March 2012 Issue 11
Reporting Welcome from the Editor Marco Mongiello Welcome to the eleventh edition of RSM Reporting – the newsletter from RSM International covering technical developments in global accounting and reporting.
In this edition we focus our attention on some particularly hot topics in accounting and reporting.
In this issue:
Another much talked about topic is the leasing project, developments of which we have recently addressed from various points of view (see RSM Reporting issues 8 & 9). In this edition, Paule and Katell illustrate their perspective of the leasing project impact on businesses and the leasing market.
Section 1: Accounting and reporting this quarter
Updates from the IASB and EFRAG Section 2: The point of view of ...
...Andy Simmonds on Consolidation
...Gil Rosenstock and Shlomi Shuv on IFRS for SMEs – Hierarchy to establishing accounting policy (3 of 3)
...Paule Bouchard and Katell Burot on business impacts of IFRS developments on leases Section 3: Hot Topics in Accounting by Joelle Moughanni
The new IFRS 10 and IFRS 11 on joint ventures and consolidation are certainly among some of the most discussed, both for the change they bring and for the change they do not bring to the reporting practice. We were fortunate enough to discuss this topic with Andy Simmonds who shared with us his practitioner’s, academic and regulatory view. As you can expect, you will find some valuable insights in those pages.
Anything that has to do with global warming is ‘hot’ by definition and so is the accounting treatment of Carbon Trading Schemes. Hence, this is the perfect topic for Joelle’s new column ‘Hot Topics in Accounting’. The topic is analysed in light of the developments that have occurred since it was first addressed in issue 4 (two years ago) of this newsletter. Finally, Gil and Shlomi bring to a conclusion their three-part series on IFRS for SME, with insights that will help our readers to better comprehend the 2012 first review process of these new standards. Enjoy your reading.
Dr Marco Mongiello ACA E: firstname.lastname@example.org
Accounting and reporting this quarter
IASB >> for further news and updates please visit www.ifrs.org
IASB December 2011 The IASB and the FASB issued common disclosure requirements that are intended to help investors and other financial statement users to better assess the effect or potential effect of offsetting arrangements on a company’s financial position. The eligibility criteria for offsetting are different in IFRSs and US GAAP. Offsetting, otherwise known as netting, is the presentation of assets and liabilities as a single net amount in the statement of financial position. Unlike IFRSs, US GAAP allows companies the option to present net in their balance sheets derivatives that are subject to a legally enforceable netting arrangement with the same party where rights of set-off are only available in the event of default or bankruptcy. An exposure draft addressing these differences was issued in January 2011. However, in response to feedback from their respective stakeholders, the boards decided to retain their existing offsetting models and instead issue new disclosure requirements. The Chairman of the IASB said: “These disclosures will help investors to bridge differences in the offsetting reporting requirements of IFRSs and US GAAP, while the additional requirements will also provide better information on how companies mitigate credit risk related to offsetting. That said, using disclosures to bridge differences in offsetting requirements was plan 'B' for both boards.”
The Chairman of the FASB said “The expanded disclosures are responsive to the feedback we received from investors, who wanted to understand both the gross and the net amounts for items offset in accordance with legally enforceable netting arrangements. We are also requiring expanded information about the collateral pledged and held in these arrangements.” Companies and other entities are required to apply the amendments for annual reporting periods beginning on or after 1 January 2013, and interim periods within those annual periods. The required disclosures should be provided retrospectively. The IASB decided that the mandatory effective date of IFRS 9 Financial Instruments be deferred from 1 January 2013 to 1 January 2015. Early application of IFRS 9 is still permitted.
January 2012 The IASB and the FASB agreed to work together to seek to reduce differences in their respective classification and measurement models for financial instruments. IASB Chairman said: “When IFRS 9 was introduced in 2009 we said that further amendments might be required once the direction of travel on insurance contracts became clear. We are now at that point. At the same time, this limited-scope review now presents an ideal opportunity to align IFRS and US GAAP more closely, in this important
area of financial reporting. We will proceed with caution, recognising the investment that many jurisdictions have made in preparing for the introduction of IFRS 9 in 2015.” The FASB Chairman said: “The boards will share the feedback they have received on their respective decisions and strive to develop a more closely converged approach that addresses those concerns. The boards will continue to develop a common approach on impairment of financial assets, which is being handled as a separate work stream.” The IASB and the FASB have agreed that purchased financial assets with an explicit expectation of credit losses at acquisition should be included initially in Bucket 2 or 3 and no impairment loss would be recognised on acquisition. The purchase discount would be accreted from the purchase price to the expected cash flows. Any subsequent unfavourable change in expected cash flows would be recognised as an impairment loss on the basis of changes in expected lifetime loss from period to period. Hence, unlike the approach for all other originated and purchased financial assets, purchased financial assets with an explicit expectation of credit losses at acquisition would not be included in Bucket 1 at acquisition.
February 2012 No major news to be reported. =====================================
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EFRAG >> for further news and updates please visit www.efrag.org
EFRAG December 2011 No major news to be reported. =====================================
January 2012 EFRAG published its agreement with the IASB’s proposal for an exception to the consolidation principle, whereby investment entities are required to measure their investments in controlled entities at fair value through profit or loss in accordance with IFRS 9. This is because measuring an investment entity’s controlled investments at fair value produces more decision-useful information that meets users’ needs as it better reflects the entity’s business model. However, EFRAG believes that a non-investment entity parent should be required to consolidate its investment entity subsidiaries, but that it should retain the fair value measurement of the controlled entities that are held through those investment entity subsidiaries (i.e. the parent would ‘roll-up’ the accounting of its investment entity subsidiary). The SME Working Group of the European Financial Reporting Advisory Group (EFRAG) and IASB issued an update report with the following highlights: (i) the number of countries adopting or planning to adopt IFRS for SMEs is now higher than 70 and (ii) IFRS for SMEs are now due for their first major tri-annual review.
