance obligation by transferring control of a promised good or service to the customer, which could occur over time or at a point in time. The amount of revenue recognised may be constrained (i.e., limited because of variable consideration and rights of return). An entity would recognise a liability and a corresponding expense if a performance obligation satisfied over time becomes onerous provided the performance obligation is satisfied over more than one year. Transition: Full retrospective application, with some relief, is proposed and early adoption would be permitted under IFRS. The Boards have not yet proposed an effective date, but have indicated that it would not be before 1 January Many of the changes will have a significant impact on entities and may require significant cost to implement. Accordingly, we strongly support the Boards decision to give constituents a chance to formally comment on the revised proposal. 16

18 Insurance contracts Joint project (Re-exposure or review draft expected first half 2012) Background: Although a number of tentative decisions have been made since redeliberations began in February 2011, the Board continues to actively discuss this project. The IASB tentatively decided at its November 2011 meetings to initiate a limited scope review of IFRS 9 and, in particular, to consider the interaction with the insurance contracts project. Scope: Applies to all types of insurance contracts (life, non-life, direct insurance and reinsurance). Key features: The proposed approach for the measurement of insurance contracts is based on the following building blocks: Expected present value of future cash flows A risk adjustment A residual margin that eliminates any gain at inception of the contract, but will be adjusted subsequently for changes in estimates of cash flows The discount rate used to measure insurance contracts would be a current rate updated at the end of each reporting period (i.e., the discount rate would not be locked in at inception of the contract). Rather than a prescribed rate, the proposed approach would include the principle that the rate should reflect the characteristics of the liability. The Board s proposals are far-reaching and may have a significant impact on insurers (e.g., estimating all future cash flows arising from the fulfilment of an insurance contract on a probability-weighted basis, accounting for acquisition costs incurred by insurers to secure contracts with policyholders). This would have a related impact on key processes and internal controls. The proposed model would result in a significant change to a number of financial metrics and may also result in an increase in volatility of profit or loss. The tentative decisions made by the IASB differ from the FASB decisions in some important areas (e.g., margins and acquisition costs). As a result, there is a risk that the Boards may not reach a converged solution. 17

19 Insurance contracts cont d Initial recognition of insurance contracts would ordinarily be the date coverage becomes effective. The measurement of the insurance contract would include the direct acquisition costs that the insurer incurs when acquiring the contracts in a portfolio, without making a distinction between successful and unsuccessful efforts. Reinsurance would substantially follow the overall concepts proposed with a few modifications to reflect the nature of reinsurance arrangements. A modified approach based on a premium allocation model would be applied to the liability for remaining coverage for some types of contracts (e.g., contracts with a coverage period of one year or less). Transition: A limited retrospective approach was proposed in the original ED. However, the Board has not concluded on the transition method or the effective date. In our comment letter, we expressed concerns about some of the features of the measurement model proposed in the ED. We believe these must be resolved before a standard on insurance contracts can be finalised. We also proposed a number of changes to aspects of the model. We are closely monitoring the impact of the Board s recent decisions on our concerns and convergence with the FASB. In particular, the Board s decisions on the topic of asset and liability mismatch will be a critical aspect of finalising the model. 18

20 Annual improvements (Final amendments expected first half 2012) Background: The Improvements to IFRS project is an annual process that the IASB has adopted to deal with non-urgent, but necessary, amendments to IFRS (the annual improvements). The IASB issued an ED in 2011 and is expected to issue two additional EDs in 2012 on annual improvements and ). Scope: The June 2011 ED proposes seven amendments to five standards. Key features: Proposed clarification that income tax relating to both a distribution to holders of an equity instrument and to transaction costs of an equity transaction would be recognised in accordance with IAS 12 Income Taxes. Other clarifications are proposed for IFRS 1 First-time Adoption of International Financial Reporting Standards, IAS 1 Presentation of Financial Statements, IAS 16 Property, Plant & Equipment and IAS 36 Impairment of Assets. Transition: The amendments are expected to be effective for annual periods beginning on or after 1 January Amendments made as part of annual improvements are generally intended to clarify requirements rather than result in substantive changes to current practice. However, management may need to re-evaluate existing policies, procedures or disclosure practices. 19

21 Amendments to IFRS 1 (ED issued October 2011) Background: The IASB proposed limited scope amendments to IFRS 1 in October The Board will decide whether to proceed with the amendments based on comments received on the ED. Scope: The amendments would provide an exception to first-time adopters with government loans that have below market interest rates that were entered into prior to the transition to IFRS. Key features: The proposed exception requires first-time adopters to apply paragraph 10A of IAS 20 Accounting for Government Grants and Disclosure of Government Assistance prospectively to government loans with a below-market rate of interest entered into on or after the date of transition to IFRS. An entity may only apply the requirement of paragraph 10A of IAS 20 to earlier transactions if the necessary information required was obtained at the time of initially accounting for that loan. Transition: The amendments would be effective for annual periods beginning on or after 1 January Earlier application would be permitted. The proposed amendments are expected to be applicable to jurisdictions where below-market interest rate loans from governments are available to entities. This would provide relief to first-time adopters with such government loans that were accounted for at cost under previous GAAP. 20

22 Agenda consultation (Agenda decision expected 2012) Background: As the IASB moves closer to finalising the remaining projects from its current work plan, the Board is looking forward to the next three years of standard setting. As part of this process, in July 2011, the IASB issued a Request for Views on the strategic direction and overall balance of its future agenda. Constituents responses will be considered when setting the future agenda in Key features: The IASB has proposed that the following three aspects should be reflected in the strategic approach for setting its future agenda: A more diverse IFRS community potentially leading to new issues A more complex market environment creating new challenges in financial reporting A number of new and amended IFRS have been issued or are expected to be issued in 2012 placing pressure on preparers to implement these changes and users to understand the key differences The Request for Views also highlights that the strategy of the future agenda should not only focus on the development of new IFRS, but should also emphasise the need to maintain existing IFRS. This includes completion of the conceptual framework project as a strategic priority and initiating the post-implementation reviews project. The IASB has the unique ability at this point in time to step back and re-assess the strategic direction of IFRS as a valuable tool for financial reporting. To achieve this, we believe the IASB s agenda should include a long-term project on the future of performance reporting. This project would focus on the decision usefulness of IFRS and consider IFRS financial statements as a whole. This will help to enhance confidence in the relevance of IFRS financial statements for both users and preparers. 21

23 Post implementation reviews IFRS 8 and IFRS 3 Background: The IFRS Due Process Handbook establishes that a post-implementation review is normally carried out two years after the new requirements have become mandatory and been implemented. Such reviews are normally limited to important issues identified as contentious during the development of the pronouncement and consideration of any unexpected costs or implementation problems encountered. Key features: A review of IFRS 8 Operating Segments, applicable for annual periods beginning on or after 1 January 2009, has been initiated and is expected to be completed in A review of IFRS 3 Business Combinations, applicable for annual periods beginning on or after 1 January 2010, is expected to be initiated in One outcome of these reviews could be proposals for revisions to IFRS 8 and IFRS 3. 22

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