The Exposure Draft “Conceptual Framework for Financial Reporting” (ED/2015/3) and its potential impacts on measurement and recognition of measurement gains and losses in the other comprehensive income

a) Current situation

According to IAS 16.29 and IAS 38.72, IFRS applying entities have the accounting choice to measure tangible fixed assets and intangibles after initial recognition at cost less accumulated depreciations and accumulated impairment losses or at revalued amounts. By application of the revaluation model, in general39 gains and losses from the revaluation are recognised in the other comprehensive income that will not be reclassified subsequently to profit or loss;40 in the statement of financial position the accumulated gains from the revaluation of these assets are presented as revaluation reserve that forms part of the entity’s equity. If a non-depreciable asset (e.g. land) is sold the corresponding revaluation reserve may be transferred directly to the retained earnings and does not touch the p/l-statement any more.41 Regarding the depreciable assets, there is neither in IAS 16 nor in IAS 38 a statement what basis for calculating the depreciation charge should be used. Due to the predominating opinion in literature, revalued assets that are subject to wear and tear shall be depreciated from revalued amounts;42 the decrease of the revaluation surplus due to wear and tear of these assets is considered by a transfer from the revaluation surplus to the retained earnings proportionate to the use of these assets.43 Only some authors believe that for calculating depreciations on revalued assets also a cost basis could be used. In addition to the depreciation from cost basis in the p/l-statement, these authors propose to recognise an expense for the difference between the depreciation from revalued amounts and from cost basis in the other comprehensive income. This expense in the other comprehensive income for the time or use related reduction of the revaluation surplus is credited against the carrying amount of the revalued asset in order to avoid an overstatement of both, the assets and the equity.44

b) Selection of an appropriate measurement basis according to ED/2015/3

First, it has to be analysed if the assets for which the accounting choice of IAS 16.29 and IAS 38.72 exists still qualify also for the use of a current value measurement basis according to the proposals contained in the ED/2015/3. ED/2015/3. chapter 6.54 mentions as factors which have to be considered when selecting an appropriate measurement basis the manner of contributing cash flows (e.g. producing cash flows in a direct way by selling the asset vs. producing cash flows by the use of the asset in the entity’s production process and the sale of the therefrom generated goods or services) and the characteristics of the assets (especially the causes for the variability in the item’s cash flows). As mentioned above45 the IASB avoids in ED/2015/3 a direct mapping of measurement bases to the different kinds of assets and liabilities. Despite the quite high and abstract level of discussion of factors that according to ED/2015/3. chapter 6.53–6.77 influence the selection of the appropriate measurement basis of assets and liabilities the IASB’s general view regarding the appropriate measurement bases seems to be quite very similar compared to the assessments of the preceding DP/2013/1. Therefore, the classifications proposed in DP/2013/1 could also be consulted in addition:

• In the terminology of ED/2015/3, a historical cost basis should be applied, if assets only in combination with other assets produce cash flows and/or variations of cash flows are caused more by risks inherent to the assets than to changes in market factors.46 According to DP/2013/1. chapter 6.78–6.79 an asset that contributes indirectly to future cash flows in the course of the operating activities (assets used in purchasing, producing, marketing or delivering assets or services, or administration, treasury or any other function to keep the entity operating) has to be measured with a cost basis.

• Assets that generate cash flows by leasing, renting, franchising, generating entry fees or similar have an ambivalent character in regard to the selection of an appropriate measurement basis. In the opposite to the assets that are measured with a current value measurement basis, the economic benefits embodied in these assets are not realized by one sales act. On the other side, in most cases these assets produce cash flows by their own and are not integrated in the entity’s operating activities. Furthermore, the cash flows of these assets do not only depend on the efficiency of the leased, rented or franchised asset but also the market valuations of these assets have a strong impact on the amount of the therewith produced cash flows. Due to this ambivalent character, DP/2013/1. chapter 6.94–6.95 states that either a cost-based measurement or current market prices can provide relevant information. In addition, the relevance of a current value measurement basis is supposed to increase by the value of the individual asset.47

