Contingent Liabilities about to bite the bullet! Robert Kirk examines the implications of the proposed changes to IAS 37 Introduction After briefly diverting attention from a specific review of IFRSs in March 2006, to taking an overall view of how the convergence process has been working to date, this article now reverts back to more specific issues. One of the most controversial topics in the convergence process is the latest project of the IASB to amend its standard IAS 37 Provisions, contingent liabilities and contingent assets. At present, IAS 37 is very similar in its approach to its UK/Irish equivalent with the same title, FRS 12. That is not very surprising since both standards were developed at the same time and by largely the same staff. However, the latest ED, published in June 2005 (FRED 39 in the UK/Ireland July 2005), is proposing fundamental changes to IAS 37. This article will investigate the key points within the existing IAS 37 and look at the changes that are being proposed. The ED does not adopt the term provision but instead uses the phrase non financial liability and, if implemented, will apply to all liabilities except for those defined as purely financial liabilities governed by the financial instruments project in IAS 32. Recognition Under both the current and proposed standard, a non financial liability should be recognised when: * the definition of a liability is satisfied; and, * it can be reliably measured. However, in addition, the current IAS 37 also requires a probability of economic benefits flowing to another entity. That is now proposed to be dropped by the ED as uncertainty will no longer be taken into consideration as to whether or not a liability is recorded but instead on how a liability is measured. That will result in all contingent liabilities being recorded on balance sheet. This could therefore result in major court actions being recorded on balance sheet such as the current health damage cases against tobacco companies and the many legal actions against drug companies. The local Accounting Standards Board (ASB) itself is unhappy with this proposal and has written in no uncertain terms to the IASB to rethink its proposal. Under both IAS 37 and the ED, a liability can be either constructive or legal but it should be noted that it may be merely an intention which could always be reneged in the future. An example of a constructive obligation is provided below: Example 1: Contaminated land and constructive obligation An entity in the oil industry causes contamination and operates in a country in which there is no environmental legislation. However, the entity has a widely published environmental policy in which it undertakes to clean up all contamination that it causes. The entity has a record of honouring this published policy. The past event is the contamination of the land, which gives rise to a present constructive obligation. This is because: * By publishing its environmental policy, the entity has publicly indicated that it will accept the responsibility to clean up its contamination. * By publishing that policy and honouring it in the past, other parties can reasonably rely on the entity to clean up its contamination. * Other parties will suffer harm if the entity does not clean up its contamination. A non-financial liability is recognised for the clean-up obligation. 14
As already mentioned, instead of incorporating uncertainty in the decision as to whether or not a liability is recorded on balance sheet, uncertainty is now to be incorporated in the measurement process. The ED now looks at contingent liabilities as follows: Where a liability is contingent on the occurrence/non occurrence of one or more uncertain future events, there two obligations: * Unconditional (stand steady) e.g. warranties to repair if faulty and, * Conditional. The former is recognised independently of its probability of occurrence and uncertainty is reflected in what value is to be placed on the liability. If an entity has a non financial liability accompanied by a conditional obligation, the probability recognition criterion is applied to the conditional obligation rather than the unconditional obligation. Thus the probability recognition is always satisfied and the criterion is dropped. The ED provides a number of examples to illustrate the proposed change and one of these is illustrated below. Example 2: Potential lawsuit Facts Shortly before 31 December 20X0, a patient dies in a hospital as a result of a mistake made during an operation. The hospital is aware that a mistake has occurred. In these circumstances, the hospital s past experience and lawyers advice indicate that it is highly likely that the patient s relatives will start legal proceedings and, if the matter comes to court, that the hospital will be found guilty of negligence. However, at the time that the financial statements are authorised for issue in early 20X1, the hospital has not received notice of legal proceedings against it. The past event is the operation at which the negligence occurred. A non-financial liability is recognised. A note about measurement Uncertainty is incorporated in the measurement of the liability and should reflect the likelihood that the hospital will be required to pay compensation because of the mistake, and the amount and timing of that compensation. Measurement Currently, IAS 37 requires provisions to be measured at the most likely amount to be paid but, under the proposals in the ED, all non financial liabilities should be measured at the amount an entity would rationally pay to settle the obligation. Sometimes this can be market value but if this does not exist then expected cash flows can be adopted. This should reflect a range of possible outcomes weighted by their associated probabilities. Any estimates are determined by the management team. In the case of a contingency, e.g. a warranty, an entity should consider the likelihood of claims and the amount and timing of cash flows required to meet those claims. It should be measured before tax. One example of measurement of a single guarantee is provided below: Example 3: Single guarantee On 31 December 