September 2008 Insights on International GAAP IFRS outlook In this issue... SEC Roadmap Feature 2 SEC roadmap Technical focus 4 Post-employment benefits views on proposed amendments Guidance on the fair value of 8 financial instruments in markets that are no longer active Upcoming Comment Letters 10 Resources 11 On 27 August 2008, the SEC approved for release its proposed Roadmap for the mandatory adoption of IFRS by US public companies. Read about the key milestones and conditions that we expect to see in the Roadmap when it becomes available for public comment shortly. Post-employment benefits views on proposed amendments A discussion paper, recently issued by the IASB, proposes significant changes to accounting for post-employment benefits. The key changes proposed impact existing smoothing mechanisms, presentation of defined benefit promises, introduce a new category of benefits and a new accounting model for contribution-based benefits. Find out more about the potential impact of these proposed changes. Guidance on the fair value of financial instruments in markets that are no longer active Due to the recent credit crisis, the markets for many financial instruments have become inactive; this leads to difficulties in determining their fair value. In response, the IASB has set up an expert advisory panel. Learn more about the panel s discussions to date and its future plans. Upcoming comment letters In the coming months, the comment period will end for a number of papers issued by the IASB. Don t miss your opportunity to provide feedback. Our regular financial reporting developments section will return in the October edition. This will summarise September s IASB and IFRIC meetings. We welcome your feedback on IFRS outlook. Please contact us at ifrs@uk.ey.com. The next issue will be published in October 2008. Will Rainey Global Director of IFRS Services
SEC roadmap Overview On 27 August 2008, the US Securities and Exchange Commission (the SEC) approved for release its long awaited proposed Roadmap for the eventual use of International Financial Reporting Standards (IFRS) by US public companies. This is the most significant step the SEC has taken towards the adoption of a single set of high-quality global accounting and financial reporting standards that everyone can use, and we applaud the SEC for this action. We outline below the key points that we expect to see in the Roadmap when it becomes available for public comment in the near term. The proposed Roadmap anticipates mandatory reporting under IFRS beginning in 2014, 2015 or 2016, depending on the size of the issuer the final decision is to be made in 2011. The proposed Roadmap is also expected to provide for early adoption in 2009 by a small number of very large companies that meet certain criteria. It is also possible that the SEC will later decide to permit other companies to early adopt IFRS at some point in time prior to the mandatory date of conversion. The SEC identified several milestones and conditions for inclusion in the Roadmap, which it will consider when making its decision in 2011 about whether to proceed with mandatory adoption of IFRS. The Roadmap In addition to proposing a phased in schedule for mandatory adoption of IFRS, which is dependent on the size of the issuer, the Roadmap is expected to outline what companies need to provide in their first set of IFRS financial statements filed with the SEC. Consistent with existing requirements in the US, the SEC is expected to require three years of audited financial statements in the first year of IFRS reporting. Therefore, assuming a 2014 conversion date, this means a calendar-year filer would need to include in its 2014 filings: balance sheets as of 31 December 2014 and 2013 and income statements, cash flow statements and statements of changes in equity for the years ended 31 December 2014, 2013 and 2012. In addition, IFRS 1 First-time Adoption of International Financial Reporting Standards would require the presentation of the opening balance sheet as of the date of transition to IFRS (in this example 1 January 2012). This transition approach differs from the approach the SEC took with foreign private issuers (FPIs) in their initial IFRS filings. For those filings, the SEC provided transition relief by requiring only two years of income statements, cash flow statements and statements of changes in equity. Milestones The Roadmap is expected to include the following milestones and conditions: Improvements in accounting standards: the SEC expects the Financial Accounting Standards Board (FASB) and the IASB to continue to work together and progress towards convergence of IFRS and US GAAP. 2 IFRS outlook September 2008
The proposed Roadmap anticipates mandatory reporting under IFRS beginning in 2014, 2015 or 2016, depending on the size of the issuer the final decision is to be made in 2011 Accountability and funding of IASCF: to date, the International Accounting Standards Committee Foundation (IASCF) has financed IASB operations largely through voluntary contributions from companies, accounting firms, international organisations and central banks. The Roadmap is expected to include a milestone that would require the IASCF to develop a funding mechanism that will enable it to remain a stand-alone, private sector organisation with the necessary resources to conduct its work in a timely fashion. The SEC staff indicated that the IASCF has made significant progress towards the development of such a funding mechanism. Improvement in the use of interactive data (XBRL) for IFRS: the SEC has invested heavily in XBRL and expects that IFRS information will be capable of being provided to the SEC in interactive data format. Improvements in IFRS education and training: the SEC would consider the state of preparedness of US issuers, auditors and users, including the extent and availability of IFRS education and training. Timing of proposed rulemaking: the SEC plans to make its final decision in 2011 on the mandatory