Therefore, probably only a smaller part of the assets for which there is at present the accounting choice for revaluation would qualify for the use of a current value measurement basis according to ED/2015/3. Tangible fixed assets and intangibles which are used for the entity’s operating activities do not fulfill the criteria for selecting a current value measurement basis. In contrast, assets that are leased, rented, subject to franchising, or similar can qualify for the use of a current value measurement basis. If these long-lived assets are leased, rented or subject of franchising on a long-time basis the level of measurement uncertainty is quite low as the conditions of leasing, renting or franchising are regulated in the respective contracts; under these circumstances there are strong arguments in favour of the use of a current value measurement basis.48 This also applies for assets that are leased, rented or subject of franchising on a short term basis but which are traded on active markets (e.g. property).

c) Recognition of gains and losses from revaluation in the other comprehensive income according to ED/2015/3

Prerequisite for recognising the gains and losses from revaluation in the other comprehensive income are the two conditions mentioned in ED/2015/3. chapter 7.24. The use of a current value measurement basis is only possible for the identified part of long-lived assets.49 If these assets that are not integrated in the entity’s operating activities are hold for a longer period the inclusion of revaluation gains or losses in the other comprehensive income will regularly enhance the relevance of the financial information in the p/l-statement as these gains and losses can be reversed during the holding period of these assets. Therefore gains and losses from the revaluation of long-lived tangible fixed assets and intangibles that are not used for the entity’s operating activities fulfill also the criteria of ED/2015/3. chapter 7.24 for the recognition in the other comprehensive income.

Notwithstanding this, if gains or losses are recognised in the other comprehensive income ED/2015/3. chapter 7.27 presumes refutably that there exists a clear basis for identifying the period in which reclassification would enhance the relevance of the information in the p/l-statement. If a non-depreciable revalued asset is sold or is retired at that point in time the accumulated other comprehensive income could be reclassified into the p/l-statement. If this occurs the gains and losses from the sale or other retirement of long-lived revalued assets would be recognised in the p/l-statement in the same way as the gains and losses from sales of long-lived assets measured at a historical cost basis. This seems to be in favour of reclassifying the gains and losses from revaluation into the p/l-statement. Also the understandability and comparability will probably be enhanced by the reclassification if gains and losses from the sale or other retirement of all long-lived assets are recognised in the same way.

In the case of assets that are subject to wear and tear corresponding to the depreciation from the current value measurement basis a reclassification into the p/l-statement could take place in order to reflect the reduction of the revaluation surplus caused by use. In this case in the other comprehensive income for the reduction of the revaluation surplus an expense is recognised at an amount of the difference between the depreciation from current value measurement and cost basis; in the p/l-statement a corresponding income is recognised. This time or use related reclassification leads in the p/l-statement thereto that both, this reclassification adjustment and the depreciation of the revalued asset calculated from the current value measurement basis together are as high as the depreciation derived from cost basis. Therefore, the effects on both, the p/l-statement and the other comprehensive income, are in the case of reclassifying gains from prior revaluations to the p/l-statement the same as in the present revaluation model (without reclassification) if the revalued assets are depreciated from cost.50 If the revalued depreciable assets are sold or retired otherwise regarding the reclassification of the accumulated gains at the time of sale or other retirement the same goes analogous as for the above mentioned non-depreciable assets.

a) Current situation

According to IFRS 9 the equity instruments have to be measured at fair value. At initial recognition, for the equity instruments are neither held for trading nor contingent consideration recognised by an acquirer in a business combination to which IFRS 3 applies the entity is entitled to make the irrevocable election to present in the other comprehensive income that will not be reclassified subsequently to profit or loss the changes in fair value of these equity instruments.51 This also applies in the cases of impairment, sale or other retirement of these investments. Nevertheless, also by exercising the irrevocable election of IFRS 9. chapter 5.7.5 dividends from these investments must be recognised in the p/l-statement.52

b) Selection of an appropriate measurement basis according to ED/2015/3

The factors that have to be considered when selecting an appropriate measurement basis show in the case of the equity instruments not held for trading the following picture:

• These equity instruments generate cash flows by receiving dividends and proceeds from sale when selling them. An integration of these investments in the entity’s operating activities does regularly not take place as investments in associates, joint ventures or subsidiaries are excluded from the scope of IFRS 9.53 Compared to the long-lived assets that are leased, rented, or subject of franchising which are mentioned under section II. 1 b), the degree of generating cash flows by the sale of the assets should be significantly higher as the investments in the equity instruments are non-depreciable assets.54 Therefore there is a much stronger argument in favour of the use of a current value measurement basis instead of only an accounting choice between a current value and a historical cost measurement basis.55

• The variability in the equity instrument’s cash flows depends on both, the characteristics of the investments (especially the variability of dividends which reflect the performance and the strength of the financial position of the underlying investment) and on market factors (especially the sales price that is also influenced by interest rates, the volatility, the market participants’ expectations or the fungibility of the equity instruments). The variability in the equity instrument’s cash flows is more in favour of an accounting choice between a historical cost and a current value measurement basis.

• The level of measurement uncertainty of the equity instruments that are traded on public markets, especially active markets, is regularly quite very low. In addition, also the faithful representation is in these cases in favour of the use of a current value measurement basis, especially the fair value.56

• Even in the case of non-publicly traded equity instruments the IASB assumes that the valuation models for investments in equity instruments are in contrast to the valuation of options sufficiently developed.57 Therefore, the level of measurement uncertainty is also quite acceptable, especially if the necessary estimations are properly described and disclosed;58 the same also applies for the faithful representation.59

From all this follows, that the equity instruments not held for trading qualify also for the use of a current value measurement basis according to the proposals of ED/2015/3.

c) Recognition of gains and losses from fair value adjustments in the other comprehensive income according to ED/2015/3

According to the proposals of ED/2015/3, a recognition of the change in the fair value of these equity instruments in the other comprehensive income is only possible if – unchanged to IFRS 9. chapter 5.7.6 – dividends are recognised in the p/l-statement because also in the case of the hypothetical use of a historical cost measurement basis dividends would be recognised in the p/l-statement.60 Furthermore, according to ED/2015/3. chapter 7.24 b) the relevance of the financial information in the p/l-statement must be enhanced by excluding these fair value changes from the p/l-statement. The last mentioned requirement for recognising these fair value adjustments outside the p/l-statement can be justified because recognising fair value changes on these investments not held for trading that arise during a particular reporting period in the p/l-statement might cause irrelevant fluctuations in the net income excepted for sustainable impairments of these investments.

The presumption of ED/2015/3. chapter 7.27 sent. 1 that there exists a clear basis for identifying the period in which reclassification would enhance the relevance of the information in the p/l-statement cannot be rebutted. A reclassification will enhance the relevance of information in the p/l-statement, if the final results of holding these equity instruments are certain (in the case of sale or other retirement) or virtually certain (e.g. in the case of sustainable asset impairments). Nevertheless, the peculiar character of these gains and losses (i.e. infrequent gain or loss that is attributable to the holding period of these equity instruments and not only to the current reporting period) possibly embodied in the p/l-statement should be presented or explained.61 Remarkable in this context is that the IASB does not justify the recognition of these fair value changes in the other comprehensive income that will not be reclassified subsequently to profit or loss with the usefulness or relevance of the information but only with a lower complexity of the accounting rules in comparison to IAS 39.62

a) Current situation

Investment properties are properties (land or buildings) held to earn rentals or capital appreciation or both.63 Investment properties produce cash flows in a direct way, independently of other assets, by selling the asset or on its own.64 That differ investment properties from owner-occupied property held for use in production of goods and services, use in supply of goods and services or administrative purposes. At initial recognition investment properties are measured at cost, transaction costs included.65 After initial recognition cost model or fair value model is selected.66 Gains and losses due to changes in fair value are recognised in the p/I-statement. If cost model is selected, information about the fair value must be reported.67 In Sweden all of the listed companies have chosen the fair value model. One reason, besides more relevant information, might be that fair values must be reported anyway.68