EFRAG supports the Amendments to IFRS 1 Severe Hyperinflation and Removal of Fixed Dates for First-time Adopters, which introduce a new exemption in the scope of IFRS 1 First-time Adoption of International Reporting Standards. Under these amendments entities that had been subject to severe hyperinflation are allowed to use fair value as the deemed cost of their assets and liabilities in their opening IFRS statement of financial position. In addition, the Amendments also replace the references to fixed dates in IFRS 1 with references to the date of transition. EFRAG supports IFRS 13, which sets out a single IFRS framework for measuring fair value and provides comprehensive guidance on how to measure the fair value of both financial and non-financial assets and liabilities. IFRS 13 applies when another IFRS requires or permits fair value measurement or disclosures about fair value measurements, but it does not set out requirements on 'when to' apply fair value measurement.
February 2012 EFRAG has issued its initial assessments and draft assessment letter of IFRS 10 Consolidated Financial Statements, IFRS 11 Joint Arrangements, IFRS 12 Disclosure of Interests in Other Entities, IAS 27 Separate Financial Statements and IAS 28 Investments in Associates and Joint Ventures.
The point of view of ...
1 Andy Ian Mackintosh Simmonds … on Consolidation Global financial crisis and and a change at the top:top: a crucial timetime for the global financial crisis a change at the a crucial the IASBIASB for the
The words attributed to the interviewee represent his own personal opinions and do not represent the official position of the ICAEW or EFRAG. It is vital for Accounting and Reporting that principles and rules as set by the standard setters make sense for the practitioners and obtain academics’ broad intellectual endorsement. The former is because on a daily basis preparers and users worldwide base their professional decisions on accounting standards and on accounting information, hence principles and rules must conform to the daily informational needs of the business world. In addition, the academic endorsement guarantees that developments are made focusing on a wider scheme rather than pushed by the urgent day-to-day necessity. Standard setters must reach out to both practitioners and academics in order to obtain recommendations and suggestions to support the thought process that leads to issuing new standards. As obvious as this statement may sound, its implementation requires the commitment of huge efforts and considerable resources to elicit observations, comments, recommendations and dialogue from the global communities of practitioners, academics and standard setters. Andy Simmonds plays an important role in making this happen, by blending his academic capacity, his professional expertise and his regulatory contribution. Andy recently authored an article on the new consolidation standards, published in the Members’ Journal of the Financial Reporting Faculty at ICAEW (January 2012) and my conversation with him builds on that article.
What was in your opinion the aim for the IASB to issue IFRS 11? Has the IASB achieved this aim? “Under IAS 31, the current standard, the primary consideration is the legal structure as to whether the arrangement is an entity or not an entity. If it is an entity we are required to say that it is a jointly controlled entity but we then have a choice of applying the equity method or the proportionate consolidation. Now, one of the IASB’s issues is to eliminate options. The real issue behind the equity method for preparers is that it gives a net presentation. It shows a share of a net profit after tax and net assets, so it represents the whole joint agreement in one line, whereas the proportionate consolidation is a gross presentation. So, the matter for preparers is often more about net or gross presentation than whether it is a joint entity or a joint operation. For example, there are quite a significant number of property companies who use the option of proportionate consolidation, which enables them to show the rental income within the revenue line. That is a significant issue; the property company’s revenue is one of the key performance indicators that they would compare to other companies. Under the old regime [IAS 31 is current but is called ‘old’ because it is being superseded by IFRS 11] we had the option to have the separate gross presentation, even when we were structured as an entity. In order to allow companies to continue to use the gross approach, even in the case that their joint arrangement is structured through a separate vehicle, the IASB inserted an additional step. Although the joint arrangement may be structured as a separate vehicle, which appears to be an entity, this additional step enables a company to look at the way which the assets, the liabilities, the revenues and the expenses can be allocated and, if they can be allocated on a more specific basis, then the company can achieve a gross presentation for revenues and assets. Those property companies in the above example, because they have lost the option of applying proportionate consolidation of separate entities, have to justify joint operation classification in order to be able to continue to enjoy gross revenue in their P&L account, by considering the legal form, the terms of the contractual arrangement and, if relevant, other facts and circumstances. Clearly there is a critical decision: as to whether we can identify separable, identifiable, divisible interests in specific assets and revenues or whether the companies are interested in the net profit and assets. We don’t find anything that is really specific in the standard (IFRS 11) to help with that analysis, so we need to apply first principles.
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Consider companies which have different percentages in rights and liabilities in a joint arrangement. Typically, one entity may be an insurance company who has an interest as a long term investor and another entity, which may be the developer, and then there may be a construction company. If you can identify a distinct role, then it is not unusual to find that they will have a slightly different exposure to liabilities: one of the parties will undertake to guarantee the entire debt, whereas the other party may have a different exposure. Particularly when you examine the liabilities you might find that there is a disproportion. That might be the significant factor to justify joint operation under IFRS 11. However, if we end up in a situation where a company has 30% of the assets and 30% of the liabilities, 30% of the revenues and 30% of the expenses, does that automatically mean that the joint arrangement is presumed to be a joint venture? This is relevant because we are going to see the pressure of companies that will want their joint arrangements to be joint operations. Under IAS 31, because arrangements had been structured through a jointly controlled entity, you were required to say it was a jointly controlled entity, therefore you had to account using joint venture accounting, which meant that you had a choice. The fact that you had a choice took the pressure off. As much as many entities were quite content to account using the net equity method, many others, e.g. in the property sector, preferred the gross proportional method. I think that, once the new standard gets under way, it will be quite an interesting area of research to look at and find out who takes which model. Will a particular industry or sector tend to take a particular model, for example? I expect that for most companies the presentation in the accounts will look exactly the same under IAS 31 (applying the option) and IFRS 11 (considering the legal form etc.) I think that in practice we will find companies almost deciding what accounting outcome they would like, whether they want a net outcome or a gross outcome and then, in a sense, backing the argument to emphasise the contractual arrangements and other facts and circumstances. Obviously the effect on the bottom line of the income statement is exactly the same, but I think the lack of a detailed guide in the new standard will enable the companies to make that choice.”
