6 March 2008

D22 Hedges of a Net Investment in a Foreign Operation – Preliminary discussion of comprehensive example

At the January 2008 IFRIC meeting، the IFRIC discussed the comments received on its Draft Interpretation D22 Hedges of a Net Investment in a Foreign Operation. As a result of the deliberations، the staff was asked to provide a comprehensive example to confirm some of the principles underlying the draft Interpretation.

The principles the staff tried to demonstrate were:

• The same risk can be hedged only once in the group
• The amount of net investment to be hedged cannot be duplicated
• A parent entity can hedge a net investment it holds indirectly
• Where the hedging instrument is held has no effect on hedge effectiveness
• The consolidation method (direct vs. indirect) does not affect hedge effectiveness
• The nature of the hedging instrument (cash instrument or derivative) has no effect on hedge effectiveness

The staff presented various scenarios of net investment hedges involving cash instruments or derivatives to illustrate the principles. The examples contained the necessary calculations and journal entries in detail.

One IFRIC member noted that the examples are meant to prove the principles، as the spreadsheets were set up using those principles.

The IFRIC discussed some points using the spreadsheets in depth.

Method of consolidation

Some IFRIC members were particularly concerned with the assumption that the direct method of consolidation is the correct one and other methods must be adjusted to result in the same figures as the direct method. The chairman told IFRIC members that the Interpretation does not prescribe any method of consolidation but reflects the standards as currently applicable. The staff noted that the question does not deal with the consolidation procedure itself but with effectiveness testing.

Overhedging and hedging the same risk twice

It was also confirmed that an entity cannot hedge the same risk twice، and some designations/designated amounts would not be valid as they would result in overhedging. One member noted that this would normally not occur in practice as it would also make no sense to overhedge from an economic perspective.

Location of the hedging instrument

Some IFRIC members highlighted that the method of consolidation could affect the amounts recognised if the hedging instrument is not held within the (sub-)group containing the hedged item (that is، the net investment).

Recycling

The discussion then switched to the issue of recycling once the net investment or the entity containing the hedging instrument is disposed of. It was noted that this could lead to practical implications and complications، as the amounts in the respective foreign currency translation reserve must be identifiable to allow the correct timing of recycling that results from assuming IAS 39 overrides IAS 21 when it comes to hedge accounting. Some members expressed concerns over the theoretical foundation and the practical application of this approach. The chairman noted that it would not be in the scope of this Interpretation to provide guidance on this issue as this would be a general hedge accounting issue. Some members still did not seem to be convinced.

The IFRIC continued its debate on the issues of the method of consolidation and recycling. While there seemed to be agreement that the Interpretation should not prescribe the method of consolidation، some members asked the staff to include words as a caveat to remind entities that they would have to track the amounts in the foreign currency translation reserve relating to hedge accounting، which could be challenging in large and complex group structures. One member also cited possible transitional issues. Another IFRIC member believed implementing the IFRIC approach correctly could be a huge task for some entities.

The IFRIC also discussed which examples should go into the final Interpretation as illustrative examples، but did not make a final decision. The staff was also asked to align the example that currently is contained in the draft Interpretation.

Other issues raised by commentators

The staff also asked the Board to confirm its preliminary conclusions on certain issues raised by commentators to the draft Interpretation.

Could a parent entity apply hedge accounting in its separate financial statements? How should the hedged amounts be accounted for?

Yes، but that would be a different type of hedge (for example، a fair value hedge). No further clarification is required.

The IFRIC agreed.

How should an entity account for the ineffectiveness resulting from a decrease in a net investment value during the term of hedge?

All ineffectiveness will be recognised in profit or loss. No exception exists for net investment hedges. Such an ex post overhedge would result in ineffectiveness. No further clarification is required.

The IFRIC agreed.

Should the transitional requirements be clarified?

Some commentators asked for clarification on the transitional provision with regard to applying the Interpretation prospectively. The staff proposed to amend the transitional paragraph as follows:

"...when first applying the Interpretation. If an entity had designated a transaction as a hedge of a net investment but the hedge does not meet the conditions for hedge accounting in this Interpretation، the entity shall apply IAS 39 to discontinue prospectively that hedge accounting."

The IFRIC agreed.

Is an intra-group loan defined by IAS 21 paragraph 15 in the scope of this interpretation? Could such an intra-group loan be a part of the net investment?

Yes، this is obvious from the Standard. No further clarification is required.

The IFRIC agreed، however one member questioned if this really was the question the commentator asked as it was so obvious.

Does a hedge relationship designated at a lower group level require hedge documentation also at the higher group levels in order for the lower level hedge to qualify for hedge accounting at any higher level?

The IFRIC had a lengthy discussion on this issue، notably if an entity would be required at a higher level to ´unhedge´، that is، explicitly state that it does not want to continue hedge accounting coming from a lower level in the group.

