Application Issues on Convergence with International Financial Reporting Standards in Hong Kong 7 September 2005

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1 Presented by : Winnie Cheung Chief Executive & Registrar Hong Kong Institute of CPAs Application Issues on Convergence with International Financial Reporting Standards in Hong Kong 7 September 2005

2 Legal and regulatory framework HK Institute of CPAs is empowered by the law to issue financial reporting standards in HK HK incorporated companies are required under the HK Companies Ordinance to prepare financial statements giving a true and fair view Compliance with Hong Kong Financial Reporting Standards is required for financial statements to give a true and fair view Listed companies in HK are required under the Listing Rules to have their financial statements conform with either HKFRS or IFRS 2

3 Standard-setting structure Standard-setting Steering Board HK Institute of CPAs Council Financial Reporting Standards Committee 3

4 From 1 January 2005 Hong Kong Financial Reporting Standards converged with International Financial Reporting Standards 4

5 Convergence with IFRS took 3 years Due process convergence from 1 January 2002 Product convergence from 1 January

6 General application issues Complexity and understanding Inconsistencies with local law Historical cost accounting Fair value accounting Profit and loss approach Balance sheet approach SME cost and benefit consideration 6

7 Complexity and understanding Issue Increasing complexity of IFRS/HKFRS Undue burden on SMEs How to resolve Process convergence - conduct public consultation of exposure drafts at the same time as IASB so that comments can be feedback to IASB prior to finalisation of an IFRS Liaison with IASB Develop local interpretations Issued SME Financial Reporting Framework and Financial Reporting Standard 7

8 SME Financial Reporting Framework and Financial Reporting Standard Effective for financial statements that cover a period beginning on or after 1 January 2005 Qualifying entities HK companies Companies applying section 141D of the Companies Ordinance (i.e. single private companies (exclude listed companies, banks, insurance and securities companies) where all owners agreed to apply that section) Overseas companies No public accountability Meet size test - any two of the following criteria annual revenue <=HK$50 million total assets <= HK$50 million <= 50 employees All owners agree to apply the SME-FRS 8

9 Specific application issues 9

10 Definition of subsidiary - Inconsistency with local law IAS/HKAS 27 Consolidated and Separate Financial Statements Issue Different definition of subsidiary under the HK Companies Ordinance (shareholding basis) and IAS/HKAS 27 (control basis) HK incorporated companies cannot consolidate entities that do not meet the definition of subsidiary under the HK Companies Ordinance How to resolve Created an exemption for HK incorporated companies to continue to use the definition of subsidiary as set out in the HK Companies Ordinance Additional disclosure on the effect on the consolidated financial statements had IAS 27 been followed in full Law change effective from 1 January 2006 to change the definition of subsidiary to align with IAS process of law change has taken a few years 10

11 Accounting for financial instruments Issue IAS/HKAS 32 Financial Instruments: Disclosure and Presentation IAS/HKAS 39 Financial Instruments: Recognition and Measurement All derivatives must be recognised on the balance sheet with changes in fair value taken to the income statement Re-categorisation of financial instruments may lead to financial instruments being recognised differently and measured differently e.g. Entities may choose to re-categorise certain securities previously classified as held-to-maturity (HTM) securities due to the tainting rules in IAS/HKAS 39 whereby an entity cannot classify any financial assets as HTM for 3 years if it sells or reclassifies more than an insignificant amount of its HTM securities before maturity. Measurement will then be changed from amortised cost to fair value. Require early identification of systems modifications to capture data for reporting purposes Greater use of fair values impact on: Volatility in company results Key performance indicators Gearing and liquidity ratios affect regulatory reporting required by banking regulator 11

12 Accounting for financial instruments (cont d) How to resolve Liaison with banking regulator during early exposure stage Banking regulator issued guidance on the impact of new HKFRSs on regulatory reporting e.g. There is a conceptual difference between general provisions for regulatory purpose ( an expected loss model ) and collective impairment under HKAS/IAS 39 ( an incurred loss model ). Banks are now required to earmark a portion of retained earnings to be agreed with the banking regulator as regulatory reserve so that there would be enough general provisions for regulatory purpose. On first application of HKAS 39, there is no need to adjust the opening balances of financial instruments and the comparative figures as if the new standard had always been applied so as to ease preparers burden on systems changes to cater for prior period figures 12

13 Changes in the fair value of investment property to be recognised in income statement but not equity IAS/HKAS 40 Investment Property Issue Property is a significant item in the financial statements of many HK companies Recognition of changes in fair value of investment property in profit or loss increases volatility in company results Objection from The Real Estate Developers Association of Hong Kong How to resolve Public consultation and meetings with interested parties Investor education change emphasis from bottom line profit to a variety of performance indicators focusing on the changes in fair values between two balance sheet dates IASB s project on comprehensive income statement / performance reporting 13