b) Selection of an appropriate measurement basis according to ED/2015/3

Investment properties contribute to future cash flows in a direct way either by the sale of the investment property or by generating rents from the use of the asset. This is quite a strong argument in favour of choosing a current value measurement basis as the relevance of financial information is enhanced.69 Investment properties are differentiated from owner-occupied properties which are integrated in one way or another in the production process. Accordingly that is not an argument for using cost basis. Nevertheless, also an important aspect of the relevance is the measurement uncertainty; with high measurement uncertainty, an estimate is less relevant.70 Thus there is a tradeoff between measurement uncertainty and relevant information.70 Therefore, current values are only preferable if they provide the most relevant information. In addition, information must be both relevant and faithfully represented if it is to be useful.72

Investment properties are examples of non-financial assets. Prior research indicates that the relevance of fair values is less for this category of assets, due to difficulties collecting information from active markets.73 If fair values cannot be observed, valuation techniques (sometimes including the use of cash-flow-based measurements) may be needed to estimate the fair value.74 In those cases there is a risk that the inputs into the process may be subjective and it may be difficult to verify both the inputs and the validity of the process itself.74 As a consequence comparability may be reduced. These are important factors to consider when choosing measurement basis for investment properties. In those cases where there are difficulties collecting information from an active market there are strong arguments in favour of using cost model.

Thus, according to the criteria for choosing the most appropriate measurement basis, only those investment properties might qualify for the use of current value measurement whose fair values can be derived from active markets. In the other cases there are quite strong arguments for measuring investment properties at (amortised) cost.

c) Recognition of gains and losses from fair value adjustments in the other comprehensive income according to ED/2015/3

Only the investment properties which qualify for the use of the current value measurement basis according to ED/2015/3 are subject of this section. The fair value changes of those investment properties are examples of income and expenses that would not arise with historic cost. Therefore the first condition for inclusion of these fair value changes in the other comprehensive income is fulfilled.76 As a second prerequisite, the relevance needs to be enhanced by excluding the fair value changes from the p/I-statement.77 Reporting holding gains in the p/I-statement may cause irrelevant fluctuations in the net income, especially if the investment property is held for a longer time and not intended for an immediate sale. As the prices could change in the future, recognizing gains and losses from fair value changes can create irrelevant profit and loss changes. Especially if the company’s core business is to manage investment properties and the investment properties represent a vast majority of the total assets. In those cases fair value changes may affect reported income substantially. This will make the information less transparent and more difficult to compare for investors. An additional argument for excluding these fair value changes from the p/l-statement might also be the existence of measurement uncertainty which especially exists in the case if the fair values can not be derived from an active market.

If income or expenses are included in the other comprehensive income in one period, there is a presumption that there exists a clear basis for identifying the period in which reclassification would enhance the relevance of the information in the p/l-statement.78 For investment properties a clear basis when they can be reclassified to the p/l-statement can be identified. Depart from sustainable asset impairments, the realization of gains and losses on investment properties will be realized in the period when the properties are sold.

The gains or losses from the sale would be recognised in the p/l-statement in the same way as when assets are measured at historical cost. This procedure will enhance the understandability and comparability of the financial reporting because reported income and expenses will not be distorted by unrealized gains or losses and the information in the income statement will be more useful for estimating the future development of the company.

a) Current situation

Biological assets is a category including a variety of assets from vegetables and living cattle to standing timber. According to IAS 41.10 IFRS applying entities have the accounting choice to measure biological assets after initial recognition at fair value less selling costs or at cost less accumulated depreciations and accumulated impairment losses. According to IAS 41.30 biological assets initially recognised at cost, must be measured at fair value as soon as they can be estimated reliably.79 A company that has measured a biological asset at fair value must continue to measure at fair value until the asset is sold.80 Gains and losses due to changes in fair value, are recognized in profit or loss.81

b) Selection of an appropriate measurement basis according to ED/2015/3

Initially it has to be analyzed under what conditions biological assets qualify for current value measurement. ED/2015/3. chapter 6.54 includes factors important to consider when selecting a measurement basis. One important aspect is if and how the asset contributes to future cash flows (e.g. producing cash flows in a direct way by selling the asset vs. producing cash flows by the use of the asset in the entity’s production process and the sale therefrom generated goods or services). If assets only in combination with other assets produce cash flows and/or variations of cash flows are caused more by risks inherent to the assets than to changes in market factors, historical cost basis should be applied.