Let us turn our attention to IFRS 10, where we seem to have a similar story; a new standard but, perhaps, not much difference in how it will be implemented in practice. What is your position on this? “This is an area where a significant role is played by your experience in practice, familiarity with the examples that are around, and appreciation of what’s really going on on the ground. You then try to reconcile this with the principles that are in the accounting literature. When the IASB set out to deal with this area, my first response was that we have not been encountering significant problems. The IASB claimed that there were two different sets of principles: a control model in IAS 27 and risk / reward in SIC-12. The IASB suspected that there were differences in outcomes of those two. My point of view is that there wasn’t any difference in outcomes! Secondly, the IASB were clearly under pressure from the G20 to look at the consolidation rules, the premise being: is there anything off-balance sheet that should be in the statement of financial position? The conclusion I drew was that under the IFRS framework there was nothing missing from the statement of financial position: everything that should be in the statement of financial position is in the statement of financial position! It was more a US GAAP problem. The third issue was the convergence challenge. The IASB and FASB worked together, but late in the day the US decided not to adopt the draft standard. They had just changed their variable interest standard. And they like their 50% - a legal concept and a nice bright line! The two areas where the IASB seemed to think there might be a practical problem are those of ‘diversity in practice’ and ‘disclosure of unconsolidated structured entities’. Two examples which illustrate a potential change are: 1) where somebody had more than 50% economic exposure but when, upon analysing it, you would realise that there was no power, i.e. somebody had a big economic exposure but could be removed as the investment manager and 2) the situation where somebody had a minority holding such as a stake in an investment vehicle of, say 30%, but they couldn’t be removed and therefore they would appear to have more power. The IASB seemed to assume that the first case would be consolidated, but not the second.
The point of view of ...
Andy Simmonds … on Consolidation
But in fact they got it wrong on both! This was the type of judgement we were already making based on the definition of control being ‘power + benefits’: if you could not be removed as an investment manager, we would evaluate what level of economic exposure we think is significant and decide whether there is control or not. I would say we would probably put that percentage at 5-10%. So, if you cannot be removed and have more than 5-10% economic exposure, we would assume control exists and therefore you must consolidate [unless others’ control is obvious]. In the situation where you had a majority stake but you could be kicked out, we would have said that is not control, so you should not consolidate. Interestingly, the presumption of the IASB seems to be the opposite; they seem to think that the classification depends more on economic exposure rather than on the power. In practice, in the UK at least, I do not expect that we are going to find many changes in the classification as a result of this. What the IASB has produced is largely consistent with what I, as a practitioner, used to advise. According to my analysis of IFRS 10 control means power plus returns plus a link. In some situations IFRS 10 provides a quite useful articulation of some of the things we have done in the past but we did not have the words in the standard to support what we meant. If I had to condense IFRS 10 down to one phrase it would be: “do you have the practical ability to act unilaterally?” The analysis of ‘link’ is basically a discussion of principal / agent problem. Applying it to the fund management area you should think about the scope of authority and design, removal rights, the level of remuneration, and the level of variable returns. By looking at those we can build up a picture as in the following example of an investment vehicle where the investor holds 30% of the equity and also is the asset manager who manages the vehicle’s asset portfolio, he receives a management fee of 20% of returns (and this is market rate) and can be removed only for breach of contract. Taking a 30% equity stake suggests the objective is more than just providing investment advice for an advisory fee. The manager can only be kicked out for breach of contract, which looks protective. However, the manager is paid the
market rate of compensation: this alone is not inconsistent with an agent relationship. On the other hand the manager has a 30% equity return and there is an example in the standard where they seem to suggest that 20% is the tipping point. I think we would have got it much lower in the past, at 5 to 10%. But certainly 30% is significant. Based on holding 30%, having a 30% return and the restrictive clause of ‘removal for breach of contract’, we would conclude the manager is principal and I think this is very much the type of analysis we would have done in the past, but the standard has articulated that in a logical way. I think that piece of the standard is actually quite useful.”
We could argue that this is one of the roles of the IASB that works on two levels; on one hand, it is formalising what is happening if it is good and, on the other hand, is giving new direction if the current practice is not good. “Initially when we took our first look at this in EFRAG, the members of the Technical Expert Group were asked if anybody was going to have a problem with recommending the EU to endorse IFRS 10. I was the first one to put my hand up to say: ‘I think I will have a problem, because as I see it there is much greater judgement involved in how we have to approach classification. I think that IFRS 10 could potentially lead to less consistency. I don’t perceive that there is a problem presently with the way that this is dealt with. Therefore overall this might have a negative effect on the consistent application and may allow companies to engineer the answer that they would like to get by tweaking the facts.’ However, as I have got more into the standard and have actually sat down with companies, particularly in the banking industry who have gone through a very thorough exercise in looking at all of their special purpose entities, much of the guidance has proved very helpful to articulate how we might have applied it in the past. I think that generally companies, including banks, have got a pretty good grasp of what it is that they are supposed to be doing here and I think that the result is OK. So, I have actually become more
Issue 11, March 2012
accepting and within EFRAG I have said that I am OK to support IFRS 10. If any problem will be encountered on this matter in the EFRAG endorsement process, it will not be a disagreement with the principle, but with the amount of work that needs to be done by the effective date of the standard.1 In the UK, this should not be a problem because I have seen most companies already applying this approach. Another problem with the effective date is that there are aspects of this matter that have not been finished, e.g. the investment entity area, which is still in draft. You get a very strong reaction from some other countries against trying to operate on that incomplete basis. They want everything done and complete and to understand how the whole thing is going to behave together. France and Germany, in particular, see this lack of guidance as more problematic and would like the IASB to give more guidance so that companies have less discretion. They want consistency, which in turn needs more rules! An interesting difference in national approach!”
In conclusion, I found myself even more convinced that consolidation is an area of accounting and reporting worth keeping an eye on, and I trust that upon reading and hearing Andy’s observations, reflections and insights, our readers will feel equally intrigued by the theoretical and practical ramifications of the new standards.
There have been some developments with regards to the endorsement of IFRS 11 since the interview was carried out. There are now four TEG members against and giving dissenting views. Although this still gives an 8:4 majority in favour, this may give politicians grounds for delay, particularly given that three of the dissenting countries are Italy, France and Germany.