The IFRIC finally agreed that this is out of the scope of this interpretation as it would be general guidance on how to document hedging relationships. Accordingly، the IFRIC agreed with the staff recommendation not to provide further clarification.

Should the interpretation include the reason the hedging instruments may not be held by the foreign operation that is being hedged?

No، as this is would allow the net investment to hedge itself as the instrument is part of the net investment.

The IFRIC agreed.

Then the staff asked the IFRIC whether it agreed with the staff view that the following questions are addressed by the examples presented. One member expressed concerns as the examples would not be contained in the final Interpretation.

• How should an entity account for various fact patterns such as:
  • a foreign operation is held jointly by two intermediate parents with different currencies
  • a combination of instruments is held by one or several entities within the group to hedge one exposure
  • Parent A holds subsidiaries B (100%) and C (70%) and B holds 30% of C، could B´s 30% interest qualify as part of the hedged item in A´s consolidated financial statements?
• Should the interpretation indicate that the location of hedging instrument should have no effect on the amounts actually deferred in equity as an effective hedge?
• Should the interpretation further clarify possible differences in the amounts of the foreign currency translation reserve caused by the method of the consolidation?

The IFRIC agreed not to address these issues in the final Interpretation.

Way forward

The staff was asked to amend the draft Interpretation in the light of this meeting´s discussions and integrate selected examples. The staff will return at the May IFRIC meeting with a new draft of the Interpretation for clearance by IFRIC.

D21 Real Estate Sales – Redeliberations

The IFRIC discussed a revised draft interpretation reflecting the decisions made at the January 2008 meeting (Agenda Paper 3C available on the IASB website). As requested by the IFRIC the staff presented a flowchart illustrating the consensus of the revised draft interpretation (Section 2 of Agenda Paper 3B available on the IASB website).

The discussion was mainly based on the flowchart rather than the revised draft interpretation and focussed on the following topics:

• Identifying the real estate component of the underlying agreement
• Transfer of control and significant risks and rewards as construction progresses

Identifying the real estate component of the underlying agreement

For agreements with multiple components، the flowchart gives guidance on how to split the identifiable components in order to separate the real estate sale component from the sale of other goods and services. This part of the flowchart corresponds to paragraph 7 of the revised draft Interpretation. In addition، reference is made to IFRIC 12 and IFRIC 13 with regard to the allocation of the consideration to the components identified.

Some IFRIC members expressed the view that detailed guidance on multiple component sales was not within the scope of the project and that any interpretation should focus on the accounting treatment of the real estate sale component only.

There seemed to be a consensus that this part of the flowchart should be condensed by just mentioning that separate components need to be identified and referring to the general principles for multiple component sales in existing IFRSs.

Transfer of control and significant risks and rewards as construction progresses

The flowchart goes on to address the accounting treatment of the real estate sale component. This part of the flowchart corresponds to paragraphs 8 to 13 of the revised draft interpretation.

According to the revised documents presented the definition of a construction contract in accordance with IAS 11 is met ´when the buyer is able to specify the major structural elements of the design of the real estate before construction begins and/or specify major structural changes once construction is in progress´ (corresponds to the indicator in paragraph 9(a) of D21).

The staff presented two views on the accounting treatment when this criterion is not met but ´the seller transfers to the buyer control and the significant risks and rewards of ownership of the work in progress in its current state as construction progresses´ (corresponds to the indicator in paragraph 9(b) of D21).

View 1:

Even though the definition of a construction contract is not met the seller applies IAS 11 to the real estate sale component.

View 2:

The seller applies IAS 18 because the real estate sale is a continuous sale of goods. Revenue and costs are recognised by reference to the stage of completion، that is، paragraphs 22-35 of IAS 11 are applied in analogy.

The staff noted that view 2 was developed in response to comments received by constituents that paragraph 9(b) of D21 goes beyond the requirements of IAS 11.

Some IFRIC members raised the concern that the term continuous sale of goods establishes a new concept that is not covered by current IFRSs. One IFRIC member noted that this is a unit of account issue and that it seems odd that every single piece of the real estate (such as a brick) is a unit of account.

Other IFRIC members responded that view 2 is the better approach because the criteria for a sale in accordance with IAS 18 are indeed met on a continuous basis. In addition، these IFRIC members considered the ´fallback´ into IAS 11 under view 1 to be a technically inferior solution. One observing Board member was of the opinion that such an interpretation of IAS 18 would not be inappropriate.

Finally، a majority of IFRIC members supported view 2.

The staff noted that the adoption of view 2 may require additional disclosures because guidance in IAS 11 is applied in analogy for a sale in accordance with IAS 18، a standard that has less restrictive disclosure requirements compared to IAS 11. The IFRIC directed the staff to draft such disclosure requirements for discussion at the next meeting.

