HKFRS News 

Example of unexpected accounting under current requirements
 
Members of a dairy co-operative called Milky Milky are all dairy farmers.  Each member purchases shares in Milky Milky at fair value; the shares entitle the farmers to sell a specified amount of produce via the co-operative.  A dairy farmer will acquire sufficient shares to reflect the amount of produce it wants to sell via Milky Milky.  When a member chooses to reduce the amount of produce it sells via the co-operative, it must put the shares back to Milky Milky for a pro rata share of its fair value.
 
Shares of 25 have been issued to members by the end of year 1.  The proceeds are invested in tangible assets (20) and cash (5).
 
The co-operative increases its cash balance to 10 and creates 10 of internally generated brand names and goodwill in year 2.  The brand name and goodwill are not recognised on the balance sheet.  Members can put back their shares; the co-operative must therefore account for the shares as a liability measured at the appropriate share of the fair value of the entity.  This value includes the internally generated goodwill and brand names.  Milky Milky, a successful business, produces the unexpected result of a negative net asset position.  Furthermore, a loss is recognised in the income statement when the liability for puttable shares increases because of the co-operative's success.
 

Co-operative balance sheet Year 1		Co-operative balance sheet Year 2
Assets		Assets
Goodwill	0	Goodwill (not booked under IFRS)	0
Tangible assets	20	Tangible assets	20
Cash generated	5	Cash generated	10
Liabilities		Liabilities
Instruments held by members	(25)	Instruments held by members (implicitly includes a year of goodwill)	(40)
Net assets	0	Net assets	(10)

Similar issues apply to partnerships that are required to liquidate upon the exit of a partner (for example, retirement or death) and also to limited life entities.
 
ED proposals
 
The Board proposes to address this problem with the following exemption to the definition of a financial liability.  The terms in bold are explained below.
 
A contractual obligation does not include:

• an obligation to redeem or repurchase a financial instrument puttable at fair value, provided that all financial instruments in the most subordinated class of instruments with a claim to the assets of the entity are financial instruments puttable at fair value; or
   
• an obligation to deliver to another entity a pro rata share of the net assets of the entity upon its liquidation, provided that all financial instruments in the most subordinated class of instruments with a claim to the assets of the entity impose such an obligation.

Most subordinated means that the amount paid on liquidation is after all others claims are paid out.
 
Fair value is determined using IAS 39 guidance (IAS32.48A and AG 69-AG82).  Formula-based methods of fair valuing are permitted only where the formula is intended to approximate fair value.  It applies only to those entities whose securities are not publicly traded or that do not hold assets in a fiduciary capacity for a broad group of outsiders.
 
Pro rata share of the net assets means that the financial instrument's right to the entity's net assets is neither limited nor guaranteed.
 
Other important issues
 
Minority interests in a subsidiary that are puttable at fair value would not be classified as equity in the group's financial statements because such minority interests are not in the most subordinated class of instruments.  These types of minority interests would therefore continue to be classified as financial liabilities in the consolidated financial statements.
 
Warrants (and other derivatives) to be settled by the issue of financial instruments puttable at fair value are excluded from equity classification and continue to be classified as financial liabilities.  The objective of the proposed amendment is to improve the financial reporting of financial instruments that have characteristics similar to ordinary shares.  Warrants do not have characteristics similar to ordinary shares.
 
The classification of the pre-existing instrument should be reassessed if another class of financial instrument is issued that is 'more subordinate' than the instrument in question.
 
Additional disclosures are proposed in the exposure draft.  They relate to:

• Reclassifications between liabilities and equity;
• Fair value;
• Quantitative data about the amount classified as equity; and
• How the entity manages its obligation to redeem the instruments when required to do so by the instrument holders.

