ED “Proposed Amendments to the International Financial Reporting Standard for small and medium-sized entities (IFRS for SMEs)” and the ’undue cost or effort’ exemption

(1) General aspects

Beside the undue cost or effort exemptions which are discussed under chapter 3 another fundamental proposed amendment is the subdivision of the other comprehensive income in two parts on the basis of whether the items grouped in the subdivisions are potentially reclassifiable to profit or loss.21 Herewith, the IASB incorporates the main change under IAS 1 (revised 2011) into the proposed IFRS-SME. Although the structure of the comprehensive income in the future IFRS-SME financial statements might be identical in comparison with the full IFRS, the items which have to be recognised in the other comprehensive income which will not be reclassified subsequently to profit or loss, or which will be reclassified subsequently to profit or loss when specific conditions are met under the revised IFRS-SME deviate from those classified in these subdivisions under the full IFRS. For example, all exchange differences that arise from the translation of a foreign subsidiary will even on disposal not be recognised in profit or loss under the IFRS-SME.22 In the opposite, according to IAS 21.48 the cumulative amount of the exchange differences relating to a subsidiary23 shall be reclassified from other comprehensive income to profit or loss when the gain or loss on disposal is realised. The reasons for the different items to be recognised in each subdivision of the other comprehensive income are accounting policies in the IFRS-SME that deviate from those in the full IFRS (e.g. no possibility of revaluating tangible fixed or intangible assets under IFRS-SME24), and simplified accounting methods for the SMEs (e.g. no recycling of cumulative exchange differences from the translation of a foreign subsidiary, as just mentioned before).

(2) Proposed changes in the accounting of some items in the financial statements

The most important change is the proposed accounting of tax items in IFRS-SME 29. Deviating from its general procedure not to incorporate expected new standards until they have been published, the IASB incorporated the key elements of the ED/2009/2 which was issued in March 2009 into the IFRS-SME issued in July 2009. Due to extremely negative responses25 the ED/2009/2 has never been incorporated into the full IFRS. Therefore, the IASB has proposed in ED/2013/9 to change the recognition and measurement of deferred taxes in order to reach an alignment with IAS 12. Nevertheless, the simplifications in the notes disclosure which have also been incorporated into the existing IFRS-SME shall remain.26

In the case that if an entity is unable to make a reliable estimate of the useful life of an intangible asset, the IASB proposes that the life shall be based on management’s best estimate and shall not exceed 10 years, rather than be fixed at 10 years.27

Another proposed amendment is to require that the liability component of a compound financial instrument is accounted for in the same way as a similar standalone financial liability.28

(3) Proposed changes in the preparation of the consolidated financial statements

For the recognition and measurement of the identifiable assets acquired and liabilities assumed in a business combination, the proposed amendments contain three important simplifications:

• The deferred taxes and deferred liabilities arising from the assets acquired and liabilities assumed in a business combination shall be recognised and measured in accordance with IFRS-SME 29.

• The liability (or asset, if any) related to the acquirer’s employment benefit arrangements shall be recognised and measured in accordance with IFRS-SME 2829.

• If the fair value of an intangible asset acquired in a business combination cannot be measured reliably without undue cost or effort, it is not recognised separately30, and from there forms an indivisible part of the acquired goodwill.

Corresponding with ED/2013/9. 18.20, also in the case that if an entity is unable to make a reliable estimate of the useful life of goodwill, the life shall be based on the management’s best estimate and shall not exceed 10 years31, rather than be fixed at 10 years.

If the financial statements of the parent and its subsidiaries have not the same reporting date and it is impracticable to prepare the financial statements of a subsidiary as of the same reporting date as the parent, the parent shall consolidate the financial information of the subsidiary using the most recent financial statements of the subsidiary, adjusted for the effects of significant transactions or events that occur between the date of those financial statements and the date of the consolidated financial statements.32 In the opposite to the corresponding rule of IFRS 10.Appendix B 93 sent. 2, in the ED/2013/9 there does not exist any provision about a maximum difference between the date of the subsidiary’s financial statements and that of the consolidated financial statements (i.e. the parent’s financial statements).

(4) Proposed changes in the preparation of the statement of financial position at the date of transition to IFRS-SME

ED/2013/9 proposes the following additional exemptions from the retrospective application of the (other) IFRS-SME accounting methods:

• government loans33,

• event-driven fair value measurement as deemed cost34,

• operations subject to rate regulation35, and

• severe hyperinflation36.

Thus, the IASB proposes to incorporate into the revised IFRS-SME most of the amendments of IFRS 1 which have been taken place since the issuance of the existing IFRS-SME.