20X0 Entity A gives a guarantee of specified borrowings of Entity B, whose financial condition at that time is sound. During 20X1 the financial condition of Entity B deteriorates and at 30 June 20X1 Entity B files for protection from its creditors. This contract meets the definition of an insurance contract in IFRS 4 Insurance Contracts. IFRS 4 permits the issuer to continue its existing accounting policies for insurance contracts if specified minimum requirements are satisfied. IFRS 4 also permits changes in accounting policies that meet specified criteria. The following is an example of an accounting policy that IFRS 4 permits. The past event is issuing the guarantee. This gives rise to a present obligation to provide a service for the duration of the guarantee (i.e. to stand ready to repay the borrowing of Entity B). A liability is recognised. A note about measurement The guarantee is initially recognised at fair value. Subsequently, it is measured at the higher of (a) the amount that the entity would rationally pay to settle the obligation or to transfer it to a third party, and (b) the amount initially recognised in accordance with IAS 39/ FRS 26 Financial Instruments: Recognition and Measurement less, when appropriate, cumulative amortisation recognised in accordance with IAS 18. 15
Both the current IAS 37 and the ED permit risks and uncertainties to be included in the measurement process but care is needed not to deliberately overstate liabilities and not to duplicate adjustments for risk in assessing cash flows and discount rates. In addition, under both the ED and current IAS 37, where the time value of money is material, future cash flows should be discounted using a pre tax rate and the effects of future events should be brought into the measurement process as long as the obligation exists. However, future events that create new obligations are not permitted. An example of the time value of money is provided below: Example 4: Measurement of a decommissioning obligation The purpose of the example is to illustrate one way in which the requirements in paragraphs 29-42 may be applied. An entity places an offshore oil rig into service. The entity is required by law to dismantle and remove the rig at the end of its useful life, which is estimated to be 10 years. The entity estimates a range of cash flows (that include the effects of inflation) needed to dismantle and remove the rig, and assigns probability assessments to the range as follows. Estimated cash flows and associated probabilities Cash flow Probability Expected Estimate assessment cash flows % 200,000 25 50,000 225,000 50 112,500 275,000 25 68,750 Expected cash flow 231,250 The entity estimates that the cash flows should be increased by 5 per cent to reflect the uncertainties and unforeseeable circumstances inherent in the obligation (for example, the risk that removal of the rig may cost more than expected). This risk adjustment may be determined by considering factors such as the range of variability of the possible outcomes and the amount that a third party would typically demand for bearing the uncertainty and unforeseeable circumstances inherent in locking in today s price for cash flows that are expected to occur in 10 years. The entity estimates that the discount rate that reflects current market assessments of the time value of money is 6 per cent (risks specific to the liability are included by adjusting the above cash flow estimate). Subsequently the carrying amount should be reviewed at each balance sheet date and adjusted to reflect the amount the entity would rationally pay to settle. It should reflect any changes in: * the expected amount and timing of benefits required to settle the obligation; * any risks and uncertainties; and, * the discount rate. Normally a reliable measure should be determined and it is only in extremely rare cases that this will not be the case. Contingent assets The ED proposes eliminating the term contingent asset and, in a mirror accounting treatment to contingent liabilities, now refers to uncertainty being considered in calculating the amount of future economic benefits in an asset, and not on whether or not an asset exists. Thus, under the proposed ED, reimbursements can be recognised as an asset if they can be reliably measured. This certainly goes against the prudence concept which has been at the heart of asset valuations for many years. Application of the recognition and measurement rules Future Operating Losses Both documents do not permit a liability to be recognised for future operating losses as no present obligation exists. Instead an impairment review may be indicated and thus IAS 36 Impairment of assets needs to be applied. Onerous contracts Both IAS 37 and the ED require that if a contract becomes onerous by an entity s own actions, the liability should not be recognised until the action occurs. At that point, the costs of unavoidable lease commitments should be recorded net of any sublease rentals that an entity could reasonably obtain. The entity estimates the initial measurement of the obligation as follows: Expected cash flows 231,250 Risk adjustment 11,563 242,813 Present value using rate of 6 per cent for 10 years 135,586 17
Restructuring provisions The following are examples of restructuring provisions: Example 5: Closure of a division * The sale or termination of a business. * The closure of a business or relocation. * Any changes in the management structure of the entity. * Any reorganisations affecting the nature and focus of operations. A non financial liability for restructuring can only occur if it meets the definition of a liability. A liability exists if there is little, if any, discretion to avoid settling the obligation. A management decision by itself is not sufficient. Termination benefits are governed by IAS 19 Employee Benefits and are provided immediately if an involuntary agreement has been reached but only provided in a voluntary agreement when the employees agree to accept the terms of the agreement. That aspect of IAS 19 is included in FRED 36 as part of the overall package in implementing IAS 37. If the entity announces its