Concerns over the accounting for off-balance sheet arrangements and special purpose vehicles has led to the introduction of new accounting standards. Philip Quigley explores what this means for business.

In a major project the International Accounting Standards Board (IASB), in conjunction with the US Financial Accounting Standards Board (FASB), has sought to address concerns that emerged during the financial crisis in relation to off- balance sheet arrangements. The project has looked to both tighten the rules for when consolidation is required and improve transparency of all interests in other entities by requiring further disclosure.

Three new standards

In May 2011 the IASB published a package of three new standards which resulted in broad alignment of IFRS and US GAAP.

  • IFRS 10 'Consolidated financial statements' continues to require consolidation based upon the existence of control, but modifies the definition of control.
  • IFRS 11 'Joint arrangements' covers both joint ventures and joint control.
  • IFRS 12 'Disclosure of interests in other entities' sets out the disclosures for entities that have interests in subsidiaries, joint arrangements or associates.

All three standards have been endorsed by the EU and apply for periods beginning on or after 1 January 2013.

IFRS 10

When determining whether one entity controls another, IFRS 10 requires reference to three elements of control.

  1. Power over the investee.
  2. Exposure or rights to variable returns from involvement with the investee.
  3. The ability to use power over the investee to affect the amount of the investor's returns.

'Power' is defined by the new standard as when an investor has existing rights that give it the current ability to direct the relevant activities. A simple example would be voting rights, but the IFRS also requires consideration of the economic substance of the arrangements existing between the two parties. Assessing control by reference to the three elements will not always be straightforward and in more complex situations, significant judgement will be required. Furthermore, if there are changes to one or more of the three elements of control after it is initially established, the IFRS requires an investor to reassess whether it has gained or retained control.

IFRS 11

IFRS 11 introduces two categories of joint arrangements – joint operations and joint ventures. Under the new standard a joint venture is required to recognise an investment and to account for it using the equity method. The option that existed in IAS 31 to account subsequently for joint ventures using proportional consolidation isn't available under the new standard. Any change in accounting arising from adopting IFRS 11 will have to be accounted for retrospectively, giving rise to a restatement of comparative figures in the first year of adoption.

IFRS 12

IFRS 12 aims to provide users of financial statements with information about all interests the reporting entity has in subsidiaries, joint arrangements, associates and unconsolidated structured entities. The new requirement will provide quantitative data about the effect of interests in other entities on the reported consolidated figures and also qualitative information about the nature of these interests and the risks associated with them. The disclosure requirements are extensive.

A comprehensive model for fair value

Within IFRS the term 'fair value' is widely used but until now there have been inconsistencies as to how fair value should be measured.

IFRS 13 'Fair value measurement' introduced one single definition and a consistent measurement approach to fair value throughout IFRS. It also introduced enhanced fair value disclosures.

Fair value will be the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The standard explains that the fair value is measured by reference to the principal market for the asset or liability being measured. In the absence of a principal market, reference should be made to the 'most advantageous market'. The standard defines the principal market as the market with the greatest volume and level of activity for the asset or liability that can be accessed by the entity. Generally, the market in which the entity transacts most frequently will also be the market with the greatest volume and deepest liquidity.

The principal market is likely to be the same as the most advantageous market. However, in some cases this will not be the case and applying IFRS 13 could change previous measurement bases.

The new standard also states that the value of a non- financial asset must be based on the 'highest and best use' of the asset, being that which is physically possible, legally permissible and financially feasible. IFRS 13 presumes that an entity's current use of an asset is generally its highest and best use, unless market or other factors suggest that a different use of that asset by market participants would maximise its value.

Among the new disclosure requirements is a specific requirement to quantify and disclose any unobservable inputs used in fair value calculations. This could result in disclosures which may be commercially sensitive to some entities. Furthermore, detailed fair value disclosures previously only made in relation to financial instruments, will be extended to some non-financial assets and liabilities held at fair value.

Revenue recognition and leasing – the debate continues

These two areas remain the subject of debate and comment and, although the main principles are settled, there will be significant changes before the final standards are issued.

Revenue recognition

While no significant changes are anticipated in relation to revenue recognition from sale of goods, the provision of services and long-term contracts has been more challenging.

The following are among the areas being addressed by the IASB.

  • Defining when, in the context of services, a transfer is deemed to be continuous and how it should be recognised in the accounts.
  • Clarifying what is meant by 'distinct' in terms of identifying separate performance obligations within a contract, following concerns that the proposed definition could result in an overly large number of separate performance obligations being identified.
  • Modifying the method by which revenue is recognised in circumstances where there is uncertain consideration. The IASB appears to have accepted that the originally proposed probability weighted method was unlikely to be useful or relevant except for portfolio type transactions. It is now suggested that the 'best estimate' should be used for most such transactions.

Leasing

In considering the responses to the 2010 exposure draft, the IASB is particularly focusing on changes regarding initial recognition and subsequent measurement. Some of the key changes highlighted to date are summarised below.

A lessor and a lessee will recognise and initially measure lease assets and lease liabilities at the date of the commencement of the lease.

  • The method used in terms of recognising the present value of lease payments when extending or terminating a lease will be modified. A lessee will be required to determine the present value of lease payments payable during the lease term on the basis of expected outcome, not probability weighted as previously proposed.
  • On subsequent measurement, the IASB has tentatively decided that a lessee and a lessor should reassess the lease term only when there is a significant change in relevant factors such that the lessee would then either have, or no longer have, a significant economic incentive to exercise any options to extend or terminate the lease.

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