In addition, the IASB proposes that in the case of a repeated application of the IFRS-SME the SME can choose between the special regulations for the transition in IFRS-SME 35 and the retrospective application of the IFRS-SME accounting methods according to IFRS-SME 10.37

1. The role and the content of the proposed additional qualitative characteristic

Even the existing IFRS-SME contains several exemptions from accounting requirements if the compliance with them would induce undue cost or effort.38 The IASB proposes to incorporate the undue cost or effort as a qualitative characteristic of information in the IFRS-SME financial statements. According to this qualitative characteristic, an entity is exempt from a specific requirement, providing that if obtaining or determining the information necessary to comply with that specific requirement would result in excessive incremental cost or an excessive additional effort for this SME.39 The undue cost or effort exemption requires that the management assesses at the time of transaction or event (including measurement) the costs and the benefits of the information under consideration of the entity’s specific circumstances. Regarding the benefit aspect of this assessment, the management has to considerate of how the economic decisions of the expected users of the financial statements could be affected by the availability of the information.40 ED/2013/9 is silent on the question who the expected users of the financial statements are. The management has to apply its own judgement to determine the expected users of their financial statements.41

In weighing the cost of the normally required information, it could be supposed that in general the effect on the economic decisions of the expected users of the financial statements might increase by the potential difference between the normally required information (e.g. fair value) and the information which is provided if the undue cost or effort exemption (e.g. amortised cost) is applied. Thus, in the case it is most probable that economic decisions will be influenced by the alternative information provided under the application of the undue cost or effort exemption, the cost or effort must be exceptional excessive in order to justify the use of the undue cost or effort exemption.

Furthermore, the entity’s specific circumstances have to be taken into account. These include internal (e.g. accounting expertise and resources42) and external (e.g. economic situation of the entity) factors. Especially entities which are in a difficult economic or financial position have to be extremely cautious regarding the potential effect of alternative information on the economic decisions of the expected users of their financial statements. In addition, in such situations the circle of expected users who decide upon information included in the financial statements might also increase (e.g. suppliers, customers, or employees).

The assessment whether a specific requirement would result in excessive incremental cost or an excessive additional effort has to be performed separately for each exemption the entity likes to use.39 If the conditions for applying the undue cost or effort exemption of an item are fulfilled at a specified measurement date, this exemption could only be used at that date. If the entity likes to use the undue cost or effort exemption for this item also on a following reporting date, a new assessment has to be performed at that subsequent date, based on the benefits and cost or effort at that date.44

The qualitative characteristic of undue cost or effort distinguishes from the ’balance between benefit and cost’ in regard to that the last-mentioned characteristic is directed to the standardsetter and not to the management of the entity. The standardsetter has to keep this principle in mind and has to weigh the benefit against the cost of a special requirement.45 In addition, the undue cost or effort has also to be delimitated from another qualitative characteristic, the ’materiality’. Just as undue cost or effort, materiality aims at the influence on the economic decisions of users made on the basis of the financial statements. Furthermore, materiality depends also on the particular circumstances of an omission or misstatement of information46, and it is a qualitative characteristic which requires managerial judgement too. The main difference between undue cost or effort and materiality is that the last mentioned neglects the cost or effort to provide the required information completely. From there, management has in the first step to examine the materiality of information and the potential effects of its omission or misstatement. If information is material and thus it has to be reported, it could nevertheless cause such excessive incremental cost or such an additional effort that under the entity’s circumstances the benefits of that information do not justify the excessive cost or effort needed for providing that information. This assessment has to be performed by the management of the SME in the second step. Moreover, materiality can be applied in general to all information presented in the financial statements, whereas the undue cost or effort exemption can only be used in such cases in which this exemption is explicitly allowed.47

2. Cases of ’undue cost or effort’ exemptions

Even the existing IFRS-SME contains in the following cases undue cost or effort exemptions:

• application of the cost model for investments in associates or in jointly controlled entities, if the entity has chosen in general the fair value model to measure its investments in those entities, but for which it is impracticable to measure fair value reliably without undue cost or effort (IFRS-SME 14.10 and 15.15)

• application of the cost model for investment property whose fair value cannot be measured reliably without undue cost or effort on an ongoing basis (IFRS-SME 17.1 and also 16.1 sent. 2, 16.3 f., 16.7 f., 16.10 e) (iii))

• exemption from disclosing of an estimate of the financial effects (measured using the principles set out in IFRS-SME 21.7 – 21.11) of those contingent assets whose inflow of economic benefits is probable but not virtually certain, when an estimate is not practicable without undue cost or effort (IFRS-SME 21.16)