Guest Contributor: Andy Simmonds Andy is Chairman of the Institute of Chartered Accountants in England and Wales (ICAEW) Financial Reporting Faculty and Member of the ICAEW Council, Member of EFRAG Technical Expert Group and of the UK Accounting Standards Board. As a Partner in the National Accounting and Audit department of Deloitte in London, Andy provides advice on financial reporting topics to audit partners and senior staff. He is a contributing author and editor of Deloitte’s UK and international books published under the “iGAAP” and “ukGAAP” titles, and represents the firm on various external professional committees.
The point of view of ...
Gil Rosenstock and Shlomi Shuv … on IFRS for SMEs – Hierarchy to establishing accounting policy (3 of 3)
This is the third and last article in a series on the application of IFRS for SMEs in practice. In the first two articles we introduced the concept of hierarchy of sources that preparers should use when faced with lack of explicit directions in the IFRS for SMEs. We also listed and proposed a solution for eight such cases: »» »» »» »» »» »» »» »»
Transfer of a property to, or from, investment property Classification of gains from sale of assets held for rental Accounting-policy choice for the recognition of actuarial gains and losses Offsetting a financial asset and a financial liability in the statement of financial position Quantitative threshold in relation to substantial modification of the terms of a financial liability Date of documenting hedging relationship Exceptions to the recognition and measurement principles used to account for business combinations Classifying and designating assets acquired and liabilities assumed in a business combination
In this article, we will further cover the following cases: »»
»» »» »»
Measuring non-controlling interests in an acquiree Reverse acquisitions The requirement for the difference between the reporting date of a subsidiary and that of a parent to be no more than three months Fair-value measurement for associates with published price quotations
Measuring non-controlling interests in an acquiree For each business combination, IFRS 3 allows an entity to choose one of two alternatives for measuring a non-controlling interest in an acquiree which is a present ownership interest and entitles holders to a proportionate share of the entity’s net assets in the event of liquidation:
at fair value; or
as the present ownership instruments’ proportionate share in the recognised amounts of the acquiree’s identifiable net assets.
Since goodwill is defined in IFRS 3 as a residual value, entities that choose to measure non-controlling interest at fair value recognise in effect the part of goodwill attributable to the non-controlling interest in their consolidated financial statements. Consequently, under this
choice, goodwill is not measured at the excess of the cost of the business combination over the acquirer’s interest in the recognised amounts of the identifiable net assets of the acquiree. There is no specific guidance in the IFRS for SMEs for measuring noncontrolling interests in an acquiree. Based on the hierarchy to establishing accounting policy [see first article of this series in issue 9 September 2011], an entity shall turn to the requirements and guidance in the IFRS for SMEs dealing with similar and related issues. In the authors’ view, an entity shall turn to the guidance in the IFRS for SMEs for measuring goodwill. The IFRS for SMEs states that, at the acquisition date, the acquirer shall measure goodwill at the excess of the cost of the business combination over the acquirer’s interest in the net fair value of the identifiable assets, liabilities and contingent liabilities. Therefore, in order for the goodwill to be measured as stated in the IFRS for SMEs, in the authors’ view, SMEs are not allowed to measure noncontrolling interests in an acquiree at fair value, but rather at the noncontrolling interest’s proportionate share of the acquiree’s identifiable net assets. Measuring non-controlling interests in an acquiree at fair value would in effect cause the goodwill recognised in the consolidated financial statements to include the part of goodwill attributed to non-controlling interest, which is not permitted under the IFRS for SMEs.
Reverse acquisitions A reverse acquisition most commonly occurs in practice when the entity that issues securities (the legal acquirer) is identified as the acquiree for accounting purposes. Both IFRS 3 and the IFRS for SMEs include detailed guidance for identifying the acquirer in a business combination. The acquirer is defined as the combining entity that obtains control of the other combining entities or businesses. However, only IFRS 3 provides additional guidance for accounting for reverse acquisitions, including requirements for measuring the consideration transferred, measuring non-controlling interest in the accounting acquiree (the legal acquirer), disclosing earnings per share and preparing consolidated financial statements. There is no guidance in the IFRS for SMEs as to how to account for reverse acquisitions. Where there is no specific guidance in the IFRS for SMEs for accounting for a certain transaction, the hierarchy for establishing accounting policy requires an entity to turn to, among other sources, the Concepts and Pervasive Principles section of the IFRS for SMEs.
Issue 11, March 2012
The Concepts and Pervasive Principles section of the IFRS for SMEs states that transactions should be accounted for and presented in accordance with their substance and not merely their legal form. Therefore, in the authors’ view, SMEs shall apply the same guidance for reverse acquisitions as set out in IFRS 3, since the legal acquiree in a reverse acquisition is the combining entity that obtains control of the legal acquirer.
Furthermore, in the authors’ view, the length of the reporting periods and any difference between the reporting dates are not required to be the same from period to period.2
Fair-value measurement for associates with published price quotations
The requirement for the difference between the reporting date of a subsidiary and that of a parent to be no more than three months
The IFRS for SMEs allows an investor to account for all of its investments in associates using one of the following: (a)
the cost model;
IAS 27 includes guidance for a situation where the financial statements of a subsidiary used in the preparation of consolidated financial statements are prepared as of a date different from that of the parent’s financial statements.
the equity method; or
the fair value model.