You might, for example, expect that the term 'probable' would give rise to a common understanding between the Americans and the English, even if a shared understanding might be harder to achieve amongst those for whom English is their second or third language.  Unfortunately, even that expectation does not hold water.  Probable, to many English accountants, means more likely than not - say, a probability of 51% or more; to many American accountants, probable has a significantly higher threshold - in the region of perhaps 75%.  This definition alone became so significant that the IASB predecessor body, the IASC, felt it necessary to explain in IAS 37 (provisions) that it was using 'probable' in that standard to mean 'more likely than not'.  The IASB recently found it necessary to explain in IAS 39 (financial instruments) that the term 'highly probable' should be read as equivalent to the FASB's use of 'likely to occur'.
 
Potential for misunderstanding
 
A review of the full IFRS text suggests that the potential for misunderstanding the literature in relation to terms of probability is high.  As the table on the next page demonstrates, in addition to 'probable' and 'highly probable', there are 25 other terms embedded in the IFRS literature that require preparers and auditors to exercise their judgment at different levels of probability.  Differing interpretation of terms is also a potential threat to convergence with US GAAP.  The short-term convergence efforts have already shown that full convergence requires the same scope, the same words and the same meaning being attached to those words.  Any other approach could lead to GAAP differences, intended or otherwise.
 
Translation factor
 
In order to exercise our judgment in the right circumstances, first we need a shared picture of what a threshold condition really means.  Add into the mix the fact that IFRS is now being translated into over 20 different languages, many of which have been embedded into national or regional laws, and the scale of the potential problem for diversity in understanding how to apply IFRS standards becomes transparent.
 
We need to remind ourselves of the background to IFRS, which sheds a lot of light on how this situation has arisen.  Many of the IFRS standards were developed by individual national standard setters using the language of that country.  IAS 32 (debt equity) is substantially the standard developed by the Canadian standards board; IAS 39 (financial instruments) is substantially based on its US GAAP equivalent; and IAS 37 (provisions) is substantially based on work done by the UK standard setter.  It should be no surprise - given that the IASC itself had few own resources and was dependent upon work subcontracted to others - that a higher than desirable level of diversity was the result. So how has the IASB performed, when compared to the IASC? 'Needs to do better' seems to be the response, based upon the experience of IFRSs 1 to 7.  IFRS 4, Insurance contracts, and IFRS 5, Non-current assets held for sale and discontinued operations, added to the list of threshold measures, with the prize going to IFRS 4 for the addition of 'extremely unlikely' and 'minimal probability'.
 
Time to reflect
 
There is a good case for the IASB to pause for a minute and look closely at how it guides its staff in the use of different probability thresholds and in the construction of plain English text more generally.  For example, a comprehensive authoritative glossary would help the staff and constituents, and a strategy to reduce the number of probability thresholds to, say, a maximum of between five and 10 would be a notable success.
 
Terms of likelihood
 
The table below sets out 27 terms for likelihood used in IFRS.  These are set out broadly in order of decreasing likelihood:
 

Term	Example of use
'Virtually certain'	IAS 37.33
'No realistic alternative'	IAS 37.10
'Highly probable' - significantly more likely than probable	IFRS 5 BC82
'Reasonably certain'	IAS 17.4
'Substantially all' risks and rewards, recover, difference)	IAS 17.8
'Substantially enacted'	IAS 12.46
'Highly effective'	IAS 39.88
'Principally'	IFRS 5.6
'Significant'	IAS 18.14(a)
'Major part'	IAS 17.10(c)
'Probable' - more likely than not	IAS 37.14(b)
'More likely'	IAS 39.22
'Likely'	IAS 39 AG 40
'May, but probably will not'	IAS 37 Appdx A
'Reasonably possible'	IAS 32.92
'Possible'	IAS 37.10
'Unlikely'	IAS 39 AG44
'Highly unlikely'	IAS 40.31
'Extremely unlikely'	IFRS 4 Appdx B23
'Minimal probability'	IFRS 4 Appdx B25
'Sufficiently lower'	IAS 17.10(b)
'Insignificant'	IAS 39.9
'Remote'	IAS 37.28
'Extremely rare'	IAS 1.17
'Virtually none'	IAS 34.IN6
'Not genuine' (highly abnormal and extremely unlikely to occur)	IAS 32.25