• exemption from the application of the projected unit credit method to measure the entity’s defined benefit obligation in the case that the entity is not able to do it without undue cost or effort (IFRS-SME 28.18 f.; see also IFRS-SME 28.41 c) for the disclosure in the notes)

• application of the cost model for those biological assets for which the fair value is not readily determinable without undue cost or effort (IFRS-SME 34.2 b)

• at the date of transition to the IFRS-SME, exemption from the recognition of deferred tax assets or liabilities due to the differences between the tax basis and the carrying amount of any assets and liabilities for which recognition of those deferred tax assets or liabilities would involve undue cost or effort (IFRS-SME 35.10 h)

In ED/2013/9, the IASB proposes the following additional undue cost or effort exemptions:

• application of the (amortised) cost model for the measurement of investments in non-convertible preference shares and non-puttable ordinary or preference shares that are not publicly traded and whose fair value cannot otherwise be measured reliably without undue cost or effort (ED/2013/9. 2.47, 11.4, 11.14 c) (i), 11.27, 11.32, 11.44, 12.8 b) and 12.9)

• exemption from the (separate) recognition of an intangible asset acquired in a business combination if its fair value cannot be measured reliably without undue cost or effort (ED/2013/9. 18.8 and 19.15 c))

• exemption from measuring the equity instruments issued as a consideration paid for extinguishing financial liabilities at fair value if the fair value of the equity instruments issued cannot be measured reliably without undue cost or effort (ED/2013/9. 22.15 A)

• exemption from offsetting current tax assets and current tax liabilities, and deferred tax assets and deferred tax liabilities, if the entity has a legally enforceable right to set off these amounts, in the case that it is not evident without undue cost or effort that the entity intends either to settle on a net basis or to realise the asset and settle the liability simultaneously (ED2013/9. 29.29).

1. Guidance for estimating fair values in practice

In theory there are strong arguments for the use of fair values48. Previous research shows though that there are difficulties in applying fair valuation in practice49. One challenge is to estimate the market value when a transaction has not occurred. In those cases there are quoted prices available for a standardized asset, for example a security, the estimates are to be considered reliable. It becomes more complicated when an active market does not exist, which sometimes is the case for non-financial assets.50 This is true in some cases for biological assets as well as for investment properties.

According to IFRS-SME, general guidance concerning fair value measurement is contained in IFRS-SME 11.27–11.32. In the proposed amendments, one suggestion is to clarify the interaction of the scope of IFRS-SME 11 with the other sections of the IFRS-SME.51. One section, requiring fair value measurement, which is not making reference to IFRS-SME 11 is IFRS-SME 34, Specialized Activities, including biological assets.

In the full IFRS management of the company must follow a hierarchy containing three levels when estimating the fair value. According to IFRS 13 it is preferable if companies use level 1 fair value measurements (direct observations of market prices for identical assets). If that is not possible level 2 (mark to market) or level 3 (mark to model) should be used.52

Guidance to fair value measurement is included in IFRS-SME 11 “Basic Financial Instruments”. This may be confusing to the users. The fair value hierarchy is not clearly defined even though prices from an active market are preferable. Unclear guidance is an obstacle to companies when estimating fair values. Since SMEs usually do not have personal backing as a larger entity it might be necessary to use external experts and advisers, which could result in general undue cost or effort for the company. Furthermore there is a risk that provided information will not be useful and relevant for economic decision making. According to the IASB, in comparison to the full IFRS the IFRS-SME is simplified and less complex in order to ease its application in practice.53 Yet it is important to not simplify to such an extent that the guidance will not be useful in practice.

2. Exemption from the fair value measurement for biological assets

As already mentioned under section III.2, biological assets and agricultural produce should be measured at fair value if they can be measured reliably without undue cost or effort. The ED/2013/9 does not propose any change or add any additional exemption of undue cost or effort in this special case. As mentioned under section IV.1, this section is not referring to section 11.27–11.32 including general guidance of fair value measurement.

Agricultural produce is defined as “the harvested product of the entity´s biological assets” and biological asset as “a living animal or plant”.54 Important to notice is that additional issues raised by respondents include suggestions to add more guidance concerning accounting for biological assets.55 Nevertheless, in the eyes of the IASB the level of guidance in the IFRS-SMEs is appropriate.55 Thus, for the IASB no amendment is necessary. Another suggestion was that a cost model should be permitted for biological assets.55 The IASB did not see that there are convincing arguments to reconsider the current approach.55

A difficult challenge in practice, is that a biological asset can be anything from wheat to standing timber. Volume, quality and price level are three equally important variables when assessing the fair value of biological assets. In those cases the life cycle is short (0–2 years) and there is an active market, estimating the fair value is possible without undue cost or effort. When the life cycle is long it is more complicated and time consuming; one example is standing timber.