IAS 27 states that when the date of financial statements of a subsidiary used to prepare consolidated financial statements is different to that of the parent, the difference between the reporting date of the subsidiary and that of the parent shall be no more than three months. In addition, IAS 27 states that the length of the reporting periods and any difference between the reporting dates shall be the same from period to period. Those requirements are not included in the IFRS for SMEs. This standard states only that the financial statements of the parent and its subsidiaries used in the preparation of consolidated financial statements shall be prepared as of the same reporting date unless it is impracticable to do so. Where the issue not addressed in the IFRS for SMEs cannot be settled by turning to the guidance in the IFRS for SMEs dealing with similar and related issues or the Concepts and Pervasive Principles in the IFRS for SMEs, the hierarchy to establishing accounting policy allows, but does not require, management to consider the requirements in full IFRSs dealing with similar and related issues. It should be noted that the Basis for Conclusions on the IFRS for SMEs specifies the main changes from the principles proposed in the exposure draft. One of the changes is the elimination of the requirement, when applying the equity method, of a maximum three-month difference between the reporting date of the associate or jointly controlled entity and that of the investor. The Basis for Conclusions refers only to applying the equity method, and does not mention the requirements as to the reporting date of a subsidiary when a parent prepares consolidated financial statements. Based on the hierarchy to establishing accounting policy, in the absence of a specific guidance in the IFRS for SMEs in respect of the reporting date of a subsidiary and the length of its reporting periods, in the authors’ view, an entity is not required to turn to full IFRSs, but rather is allowed to consolidate a subsidiary where the difference between the reporting date of the subsidiary and that of the parent is more than three months, provided that adjustments are made for the effects of significant transactions that occur between those two reporting dates.
On this matter there are widely diverging opinions: others point out that advocating a difference with IAS 27 is weakly defensible a stance and do believe that consistency from period to period should be required. It is also worth pointing out that neither the IFRS for SMEs nor IAS 27 require that audited annual financial statements have to be used. A parent could use management accounts of a subsidiary for consolidation, and it would be up to the auditor of the parent, based on their assessment of risk and materiality, to determine what audit procedures would be necessary. 2
For an investor that chooses to use the cost model, the IFRS for SMEs requires that investments in associates for which there is a published price quotation be measured using the fair value model. It is important to note that the Basis for Conclusions on the IFRS for SMEs states that contrary to IAS 28 (which requires investments in associates to be measured using only the equity method and does not make an accounting measurement distinction when associates happen to have a published price quotation) SMEs are required to account for any investment in an associate for which there is a published price quotation using the fair value model. However, the requirements in the IFRS for SMEs for an investor that uses the equity method do not include any guidance for accounting for associates for which there is a published price quotation. Furthermore, the IFRS for SMEs requires an investor in an associate to disclose the fair value of investments in associates accounted for using the equity method for which there are published price quotations. If the “requirement” inferred by the Basis for Conclusions was in fact a requirement of the standard, this disclosure requirement would be unnecessary. In light of the fact that the Basis for Conclusions accompanies, but is not part of, the IFRS for SMEs, in the authors’ view an investor is allowed to account for its investments in associates using the equity method, even for associates for which there are published price quotations and would disclose the fair value of these investments in the notes to the financial statements.
Gil Rosenstock, CPA, IFRS Consultant Head of Professional Practice in RSM Shiff, Hazenfratz & Co, Israel T: +972 (3) 791 9111 E: email@example.com Shlomi Shuv, CPA, IFRS Consultant, Vice Dean at the School of Business (IDC) Herzliya, Israel T: +972 (9) 952 7655 E: firstname.lastname@example.org
The point of view of ...
Paule Bouchard and Katell Burot … on business impacts of IFRS developments on leases
The leases project has been a topic of controversy for more than a year now. The Exposure Draft (ED) initially published in August 2010 (2010 ED) in connection with a joint project involving the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) led to many comments, followed by numerous redeliberations between the two Boards. Even if the second version of this project, expected at the end of the first half of 2012, will have been simplified in many respects, it is still a hot topic: the leases project and the resulting consequences remain a major issue for businesses. From the accounting to the business impacts, how can this project impact the leasing market? Overview of the main underlying principles The “right of use” is the central concept in the 2010 ED. A lease is now defined as a contract in which the right to use a specified asset is conveyed to a third party for a period of time, in exchange for consideration. According to this definition, two elements become of importance: the concept of control of the asset and the notion of specific identifiable asset. Where lessees are concerned, this concept results in the recognition of most lease contracts in the statement of financial position, representing the right to use an asset, in exchange for debt payable equivalent to the present value of the future lease payments over the duration of the lease term. Where lessors are concerned, the IASB and the FASB very recently agreed on a single model: ‘the receivable and residual asset model’. In concrete terms, this means that the lessor will de-recognise the underlying leased asset and instead record a right to receive future payments (at present value) as well as a net residual asset in the asset section of the statement of financial position. However, certain types of leases are excluded from the scope of the project, including short-term leases and leases of investment property. Even if the revised ED will bring simplification compared to the initial version of the project, this project makes analysing and monitoring leases more complex and entities must prepare to deal with this increased level of complexity.