Way forward

The IFRIC asked the staff to revise the draft interpretation and the flowchart taking into account the decisions made at this meeting. The revised documents will be discussed at the May 2008 meeting. The IFRIC postponed the decision on whether the flowchart should be an integral part of the final interpretation.

Review of Tentative Agenda Decisions published in November 2007 and January 2008 IFRIC Updates

IAS 37 Provisions، Contingent Liabilities and Contingent Assets – Deposits on returnable containers

The IFRIC was asked for guidance on the accounting for deposits received for returnable containers.

In November 2007 the IFRIC published a tentative agenda decision proposing not to add the item to its agenda. In January 2007 the IFRIC reaffirmed that decision، but could not agree on the wording of the agenda decision.

The IFRIC discussed a revised tentative agenda decision proposed by the staff at this meeting. While there seemed to be agreement not to add the item to the agenda، some members continued to be concerned with the wording of the agenda decision. Specifically، they were concerned that the proposed wording (for example، ´the seller has the right to force return´) could be interpreted as guidance while the staff made clear those were meant to be examples only. It was agreed to change the wording to avoid providing application guidance and publish the agenda decision.

IAS 7 Statement of Cash Flows – Classification of Expenditures as Investing or Operating

In January 2008 the IFRIC discussed a possible agenda item regarding the criteria for classifying expenditures as ´operating´ or ´investing´ in the statement of cash flows. The original submission focused on exploration and evaluation activities، but the staff concluded this could be extended on many situations. The IFRIC tentatively agreed not to add the item to the agenda، but refer it to the Board، as IAS 7 was considered ambiguous in this respect. The tentative agenda decision also contained a recommendation to the Board that classification in the statement of cash flows should follow recognition، that is، only expenditure for an asset recognised in the statement of financial position qualifies for classification as ´investing´ in the statement of cash flows.

The IFRIC received two comment letters expressing disagreement with the content of the proposed agenda decision. The IFRIC discussed what their recommendation to the Board should be (if any). Some IFRIC members were of the view that an exception in IAS 7 should be created for IFRS 6 expenditures and hence، not dealing with the broader issue. Others were of the view that nothing should be recommended. In response to that، the Chairman reminded IFRIC members that if IFRIC refers anything to the Board، the Board expects IFRIC to make a recommendation (as it would ask this question anyway).

The IFRIC agreed that the wording as proposed in the published tentative agenda decision should be kept and published as a final agenda decision.

Staff Recommendations for Tentative Agenda Decision

IAS 19 Employee Benefits – Settlements

At the January 2008 meeting، the IFRIC discussed a possible agenda item on how payments of benefits under a defined benefit plan are to be accounted for and if such payments represented settlements in the IAS 19 meaning. The payments in question arise when plan participants have an option to receive a lump sum payment instead of ongoing payments.

The staff originally concluded that such payments would fall under the settlement notion in IAS 19 and that this would be in line with US GAAP. However، US GAAP provides for a materiality threshold for settlement treatment (that is، below this threshold the entity has an option not to treat the payment as a settlement) while IAS 19 does not، which would in practice lead to divergence. Further staff research showed that there is a consistent practice under IFRS of not treating such payments as settlements. Requiring this treatment would have material practical consequences. Due to the threshold under US GAAP and many preparers in the US using this threshold in practice، the treatment under IFRS and US GAAP is already consistent in most cases. Theefore، although there is theoretical divergence from US GAAP، in practice it does not exist.

Classifying such payments as settlements mandatorily would in fact lead to divergence unless IFRS would also introduce a threshold.

The IFRIC therefore decided not to add the item to its agenda on the basis that it expects no divergence in practice. However، there will be no reference to the outcome of the IASB´S project on pensions.

Administrative Session – IFRIC Work in Progress

The IFRIC Co-ordinator updated the IFRIC on the current working plan of the IFRIC. It was noted that the IFRIC´s project on derecognition of financial instruments is halted due to staff shortage. The IFRIC Co-ordinator also noted that the staff plans to prepare a paper on ´regulatory assets/liabilities´ for consideration as an agenda item.

The draft Interpretations D21 Real Estate Sales and D22 Hedges of a Net Investment in a Foreign Operation will be brought back at the May IFRIC meeting while the comment letter analyses for draft Interpretations D23 Distributions of Non-cash Assets to Owners and D24 Customer Contributions will be discussed at the July IFRIC meeting.

Finally، the tentative agenda decision on IAS 19 Employee Benefits–Settlements (see above) will be reviewed at the May IFRIC meeting.

This summary is based on notes taken by observers at the IFRIC meeting and should not be regarded as an official or final summary.