Determining the volume and quality of standing timber may include substantial judgements as well as complex calculations. This is especially true when market observations are not possible and level-3 (mark to model) is used. When using a discounted cash flow (DCF) models several assumptions need to be made by management. That is expected income at harvest, expected cost during growth, expected point of sales cost and a market based discount rate. The information also needs to be continuously updated in order to be useful at each re-valuation point. If using DCF-models, management must perform a series of qualified judgments, estimates and as well field studies in order have useful information available. The rotation periods of standing timber can be as long as 100 years; it is very difficult to make predictions for a so long time in the future.

For an SME it is not possible to hold competence within all areas. All together this may bring undue cost or effort due to using independent valuers, taking advice from external experts and as well as efforts from the employees. Taken in consideration the amount of effort and cost, it is questionable if not the cost model should be permitted.

A strong argument for fair values is that more relevant information is provided. For companies using IAS 41, the variation of estimated values has in many cases substantially affected reported numbers. For small companies lacking competence there is a risk that fair values can bring volatility. This may increase the cost of capital, which is another example of undue cost.

3. Exemption from the fair value measurement for investment properties

According to IFRS-SME 16.1, investment properties whose fair value can be measured reliably without undue cost or effort, shall be measured at fair value. Otherwise the cost model of IFRS-SME 17 which is also used for property, plant and equipment should be applied.

One suggestion that did not lead to an amendment was that SMEs should be able to choose to account for their investment property either under a fair value model or a cost model. The IASB did not agree to this suggestion. One argument was that SMEs may find it easier to account for an investment property at fair value than use the cost model, another one was that under IFRS-SME, an entity is only required to measure the fair value of an item of investment property if it can do so reliably on an ongoing basis without undue cost or effort.59 Thus, the IASB did not feel that there is a convincing argument to reconsider the current approach in the existing IFRS-SME.59

Experiences from companies using IAS 40 show, that even though there are transactions of investment properties, these may not be useful.61One argument is that different properties are not identical which disqualifies level 1, that is direct observations of identical assets. Even level 2 observations may be difficult to use since management argues that it is difficult to distinguish between different properties. If level-1or level-2 observations should be used, it requires a number of transactions in order to find relevant information. Since the re-valuations must be up-dated annually it will require some efforts from management as well as other employees. Undue cost and efforts can be due to using external expertise as well as from extra working hours.

According to IFRS for SME, if there is a valuation technique used by market participants this should be used. All of the listed Swedish property companies use one kind or another of DCF method.62 It is likely that the SMEs will use the same technique. Using this method prediction of the future is necessary. Level of vacancies and rents, growth, discount rate and discount period are examples of important variables. These kinds of estimates are complicated. It is likely, as well as for biological assets, that engaging independent valuers and other external experts are examples of undue costs when estimating the fair value of investment properties for SMEs.

4. Exemption from offsetting deferred taxes and deferred tax liabilities

According to ED/2013/9. 29.29 an SME shall only offset deferred tax assets and deferred tax liabilities, when it has a legally enforceable right to set off the corresponding current tax assets and current tax liabilities and it is evident without undue cost or effort that the entity intends either to settle on a net basis or to realise the asset and settle the liability simultaneously. In comparison with the other undue cost or effort exemptions, mentioned above, ED/2013/9. BC 58 contains some specific application guidance in this case: “The IASB therefore decided to add an ’undue cost or effort’ exemption to clarify that offsetting income tax assets and liabilities would not be required if significant, detailed scheduling is required.”63 Thus, only in the cases in which it is quite obvious that the requirements for offsetting are met without extensive scheduling, the offsetting should take place. For example, there are insignificant deferred tax assets in comparison with the deferred tax liabilities and due to this it is quite obvious that in each of the next financial years the reversal of deferred tax liabilities will exceed the reversal of the deferred tax assets.

In comparison with other undue cost or effort exemptions the management does in general not need to weigh benefit and cost or effort of the perfect information which includes an offsetting of deferred tax assets and deferred tax liabilities, if the prerequisites of an offsetting are fulfilled, against presenting the deferred tax assets and deferred tax liabilities unsettled. This peculiarity can be justified not only with the corresponding relief in IAS 12.75, but also that this exemption does not have any effect on the SMEs’ income statement and their equity.