Is this a real transformation or merely the evolution of the leasing market? From an accounting standpoint, the changes are undeniable. The distinction between a finance lease and an operating lease has been obliterated. The main results are “grossed up” statements of financial position, changes to the method used to recognise expenses and impacts on ratios. However, can this project profoundly transform business models and the leasing market? What motivates an entity to lease its assets? A number of factors are involved when deciding to enter into a lease. Cash flows are generally a key factor. A lease allows investing in non-current assets and increasing future revenues without having to make an initial cashdown payment. Moreover, for some entities, such as SMEs, having flexibility for the management of productive assets, in particular by outsourcing the technological risk or cutting maintenance costs, is an argument in favour of leasing. There is also the benefit of off-balance sheet treatment made possible by current accounting standards or tax incentives in some jurisdictions. The leases project will result in non-accounting related changes in all industries for both lessors and lessees. A change in the balance of power and business relationships between lessors and lessees can therefore be expected. Yet, can it be claimed that this constitutes a profound transformation? The answer is yes and no. Lessees will always try to minimise their costs and maximise their cash flows. The cash-down argument will remain the key factor in deciding whether to lease an asset. The project will not change the reasons underlying this business decision. There may be differences for some strategic choices or negotiations with lessors, but the principal benefit being sought by lessees will still be the same. Although some entities may question the decision to lease rather than purchase the asset, the future of leasing is far from being called into question and this market has a good future for those able to anticipate and meet the challenge. Beyond accounting issues…getting ready for 2015 Above all else, the business dynamic underlying lease contracts is the primary issue for lessors. Although to a certain extent it may be argued that lessors have been spared the accounting impacts of this project, they will still have to re-think their business model. In particular, marketing arguments involving off-balance sheet treatment or the possibility of financing options at advantageous conditions provided by leveraged leases, for example, are no longer valid. Educating and communicating with clients is crucial for lessors
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to secure their commercial basis. Some of the main strategic and marketing issues relating to the future form that lease contracts will take will include: the duration of the lease term, additional services, the allocation of margins between rent and the performance of additional services, the allocation of lease revenues between minimum fixed and variable rent or, alternative mechanisms for variable rents. For those individuals who are willing to take risks and show innovation, this project clearly provides more opportunities than there appear to be from merely an accounting standpoint. Redefining the product and understanding new clientsâ€™ needs are some of the challenges that now await the suppliers of leases. Where lessees are concerned, the accounting impacts referred to above will have repercussions on the business decision to acquire or lease assets. However, the impacts will relate more to the form of future leases and the resulting negotiations. The evolution may differ depending on the industry. At first glance, industry requiring major capital investments and for which leased assets have a high residual value (e.g., the construction, aeronautics and transportation industries) appear to be less affected. In fact, there will always be an economic benefit relating to the decision to lease this type of asset since the present value of the payments generally remains well below the equipment cost. Despite the accounting impacts, operating decisions should continue to be the deciding factor. On the other hand, industries using small equipment (e.g., IT, office and other small equipment) may be more affected. The direct economic benefit for this type of equipment is much less significant given its shorter life and lower residual value. The new recognition method for leases may, on the contrary, highlight weaknesses of some profitability metrics which until then were transparent. Lessees will undoubtedly put considerable pressure on lessors to negotiate shorter lease terms and review renewal clauses in an attempt to either have the leases qualify as being short term or at least to shorten the duration of the related obligations. Similarly, to reduce the amount of the liability that will now be recognised on the statement of financial position, it can be expected that lessees will push to renegotiate the terms and conditions determining rent payments. For example, since variable payments based on performance indicators or usage will not be included in estimating liabilities, entities could be tempted to opt for this type of mechanism.3
Finally, another important issue relating to this project is information systems. Using new lease management applications is a priority, especially in the real estate, distribution, retail, construction and transportation industries. The new standard will require an individual monitoring for each contract, focussing on the details of the contract terms (renewal clauses, contingent rent, past changes etc. For entities operating in these industries, the lease inventory and information gathering may represent a considerable amount of work. That is why a strategic action plan should be put into place to find and implement an appropriate information system and collect data. Moreover, appropriate applications could also prove to be invaluable tools to ensure the proper processing and monitoring of leases from a tax standpoint. The accounting reform will not affect the tax treatment of rental costs. The process for preparing tax data may become more complex proportionally to the number of leases in effect. The larger number of differences between the tax and accounting basis will have to be monitored. Some uncertainty remains regarding the final form that the future standard will take. However, the main principles have now been established. The latest deliberations of the two boards have made it possible to clarify and standardise the new approach to account for leases. Whether you are a lessor or lessee, now is the time to perform some preliminary assessments and take the first steps. In fact, this can sometimes be a long and tedious task. Both lessors and lessees have challenges before them.
Paule Bouchard, FCA, Partner, Professional Practice and Financial Reporting Advisory Services Group in RSM Richter Chamberland, Canada E: email@example.com T: +1 514 934 3518 Katell Burot, Senior Manager, Financial Reporting Advisory Services Group in RSM Richter Chamberland, Canada E: firstname.lastname@example.org T: +1 514 934 8633
It is worth noting that if the variable payments based on usage are deemed to be â€œin substanceâ€? minimum lease payments, they will be included in the estimates.
Hot Topics in Accounting
Joelle Moughanni Emission Trading Schemes under IFRS
Emission Trading Schemes (ETS) are designed to achieve a reduction of greenhouse gases through the use of tradable emission permits. Since Issue 4 of RSM Reporting (June 2010), the use of, and interest in, Emissions Trading Schemes has been continuing to grow worldwide (most recently, the Climate Change Conference in Durban). With the withdrawal of IFRIC 3 in 2005, the absence of IFRS guidance dealing with accounting for emission rights has been giving rise to considerable diversity in practice. Therefore, in order to help entities selecting an appropriate accounting policy, this article reviews the treatment of Emission Trading Schemes under IFRS and discusses the main accounting issues associated with two of the most common types of schemes: emission rights under a cap and trade scheme (by far predominant) and certified emissions reductions under a baseline and credit scheme.
1. What are the main accounting issues raised by ETS? From an accounting perspective, although many jurisdictions are implementing different schemes, several common features of Emission Trading Schemes need to be considered: the existence and nature of different statement of financial position items, their recognition and their subsequent measurement. In particular, the existence of an ETS raises the following questions: »» Are emission allowances assets? If so, what type of assets? »» How should emission allowances be initially measured (in particular, where allocated free of charge)? »» How should emission allowances be subsequently measured? »» When should liabilities arising from the emission of gas under the scheme be recognised?
3. What are the main characteristics of emission rights under a cap and trade scheme (CTS)? In a CTS, a central authority sets an overall cap on the amount of emissions that can be released in a specified compliance period. This cap is then allocated to entities by distributing ‘emission allowances’ (often free of charge). Each emission allowance provides a right to emit a specified quantity of greenhouse gas (e.g. one tonne of CO2). The cap and allowances are normally below the actual levels of emissions made by entities, creating scarcity and value for the holders of such rights. Emission allowances can be traded. Accordingly, an entity that has allowances in excess of its actual or anticipated emissions can sell them to another entity that has a shortfall of allowances (if growth in emissions or inability to make reductions in emissions). 4. What accounting approaches are available for CTS under IFRS? IFRIC 3, although now withdrawn, is one approach that can be applied by entities participating in CTS. As IFRIC 3 often results in accounting mismatches, many entities apply alternative accounting, such as ‘net liability’ and ‘government grants’ approaches.
»» How should such liabilities be measured, initially and subsequently?
a. IFRIC 3 approach
»» Which disclosures on ETS are necessary to ensure decision-usefulness of financial statements?