use of IFRS based on whether, in its view, the adoption of IFRS is in the public interest and would benefit investors. The SEC believes this timing will give companies sufficient notice to begin producing IFRS information for internal purposes in 2012. Limited early use The Roadmap will contain a provision that would permit certain US companies to file IFRS financial statements with the SEC for years ending on or after 15 December 2009. In order to be eligible for this provision, a US issuer must meet the following criteria: Be one of the 20 largest companies (based on global market capitalisation) in its industry; and Participate in an industry in which the use of IFRS is more prevalent than any other basis of accounting The SEC staff have preliminary estimated that approximately 110 companies across 34 industries would qualify for this provision. For these companies, the SEC is considering whether to require either a one-year reconciliation of the issuer s financial statements from IFRS to US GAAP, in accordance with IFRS 1, or an unaudited three-year reconciliation of the issuer s financial statements from IFRS to US GAAP until such time as the use of IFRS becomes mandatory. The proposed Roadmap will seek public comment on these two alternatives before the SEC decides which reconciliation it will require. Call to comment Once issued, the Roadmap will be open for comment for a period of 60 days. The conversion to IFRS will have a pervasive effect on the US capital markets requiring changes in the way preparers prepare, and users use, those financial statements. However, the effects are not limited to just the US many of the companies in the US market have an extensive global reach. Changes of this nature require the participation of all constituents in the debate and all are encouraged to comment on the proposals. The future is now For some time, we at Ernst & Young have been supportive of the SEC setting a date for future mandatory adoption of IFRS by US public companies. Having the world follow a single set of highquality, global accounting standards provides a foundation for capital market activity that promotes investment and strengthens economies. The SEC s proposed Roadmap for moving US public companies to IFRS is a big step towards the realising that goal. IFRS outlook September 2008 3
Post-employment benefits views on proposed amendments The IASB recently published a discussion paper proposing some changes to accounting for postemployment benefits. While a comprehensive review of post-employment benefits accounting is yet to occur as part of a joint long-term convergence project between the IASB and the US FASB, if the changes described in the discussion paper do in fact become amendments, they could have significant impact on post-retirement benefits accounting as we currently know it. This article looks at the proposals presented in the discussion paper and Ernst & Young s views as expressed in our comment letter to the IASB. The release of the discussion paper (DP) Preliminary Views on Amendments to IAS 19 Employee Benefits was the first step in the IASB s two-phase project to reconsider accounting for postemployment benefits. The Board s aim in the first phase is to issue an amended standard that makes significant improvements to pension accounting by 2011, with the second phase constituting a longer-term joint project between the IASB and the US FASB to review all aspects of post-employment benefits accounting and ultimately arrive at a converged standard. In our Supplement 4 to IFRS outlook released in April 2008, we summarised the proposals in the DP regarding the amendments to IAS 19, which the Board believes will improve pension accounting in the short term. The most significant changes proposed in the DP include the elimination of the smoothing mechanisms currently permitted, new presentation approaches for defined benefit promises, revised definitions of benefit promise categories and a new accounting model for post-employment benefits described as contribution-based. Recognition and presentation of defined benefit liabilities The Board has stated its intention to eliminate the ability to defer recognition of changes in the value of plan assets and the postemployment benefit obligation; instead, requiring all changes to be recognised in the balance sheet in the period in which they occur. Full recognition, as outlined in the DP, would also result in unvested past service costs being recognised in the period of a plan amendment. At present, IAS 19 allows multiple recognition options for actuarial gains and losses, and requires unvested prior service costs arising from plan amendments to be deferred over the remaining vesting period. Current recognition options for actuarial gains and losses are: Full recognition of the surplus or deficit in the balance sheet, with actuarial gains and losses recognised in profit or loss or in other comprehensive income. Deferred recognition, where specified minimum amounts of cumulative actuarial gains and losses are recognised in profit or loss, and other gains and losses are not recognised at all (the corridor approach). Alternativey, any systematic method that results in faster recognition of actuarial gains and losses may be adopted, if applied consistently. The basic concept behind the corridor approach is that there is an inherent lack of precision in estimating a benefit obligation; therefore, the estimate should be viewed as a range, the corridor around the best estimate. Accordingly, revisions to that estimate would not require a change to the liability recorded, until a revision to the estimate causes it to fall outside of that range. Under this approach, the full benefit obligation is not included in the balance sheet, but rather is disclosed in the notes to the financial statements. The Board s proposal to require full and immediate recognition of actuarial gains and losses would create consistency of presentation between reporting entities, and consistency with the IFRS conceptual framework s definitions of assets and liabilities. 4 IFRS outlook September 2008