Measurement uncertainty is also an important factor to consider when selecting the appropriate measurement base. The most important criterion is to provide as relevant information as possible. Nevertheless, with high measurement uncertainty, an estimate is less relevant.82 Most important is to consider what measurement base provides the most relevant information by an acceptable degree of measurement uncertainty.

Biological assets represent a wide range of assets.83 These assets are fundamentally different; the life cycle of living animals may be as shorts as a few month and for standing timber as long as 120 years. In both cases the asset is a part of the production process until it can be harvested; this speaks in general for using a cost basis. It is true that there are market places for some biological assets at different maturity for example piglets. But in most cases the asset must mature until the asset will be demanded in the market. Another aspect is how the asset contributes to cash flows. If for example the idea is to refine the standing timber to other products, there is no intention selling the timber in the market. If the standing timber is not for a direct sale, maybe the standing timber should be regarded to produce cash flows only by the use of the asset in the entity’s production process. According to ED/2015/3 it would be a strong argument for cost basis. It is also a fact that early in the production process historic cost and the fair value will be similar. According to ED/2015/3. chapter 6.49 information must be relevant and it must faithfully represent what it purports to represent. As mentioned earlier this is due to the fact that it takes some time before the asset has such qualities demanded in the market. From this perspective historic cost will better fulfill the requirements of ED/2015/3. chapter 6.49 than current values and as well provide more relevant information to investors. Therefore fair value changes of the biological assets should be ignored until they are realized or by other retirement or a preceding sustainable asset impairment.

In those cases the biological assets are for direct sale and/or the market values can be estimated reliably they may qualify for current value measurement. This is true for example standing timber and living animals when they produce cash flows by their own and are not integrated in the entity’s operating activities.

c) Recognition of gains and losses from revaluation in the other comprehensive income according to ED/2015/3

If biological assets qualify for the use of a current value measurement basis, especially the fair value, the changes in the fair value could only be included in other comprehensive income if the conditions in ED/2015/3 chapter 7.24 are met: the fair value changes are examples of income and expenses that would not arise with historic cost and the relevance is enhanced.

Biological assets fulfill the first criterion since changing prices are examples of income and expenses that would not arise with historic cost. Furthermore the relevance needs to be enhanced. For some biological assets there are quite strong arguments for enhanced relevance. One example is biological assets with shorter life cycle such as living cattle. Another is standing timber when prices can be derived from an active market. It is true that in some companies biological assets represent a great proportion of the balance sheet, for example standing timber. In those cases value changes may affect reported income substantially. This may affect the financial information less transparent and more difficult to use for economic-decision-making. It will still be preferable to recognize gains and losses in the other comprehensive income compared to p/l-statement because reported income will not be distorted.

Another prerequisite is that income or expenses included in other comprehensive income in one period will be included in p/l-statement in some future period.84 In general, there must be a clear basis for identifying the period in which reclassification would enhance the relevance of the information in p/I-statement.85

For assets with a long life cycle, for example standing timber, it may be difficult to identify a specific future period when the relevance of the information will be enhanced in the p/l-statement. Nevertheless, a reclassification of the other comprehensive income to the p/l-statement could enhance the relevance of information in the p/l-statement in the period the standing timber is harvested. Thus one suggestion is to reclassify to the p/l-statement in the period when the asset is harvested or sold. For assets with a shorter production cycle, for example vegetables and living cattle, it is easier to identify a future period in which relevance would be enhanced by reclassification.