Under IFRIC 3, emission rights (whether bought or allocated) are accounted for as intangible assets in accordance with IAS 38 Intangible Assets (IAS 38), initially measured at fair value. Any difference between the amount paid (generally nil in the case of allocated allowances) and the fair value is accounted for under IAS 20 Accounting for Government Grants and Disclosure of Government Assistance (IAS 20). Such a ‘government grant’ is recognised initially as deferred income in the statement of financial position and subsequently in income over the period the emissions are made (i.e. the compliance period), regardless of whether allowances are held or sold.
2. What is the status of ETS accounting under IFRS? Currently, IFRS do not contain specific provisions on ETS.
Having noted the increasing international interest in schemes designed to achieve reduction of greenhouse gases through the use of tradable permits and the risk of diverse accounting practices for such schemes following the withdrawal of IFRIC 3, the IASB added an ETS project to its agenda in October 2005, reactivated work in December 2007 and deferred discussions in November 2010 (jointly with the FASB). The ETS project is currently paused until the IASB concludes its ongoing deliberations about its future work plan (Agenda Consultation project).
IFRIC 3 Emission Rights (IFRIC 3), issued in December 2004 in the wake of the European Union Emission Trading Scheme creation, was withdrawn hardly one year after its publication as it suffered from severe deficiencies. It did not contain any guidance on the accounting treatment of allowances acquired by non-participants (for trading, investment or speculative purposes) and of carbon derivatives as part of hedging strategies. Most importantly, measurement of emission allowances and liabilities under IFRIC 3 created accounting mismatches leading to potential volatility in the profit or loss.
Under IAS 38, the allowances are subsequently measured either at cost (fair value at grant date) or, if there is an active market, at fair value (with any revaluation surplus recognised in other comprehensive income).
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As emissions are made, a liability is recognised, measured at the best estimate of expenditure required to settle the present obligation at the reporting date (generally the spot market price of the number of allowances to cover emissions made to date) in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets (IAS 37). b. Net liability approach Under the net liability approach, emission allowances allocated for free to the entity are recognised at a nominal amount (i.e. zero). This is consistent with the option under IAS 20 to recognise grants of non-monetary assets at a nominal amount rather than at fair value, as applied in the IFRIC 3 approach. A liability is recorded under IAS 37 - only to the extent that actual emissions made exceed the emission rights granted and still held - at the current market price of emission allowances. This reflects the obligation to obtain additional allowances. No provision is recognised for the expected future shortfall of emission allowances (as the ‘obligating event’ required for recognition under IAS 37 is the emission itself). In schemes covering more than one year where an entity is unconditionally entitled to receive allowances for a certain number of years and to carry-over emission allowances to future years, deficits can be measured on the basis of either an allocation that covers the entire current phase of the scheme or an annual allocation of emission rights. In the latter case, any deficit is measured on this basis and rights cannot be carried between years. Any liability is measured at the best estimate of expenditure required to settle the obligation at the reporting date (i.e. the spot market price of the number of allowances to cover emissions made), unless the entity applies an accounting policy where purchased rights impact the measurement of the provision (see Approach B below). Entities might purchase emission rights to cover any shortfall in granted rights and can choose an accounting policy whereby these purchased rights impact the application of the net liability approach as follows: »» Approach A - The provision for emissions is based on the carrying amount of emission rights the entity has on hand, while the provision for any excess emissions is based on the market price at the reporting date. »»
Approach B – The purchased emission rights might be viewed as reimbursement rights in respect of the entity’s liability for excess emissions, in accordance with IAS 37. Therefore, to the extent the number of emission rights on hand does not exceed the number of
emission rights necessary to settle the liability, these purchased rights can be re-measured to fair value (ie market price at reporting date) through profit or loss. Consequently, a portion of the purchased rights and the provision will be measured at market price.
An acquirer in a business combination cannot apply the net liability approach (as emission rights are not received through a government grant); the acquired emission rights should be treated instead in the same way as purchased emission rights. The acquirer recognises the acquiree’s emission rights at their fair value (as identifiable intangible assets), even if recorded at nil in the acquiree’s financial statements. c. Government grants approach Under this approach, the entity initially recognises the emission rights received at their grant date fair value (rather than at a nominal amount) and the grant income is deferred in the statement of financial position for the difference between the fair value of the rights and the amount paid (generally nil). The deferred income is then released to the income statement on a systematic basis over the compliance period. The liability is recognised when emissions are made. This is similar to the requirements under IFRIC 3, however the liability is measured at the carrying amount of the rights in hand and at fair value for any shortfall. 5. What is the appropriate accounting for sale of emission rights? The sale of an emission allowance that was recognised as an intangible asset is recorded at the fair value of the consideration received. Any difference between that and the carrying amount should be recorded as a gain or loss, irrespective of whether this creates an actual or an expected deficit in allowances held. If the sale creates an actual deficit, an additional liability should be recognised with a charge to the income statement. 6. What are the main features of certified emissions reductions (CER) under a baseline and credit scheme? Under the Kyoto protocol,5 the Clean Development Mechanism (CDM) allows developed nations to invest in ‘clean’ projects in developing countries and to receive CER in return. CER can be either used by an entity (to fulfil its obligations under some ETS) or sold to other entities.
13 The three approaches were respectively referred to as Approach 1, Approach 3 and Approach 2 in Issue 4 of this Newsletter, as follows: • IFRIC 3 approach was Approach 1 • Net liability approach was Approach 3 • Government grants approach was Approach 2
5 The Kyoto Protocol is a 1997 international agreement under which most developed countries agreed to legally binding targets that will reduce emissions of the six main greenhouse gases by at least 5% below 1990 levels over the period 2008-2012.