Assuming the Board does adopt full balance sheet recognition, the key question will be how the movements in the benefit obligation and plan assets are presented in the financial statements. Originally, as part of its financial statement presentation project, the IASB planned to address whether components of other comprehensive income should be, reclassified to profit or loss and if so, what should be, and when should it be, reclassified. However, subsequent to the release of this DP, the Board has dropped this matter from the scope of its financial statement presentation project. Considering that this broader conceptual issue of which items are to be recognised outside of profit or loss remains open, as well as the Board s stated intent to complete a comprehensive review of IAS 19 in the future, any presentation option it may adopt is likely to be only an interim measure. In the mean time, the Board laid out three approaches to presentation in the DP. Each would have a different impact on profit or loss. Approach 1 Approach 2 Approach 3 Full recognition of all changes in the defined benefit obligation and value of plan assets in profit or loss, in the period in which they occur. The costs of service are presented in profit or loss. All other costs and income are reported in other comprehensive income. The remeasurements that arise from changes in financial assumptions are presented outside profit or loss, in other comprehensive income. These comprise changes in the discount rate and in the value of plan assets, other than interest income. All other amounts, including the costs of service, interest costs and interest income, are recognised in profit or loss. IFRS outlook September 2008 5
Post-employment benefits views on proposed amendments continued Of the three approaches, Approach 1 seems to be most consistent with the conceptual framework and the least complex to implement and understand. However, given that the Board is still in the process of addressing fundamental presentation issues, it believes other alternatives may be appropriate (at least for the short-term). We do not support Approach 2, as we believe it is not appropriate to exclude interest costs, a significant cost of providing pension benefits, from profit or loss. We consider Approach 3 to be an acceptable alternative, if it were further developed. This approach would avoid volatility in earnings that might otherwise be caused by fluctuating financial markets, which are outside of an employer s control. Such an approach requires additional consideration of how interest income on plan assets would be identified. In its DP, the Board considered three methods of estimating interest income: 1. Using the expected return on plan assets, as currently required by IAS 19; 2. Using dividends received on equity plan assets and interest earned on debt plan assets (using the current rate market participants would require for equivalent assets); or 3. Using market yields at the reporting date on high-quality corporate bonds to impute interest income. Conceptually, we believe the second method to be the most appropriate of those noted. However, there are a number of practical problems that will have to be further considered. Contribution-based promises One area of post-employment benefit accounting that has given rise to many questions is how to account for hybrid schemes which have features of both defined benefit and defined contribution plans. The IFRIC attempted to solve this issue in 2004. However, it later dropped the project. The Board is now proposing to introduce a new category of post-employment benefits, called contributionbased promises, for which it is proposing a new accounting approach. Contribution-based promises are those based on actual or notional contributions plus an asset-based return. This will include defined contribution plans as currently defined under IAS 19, as well as certain plans, such as cash-balance plans, that are currently classified and measured as defined benefit promises. The Board proposed that contribution-based promises are to be measured at fair value, assuming that the benefit promise does not change, with all movements in the plan assets and benefit obligation recognised in profit or loss in the period in which they occur. The DP refers to three distinct phases within the life cycle of benefit plans: accumulation, deferral and payment. (See the box on the opposite page for a summary of these phases). In this context, the DP suggests that an entity should measure the liability for benefits in the same way throughout its life cycle. Thus, a benefit promise determined to be contribution-based would continue to be measured at fair value throughout its life cycle. Depending on the approach adopted, the changes may have a significant impact on reported profit or loss. 6 IFRS outlook September 2008
Phases in the life of an employee benefit promise: Accumulation period during which the employee renders service and earns benefits promised Deferral period during which the employee no longer renders service in exchange for benefits, but before benefit payments begin Payment period during which benefit payments are made Our main concern is that the contribution-based promises approach proposed by the Board may result in two economically similar obligations being accounted for in different ways, during the deferral and payment phases of benefit promise. If the benefit, while accumulating, had been classified as a contribution-based benefit, the expected annuity payment stream would be measured at fair value based upon current market discount rates adjusted for credit risk. However, if the same benefit had been classified as a defined benefit promise, the expected annuity payment stream would be discounted, based upon market yields on high quality corporate bonds, with no consideration of credit risk of the plan