main features after the balance sheet date, disclosure under IAS 10 Events after the balance sheet date is required. An example is provided below: On 12 December 20X0 the management of an entity approved a detailed plan for closing a division. The plan requires termination of (a) various contracts and (b) the employment of the division s employees. On 31 December 20X0 the entity issued a press release announcing its decision to close the division. Before the entity took the decision to close the division, none of the contracts was regarded as onerous. On 31 January 20x1 the entity gave notice, under the terms of its contracts, to the relevant counterparties to terminate its contracts and on 1 March 20x1 the entity began to terminate the employment of its employees. (a) At the balance sheet date of 31 December 20x0 There has been no past event giving rise to a present obligation to restructure. The public announcement of the entity s intention to close the division does not, by itself, create a present obligation. No liability is recognised. (b) At 31 January 20X1 The event that makes the contracts onerous is giving notice to terminate them. A liability is recognised at 31 January 20X1 for any contract termination costs. The entity recognises termination benefits in accordance with the requirements of IAS 19 Employee Benefits/ FRS 17 Retirement and Termination Benefits. Disclosure All entities should disclose, for each class of recognised non financial liability, the carrying amount of the liability at the period and a description of its nature should be provided. This has not changed from IAS 37. An entity should also disclose: * A reconciliation of the opening and closing carrying amounts, including; Liabilities incurred; Liabilities derecognised; Changes in the discounted amount; and, Other adjustments. * Expected timing of outflows. * An indication of the uncertainties surrounding the liabilities and major assumptions. * The amount of any reimbursement recognised. If a non financial liability is not recognised as it cannot be reliably measured, entities should disclose that fact as well as providing; * a description of nature of the obligation; * an explanation of why it cannot be reliably measured; * an indication of the uncertainties re the amount and timing of outflows; and, * the existence of any right to reimbursement. In extremely rare cases where disclosure is expected to seriously prejudice the position of the entity in a dispute with other parties, only the general nature of the dispute and that fact, and the reason why it is not fully disclosed, should be disclosed. A couple of examples of disclosure requirements are provided below, including one which takes into account the possibility of adopting the seriously prejudicial exemption: 18
Financial Reporting IFRS Example 6: Disclosure of a warranty obligation A manufacturer gives warranties at the time of sale to purchasers of its three product lines. Under the terms of the warranty, the manufacturer undertakes to repair or replace items that fail to perform satisfactorily for two years from the date of sale. At the balance sheet date, a liability of 60,000 has been recognised. The following information is disclosed: A liability of 60,000 has been recognised for expected warranty claims on products sold during the last three years. It is expected that the majority of claims will occur in the next year, and all will occur within two years of the balance sheet date. Example 7: Disclosure exemption An entity is involved in a dispute with a competitor, who is alleging that the entity has infringed patents and is seeking damages of 100 million. The entity recognises a nonfinancial liability for the amount that it would rationally pay to settle or transfer the obligation, but discloses none of the information required by paragraph 68 of the [draft] Standard because this information can be expected to prejudice seriously its position. The following information is disclosed: The company is in a dispute with a competitor. This has resulted in litigation against the company alleging that it has infringed patents and seeking damages of 100 million. The information usually required by [draft] IAS 37 FRS 12 Nonfinancial Liabilities is not disclosed because it can be expected to prejudice seriously the outcome of the litigation. The directors are of the opinion that the claim can be successfully resisted by the company. Effective Date The ED, if implemented, should be applied for periods commencing on or after 1st January 2007 and this will result in the withdrawal of IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Summary Overall, there is very little difference in the approach taken to provisions under both the current FRS 12 in Ireland/UK and IAS 37 in international reporting. The only major change would be to realise that, under IAS 1 Presentation of financial statements, there is no specific heading on the balance sheet for provisions. Instead, all provisions must be split between those due within one year as current liabilities and those due in more than one year, non current liabilities. However, the ED appears to take a completely different view as to what constitutes a liability on balance sheet and by dropping the probability criterion forces what were former contingent assets and liabilities to be recorded as actual assets and liabilities on balance sheet. It will be interesting to see how these assets and liabilities will be measured as companies are likely to try to minimise their impact by measuring them at very low values on the grounds of them predicting success and it may well result in an overuse of the seriously prejudical disclosure exemption. Overall, I would suggest that the ED is not an improvement in financial reporting. The former half-way house of contingency disclosure, in my personal view, highlighted the issues very well and there was no need to change the substance of the existing standard. Time will tell whether or not these proposals will be endorsed by the IASB but the chances appear to be fairly high at present. Robert J. Kirk is Professor of Accounting with the University of Ulster. 19