The CER scheme is a ‘baseline and credit scheme’, whereby entities earn CER (via a complex process that depends on several qualification criteria) for emissions reductions below a set baseline (i.e. an entity has a right to emit up to a specified level). The baselines are assigned to a specific emitting source and cannot be traded; the trading mechanism is introduced at the end of the period, when the government issues tradable ‘credits’ to entities that have emitted below their baseline. Conversely, the government requires entities that have emitted above their baseline to provide credits. 7. What approaches are available for CER under IFRS? The withdrawn IFRIC 3 addressed CTS only and is not applicable by analogy to CER. a. A project promoter that is granted CER As CER are government grants, they should be recognised when the actual emission reductions have been realised and the entity has reasonable assurance that the reductions will be confirmed during the verification and certification process (taking all contractual terms and conditions into account). The CER are usually recognised as intangible assets under IAS 38. However, if they are held for sale in the ordinary course of business or to settle an emissions liability in the ordinary course of business, CER should be accounted for as inventory under IAS 2. They are measured initially at either fair value or nominal value (i.e. zero). As CDM projects often result in higher costs than other projects, an entity may want to recognise the grants at fair value to (partly) offset these costs. If the CER are recognised at fair value, the grant is recognised in the income statement in connection with the related costs. If the costs have been incurred before the CER are granted, the grant is recognised in the income statement immediately. However, if the expenses incurred to achieve emission reductions have been capitalised, the grant is either deducted from the asset or recognised as deferred income. In both cases, the benefit from the grant is recognised in income over the life of the asset to which it relates. When CER are recognised as intangible assets, they are subsequently measured at cost or the revalued amount (IAS 38). When the CER are recognised as inventory, they are subsequently measured at the lower of cost or net realisable value (IAS 2). b. A purchaser of CER
An entity that purchases CER will often record them as intangible assets at cost, with subsequent measurement at cost (or lower recoverable amount) or at the revalued amount (assuming the requirements of IAS 38 are met). Purchased CER will be accounted for in the same way as purchased emission rights (see above).
8. Should emission rights and CER be amortised and/or impaired? Emission rights and CER must not be amortised, as the economic benefits are consumed only when the right is surrendered to settle obligations arising from emissions made (or by selling it to another party), at which point, it will be derecognised. However, they should be tested for impairment in accordance with IAS 36, whenever there is an indication of impairment. Emission rights and CER that are held for the purpose of settling an entity’s obligations (rather than for sale) are often tested for impairment as part of a larger cash generating unit. Therefore, there is not an automatic impairment charge when an indicator of impairment triggers an impairment test and the market value of an emission right / CER is lower than its carrying amount. 9. How should forward contracts for emission rights and CER be treated? If an entity enters into a forward contract to sell or purchase an emission right or a CER (hereafter ‘right’), it should determine whether the contract is a derivative within the scope of IAS 39. When making the assessment for forward sales contracts, entities should consider that the quantity of the rights received is not within the control of the entity. In some cases, entities receive more rights than they expect to use and they sell those rights on the market through forward contracts. If the entity does not have a past practice of net settlement or an intention of actively trading rights, the forward contract may have been entered into for ‘own use purposes’ and would not be within the scope of IAS 39. An entity may also enter into forward contracts to purchase rights. This may be to supplement a shortfall in emissions held compared with actual or projected emissions. An entity must assess whether it has a past practice of net settlement or an intention of actively trading rights. If the forward contract has been entered into for ‘own use’ then it would not be within the scope of IAS 39 if the rights will be physically delivered under the contract. 10. What could be a good practice of disclosing information on ETS? In addition to the examples provided in Issue 4 of RSM Reporting, the following extract from the notes to the 2009 consolidated financial statements of ‘Veolia Environnement’ illustrate appropriate information to be disclosed by entities involved in ETS.
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Note 1. Accounting Principles and Methods (in part) 1.25 Greenhouse Gas Emission Rights Faced with increased greenhouse gas emissions into the atmosphere, the International Community introduced a regulatory system within the framework of the Kyoto protocol, aimed at reducing such emissions. This system was finalized in 1997 and came into effect in February 2005 and seeks to achieve a reduction in emission levels of at least 5% compared to 1990, over the commitment period 2008–2012 for industrialized countries. Emissions are capped through the allocation of emission rights (AAU: Assigned Amount Units) to each country, which must be surrendered in 2014 based on actual emissions during the period 2008–2012. Developing countries have no reduction objectives under the Kyoto protocol, but emission credits (CER: Certified Emission Reduction) may be presented to companies or States that contribute to investments enabling a reduction in greenhouse gas emissions in these countries. At the European level, the European Union decided to implement, via directive 2003/87/EC of October 13, 2003, an internal trading system for emission rights (EUA: EU Allowance). This system has been in effect since January 1, 2005. Draft directive 2004/101/EC established a link between the Kyoto system and the European system, enabling the operators concerned to use CER, up to an agreed maximum, to satisfy their surrender obligations in the place of EUA. Directive 2009/29/EC of April 26, 2009 amended the ETS directive and extended the allowance trading system beyond the second period (2008–2012). It covers the period 2013–2020 and provides for a progressive reduction in allowances allocated and new allocation procedures. In this context, the Group (primarily the Energy Services Division) was allocated free of charge by the different States of the European Union, a certain number of emission rights (EUA) for an initial period 2005–2007 (EUA I) and then for a second period 2008–2012 (EUA II). The actual emissions position is determined each year and the corresponding rights surrendered. The Group then purchases or sells emission rights, depending on whether actual emissions are greater or lesser than emission rights allocated. In the absence of specific IFRS provisions, the Group has adopted the “net liability approach,” which involves the recognition of a liability at the period-end if actual emissions exceed allowances held, in accordance with IAS 37. Allowances are managed as a production cost and, in this respect, are recognized in inventories: • at nil value, when they are received free of charge, • at acquisition cost, if purchased for valuable consideration on the market. Consumption of this inventory is recognized on a weighted-average unit cost basis. Transactions in these allowances performed on the forward market are recorded at market value at the period-end. Fair value gains and losses on financial instruments relating to these forward transactions are recognized in other comprehensive income or net income depending on whether they qualify as cash flow hedges in accordance with IAS 39.
Joelle Moughanni is a Technical Consultant in the RSM International Executive Office T: + 44 (0)207 601 1089 E: email@example.com
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