sponsor. Furthermore, given the proposed full recognition of movements of contribution-based promises in profit or loss, significant presentational differences could exist between two economically similar benefit obligations if the Board follows Approach 2 or 3 (discussed above) for defined benefit presentation, either of which results in a portion of pension expense being recognised outside of profit or loss. Although we understand the Board s desire to address the accounting issue for hybrid plans, we do not believe it is appropriate to introduce new inconsistencies into IAS 19. Accordingly, we do not support the introduction of the contribution-based promises approach at this time, in the absence of broader redeliberation of IAS 19 or the underlying principles. Next steps We believe the proposed changes, particularly the elimination of smoothing mechanisms, will be a significant change for preparers, and are likely to ignite some debate. At this time, the concepts put forth by the IASB are in the form of a Discussion Paper, which we would expect to be followed by an Exposure Draft of amendments to IAS 19. Therefore, while there will be a further opportunity to comment on the Board s proposal, it is important that preparers make their views known now. The IASB has requested comments on the DP by 26 September 2008. IFRS outlook September 2008 7
Guidance on the fair value of financial instruments in markets that are no longer active Over the past twelve months, the markets for many financial instruments have become inactive, resulting in difficulties for financial service organisations and corporate entities in determining their fair value. In response to this and the recommendations of the Financial Stability Forum, in April this year, the IASB convened an expert advisory panel to determine guidance on measuring and disclosing the fair value of financial instruments in such markets. The panel is chaired by an IASB board member, with panel members drawn from the banking and insurance industries, regulators, large audit firms (including Ernst & Young), analysts (including a rating agency), a FASB staff observer, an academic and IASB board members. The panel has met six times since June this year, with the aim of providing guidance to financial statement preparers. In this article, we look at what the panel has been doing and some of its preliminary thinking. Overview The panel s objective is to issue a document that sets out best practices, drawing on its experiences in the valuation of financial instruments in markets that are no longer active. This includes considering associated disclosures. The panel confirmed that it is not its intention to change current standards or to make interpretations. Moreover, its scope does not extend to other financial instruments or to impairment. The first four meetings of the panel focused on valuation matters such as evaluating available market information, including quotes received from brokers and pricing services, the use of models and measuring changes in own credit spreads. The panel agreed that it is a misconception that different entities should arrive at exactly the same fair value in situations where estimation and judgement are part of the valuation process. This is because different entities make their own estimates, the outcome of which is always subject to variation. It is through disclosure that users understand the main variables used in determining fair values by management and, therefore, the reasons for any differences. The panel agreed that a forced sale is very rare, arising only in situations such as where a regulator forces an entity to sell a particular instrument for a certain price. In other situations, where there is the opportunity to find a buyer and negotiate a price, there is, in fact, no forced sale. Therefore, if a market transaction has occurred in a particular instrument, this transaction price should always be the starting point for determining the instrument s fair value. If there is no transaction in the particular instrument, but there is a transaction in a similar instrument, then the transaction price of the similar instrument should be used as the starting point for the valuation. The panel also discussed broker quotes, focusing in particular on when it may be appropriate to use them in determining the fair value of instruments. It was agreed that it would be unusual to use a quote from only one broker, or a simple average of a range of broker quotes. The panel confirmed that it is also important that an entity understands all the terms of the instrument, the variables that were taken into account in the quote and the degree of risk 8 IFRS outlook September 2008
involved. The more prices available, the more reliable is the fair value determined. The panel also discussed the use of three different types of pricing services: consensus pricing services; pricing services that arrive at a price using a proprietary model; and pricing services that arrive at a price based partly on consensus prices and partly on their proprietary model. An entity may also develop its own model to calculate the fair value of an instrument where there is no active market. Such a model should not incorporate adjustments introducing conservatism. But it is appropriate to include a discount for the instrument s illiquidity, if a potential buyer of the instrument were to do the same in determining the price it would be willing to pay. Furthermore, all market movements, no matter how illogical they may seem, need to be taken into account when determining values of the variables in the model. These issues will be considered in more detail in the panel s report. In the last two meetings, the panel focused on best practices for disclosure, including some that are currently not explicitly required by IFRS 7. Clearly, there is a balance to be struck by management on how much information should be included about financial instruments no longer traded in an active market. The panel