14 Hong Kong land lease IAS/HKAS 16 Property, Plant and Equipment IAS/HKAS 17 Leases Issue All land in HK is leasehold. The leases are therefore operating leases regardless of the length of the lease. Land (of owner-occupied buildings) in HK can only be accounted for under IAS/HKAS 17 (as leases) but not IAS/HKAS 16 (as property, plant and equipment) How to resolve HKAS 17 provides that if the lease payments cannot be allocated reliably between the land element and the building element, the entire lease is classified as a finance lease, unless it is clear that both elements are operating leases 14

15 Length of lease term of HK land leases IAS/HKAS 16 Property, Plant and Equipment IAS/HKAS 17 Leases Issue All land in HK is leasehold and most government land leases run for 50 years from 1997 until 2047 HK Government General Land Policy is to renew such leases for a further 50 years but renewal is at the sole discretion of the Government Issues arise when some companies include the renewable term in determining the amortisation period A straight interpretation of IAS/HKAS 17 means that the amortisation period is 50 years rather than 100 years How to resolve A local interpretation has been issued to avoid market confusion in the determination of the amortisation period of HK land leases Continue discussion with the IASB due to significant impact on a considerable number of companies 15

16 Pre-completion contracts for the sale of development projects IAS/HKAS 11 Construction Contracts IAS/HKAS 18 Revenue Issue HK property developers often enter into contracts to sell properties in advance of the completion of the development Percentage of completion method was commonly used for revenue recognition However, such sale does not meet the definition of construction contracts set out in IAS/HKAS 23 for the percentage of completion method if the contracts are not specifically negotiated for the construction of the properties. IAS/HKAS 18 therefore applies in that revenue from sale is only recognised when significant risks and rewards of the ownership of the properties are transferred to the buyer and the developer retains neither continuing managerial involvement to the degree associated with ownership nor effective control over the properties sold (very often when the development is completed) Property developers are of the view that the recognition of revenue upon completion of development (which may take a few years) does not match with the recognition of expenses incurred 16

17 Pre-completion contracts for the sale of development projects (cont d) How to resolve Issued a local interpretation to clarify that revenue should be recognised only when all of the criteria specified in HKAS 18 are met. Percentage of completion method ceased to be allowed. Transitional compromise the local interpretation only applies to contracts entered into on or after 1 January 2005 but not contracts entered into before 1 January 2005 (unless early application is chosen) 17

18 Consolidation of special purpose entities IAS/HKAS 27 Consolidated and Separate Financial Statements SIC 12/HK(SIC) 12 Consolidation Special Purpose Entities Issue An entity must consolidate a special purpose entity (SPE) as a subsidiary when, in substance, the entity controls the SPE A SPE formed for the purpose of securitisation often operates on an autopilot mechanism, whereby while decision making powers have been delegated to the SPE, the entity retains the majority of the residual or ownership risks related to the SPE. According to SIC 12/HK(SIC) 12, the predetermination of the activities of the SPE for an entity s own benefit at the formation of the SPE through an autopilot mechanism often provides evidence that control exists Objection from the securitisation industry to adopt SIC 12 for the reason that this will hamper the securitisation industry since in many cases the currently held off-balance sheet SPEs would have to be brought back to the balance sheet. Banks therefore cannot improve their capital adequacy ratio by transferring loans to SPEs. 18

19 Consolidation of special purpose entities (cont d) How to resolve Public consultation and meetings with interested parties (Capital Markets Association and Hong Kong Mortgage Corporation) Obtain legal backing by the passage of the Companies (Amendment) Ordinance in June 2005 for consolidation to be based on control rather than shareholding As a result, SPEs will need to be consolidated for all HK companies. This is an example of where the Institute succeeded in advocating for shareholders interest to take precedence over industry interest for preparing financial statements Suggestion for regulators to adjust capital requirements according to the nature of the assets Investor education 19

20 Investors, business, and policymakers worldwide are looking to the IASB as the international standard-setter, in partnership with national standard-setters, to lead the global drive towards better financial reporting, based on convergence towards high quality solutions. The IASB s new accounting standards will take time to develop, and in the meantime we are keen to fix problems with existing standards now if an acceptable solution is readily available. Sir David Tweedie, IASB Chairman 20

21 Issues being followed up with the IASB Inconsistency between IAS 17 Leases and IAS 38 Intangible Assets concerning the determination of the useful life of an asset held for a limited period of time (IAS 17 is stricter in applying the legal form whereas IAS 38 relies more on the substance and intention) Inconsistency between the accounting for the revaluation surplus/deficit of investment property under IAS 40 (recognised in income statement) and available-for-sale financial assets under IAS 39 (recognised in equity) A proposal to allow land portion of owner-occupied buildings to be accounted for as property, plant and equipment at valuation rather than as operating lease (as currently required under IAS 16) 21