agreed that the more significant the instrument is and the more difficult it is to value the instrument, the more disclosure would be expected in the financial statements. The panel also considered the disclosure of valuation techniques and unobservable inputs used in models. The level of detail for best practice disclosure in this area is likely more extensive than what is currently required under IFRS. For example, instead of presenting the sensitivity of fair values to other reasonably possible assumptions as one number, an entity may show this effect by class of financial instruments. Also, an entity may include a reconciliation at the beginning and end of the period for those instruments for which the fair value was determined using a model with one or more unobservable inputs, including movements between the different levels (from the level of models with only observable inputs to the level of models with one or more unobservable inputs, or vice versa). Currently, IFRS 7 requires an entity to disclose the total change in fair value arising from estimating fair value using a valuation technique with unobservable inputs. The panel thought that the relevance of such disclosure could be increased, not only by showing the amount recognised in the income statement, but also the change in fair value that relates to just the unobservable input. Doing so would avoid showing a large value as unobservable, without showing the extent to which there may be other contracts that are, in part, effective hedges and, so, overstating the exposure to the effects of changes in the unobservable inputs. An example of such a situation is a structured liability that has unobservable inputs, however, the risk-free interest rate risk of the liability is hedged with a plain vanilla interest rate swap which is presented in the column with observable inputs. Another best practice discussed was the description of the sources of inputs used to calculate the change in fair value of liabilities due to own credit risk, as opposed to only showing the method used and the value. Next steps This month, the IASB plans to publish for comment, a draft of the recommendations of the panel. After comments have been considered, a final document will be issued. Although the publication will not have the status of an interpretation or implementation guidance, we expect that the IASB will incorporate these recommendations into future amendments of standards, and/or future standards. It is, however, unclear how regulators will view the recommendations of the panel and the extent to which they will enforce their application. Overall, we believe that the document to be published by the IASB should help answer some of the questions preparers have raised about those instruments that are most impacted by the credit crisis, as well as providing valuable best practice recommendations for disclosures relating to such instruments. IFRS outlook September 2008 9
Upcoming comment letters We highlight below documents issued by the IASB and the IASCF, awaiting comments. Many of these are due later this month. Document Comment letter due date Discussion Paper Reducing Complexity in Reporting Financial Instruments 19 September 2008 Discussion Document Review of the Constitution. Public Accountability and the composition of the IASB. 20 September 2008 Discussion Paper Preliminary views on amendments to IAS 19 Employee Benefits 26 September 2008 Discussion Paper Preliminary views on an improved Conceptual Framework for Financial Reporting: The Reporting Entity Exposure Draft An improved Conceptual Framework for Financial Reporting: Objective of Financial Reporting and Qualitative Characteristics and Constraints 29 September 2008 29 September 2008 Exposure Draft Improvements to IFRSs 7 November 2008 Exposure Draft Simplifying Earnings per Share 5 December 2008 10 IFRS outlook September 2008
Resources Supplement to IFRS outlook Issue 13 ED simplifying earnings per share The IASB recently published an Exposure Draft (ED) proposing amendments to simplify IAS 33 Earnings per Share. This publication highlights the aim of the ED: to reduce the differences between IFRSs and US GAAP, to clarify the type of instruments to be included in the average number of shares for the EPS calculation, and to simplify that calculation. Coming soon 2008 Year-end IFRS update This publication summarises the new and amended IFRS standards and interpretations that are applicable to financial periods beginning on or after 1 January 2008. It also highlights other new and amended IFRS standards and interpretations that have been issued up to 30 September 2008 but are not yet effective. The publication also includes a summary of the IFRIC agenda decisions that provide accounting guidance on IFRS interpretations. IFRS outlook September 2008 11
Ernst & Young Assurance Tax Transactions Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 130,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve potential. For more information, please visit www.ey.com Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. About Ernst & Young s International Financial Reporting Standards Group The move to International Financial Reporting Standards (IFRS) is the single most important initiative in the financial reporting world, the impact of which stretches far beyond accounting to affect every key decision you make, not just how you report it. We have developed the global resources people and knowledge to support our client teams. And we work to give you the benefit of our broad sector experience, our deep subject matter knowledge and the latest insights from our work worldwide. It s how Ernst & Young makes a difference. www.ey.com/ifrs 2008 EYGM Limited. All Rights Reserved. EYG no. AU0154 In line with Ernst & Young s commitment to minimise its impact on the environment, this document has been printed on paper with a high recycled content. This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor. IFRS outlook September 2008