Accounting for all of a reporting entity's liabilities is clearly necessary in order to accurately convey its financial position to investors, creditors and other stakeholders. Different kinds of liabilities have differing implications: short-term trade payables indicate a near-term outflow, while long-term debt covers a wide range of periods, and provisions have yet other significance to those performing financial analysis. At the same time, a company with a long operating cycle will have operating liabilities that stretch for more than a year ahead, and some long-term debt may call for repayment within one year, so the distinction is not so clear, and presentation in the statement of financial position is an issue. Transparency of disclosure will also be a consideration beyond mere questions of current or non-current classification.
Historically, it has long been recognised that prudence would normally necessitate the recognition of even uncertain liabilities, while uncertain assets were not to be recognised. IAS 37, the key standard on provisions, addresses the boundaries of recognition.
The recognition and measurement of provisions can have a major impact on the way in which the financial position of an entity is viewed. IAS 37 addresses so-called “onerous executory contract” which require a company to take into current earnings the entire cost of fulfilling contracts that continue into the future under defined conditions. This can be a very sensitive issue for a company experiencing trading difficulties.
Another sensitive issue is the accounting for decommissioning or similar asset retirement costs, which increasingly are becoming a burden for companies engaged in mineral extraction and manufacturing, but also potentially for those engaged in agriculture and other industry segments. Where historically it was assumed that these costs were future events to be recognised in later periods, it is now clear that these are costs of asset ownership and operation that need to be reflected over the productive lives of the assets, and that the estimated costs are to be recognised as a formal obligation of the reporting entity.
The reporting entity's financial position may also be affected by events, both favourable and unfavourable, which occur between the end of the reporting period and the date when the financial statements are authorised for issue. Under IAS 10, such events require either formal recognition in the financial statements or only disclosure, depending on the character and timing of the event in question, which are referred to as “adjusting” and “non-adjusting,” respectively.
In practice, there may be some ambiguity as to when the financial statements are actually “authorised for issuance.” For this reason, the standard recognises that the process involved in authorising the financial statements for issue will vary and may be dependent upon the reporting entity's management structure, statutory requirements, and the procedures prescribed for the preparing and finalising of the financial statements. Thus, IAS 10 illustrates in detail the principles governing the determination of the financial statements' authorisation date, which date is required to be disclosed.
IAS 1 requires that the reporting entity must present current and non-current assets, and current and non-current liabilities, as separate classifications on the face of its statement of financial position, except when a liquidity presentation provides more relevant and reliable information. In those exceptional instances, all assets and liabilities are to be presented broadly in order of liquidity. Whether classified or employing the order of liquidity approach, for any asset or liability reported as a discrete line item that combines amounts expected to be realised or settled within no more than 12 months after the reporting period and more than 12 months after the reporting period, the reporting entity must disclose the amount expected to be recovered or settled after more than 12 months.
IAS 1 also makes explicit reference to the requirements imposed by IAS 32 concerning financial assets and financial liabilities. Since such common items in the statement of financial position as trade and other receivables and payables are within the definition of financial instruments, information about maturity dates is already required under IFRS. While most trade payables and accrued liabilities will be due within 30 to 90 days, and thus are understood by all financial statement readers to be current, this requirement would necessitate additional disclosure, either in the statement of financial position or in the footnotes thereto, when this assumption is not warranted.
The other purpose of presenting a classified statement of financial position is to highlight those assets and obligations that are “continuously circulating” in the phraseology of IAS 1. That is, the goal is to identify specifically resources and commitments that are consumed or settled in the normal course of the operating cycle. In some types of businesses, such as certain construction entities, the normal operating cycle may exceed one year. Thus, some assets or liabilities might fail to be incorporated into a definition based on the first goal of reporting, providing insight into liquidity, but be included in one that meets the second goal.
As a compromise, if a classified statement of financial position is indeed being presented, the convention for financial reporting purposes is to consider assets and liabilities current if they will be realised and settled within one year or one operating cycle, whichever is longer. Since this may vary in practice from one reporting entity to another, however, it is important for users to read the accounting policies set forth in notes to the financial statements. The classification criterion should be set forth there, particularly if it is other than the rule most commonly employed: one-year threshold.
Current liabilities are generally perceived to be those that are payable within 12 months of the reporting date. The convention has long been to use one year after the reporting period as the threshold for categorisation as current, subject to the operating cycle issue for liabilities linked to operations. Examples of liabilities which are not expected to be settled in the normal course of the operating cycle but which, if due within 12 months would be deemed current, are current portions of long-term debt and bank overdrafts, dividends declared and payable, and various non-trade payables.
Current liabilities would almost always include not only obligations that are due on demand (typically including bank lines of credit, other demand notes payable, and certain overdue obligations for which forbearance has been granted on a day-to-day basis), but also the currently scheduled payments on longer-term obligations, such as instalment agreements. Also included in this group would be trade credit and accrued expenses, and deferred revenues and advances from customers for which services are to be provided or products delivered within one year. If certain conditions are met (described below), short-term obligations that are intended to be refinanced may be excluded from current liabilities. An amendment to IAS 1, effective January 1, 2009, clarified that terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification. For example, if a liability to be settled in full in cash after five years also allows the lender to demand settlement in shares of the borrower at any point prior to the settlement date, that liability will be classified as non-current.
Like all liabilities, current liabilities may be known with certainty as to amount, due date and payee, as is most commonly the case. However, one or more of these elements may be unknown or subject to estimation. Consistent with basic principles of accrual accounting, however, the lack of specific information on, say, the amount owed will not serve to justify a failure to record and report on such obligations. The former commonly used term “estimated liabilities” has been superseded per IAS 37 by the term “provisions.” Provisions and contingent liabilities are discussed in detail later in this chapter.
IAS 1 states that current liabilities are not to be reduced by the deduction of a current asset (or vice versa) unless required or permitted by another IFRS. In practice, there are few circumstances that would meet this requirement; certain financial instruments (to the extent permitted by IAS 32) are the most commonly encountered exceptions. As an almost universal rule, therefore, assets and liabilities must be shown “gross,” even where the same counterparties are present (e.g., amounts due from and amounts owed to another entity).
Current obligations can be divided into those where:
These types of liabilities are discussed in the following sections.
However, when the reporting entity breaches an undertaking or covenant under a long-term loan agreement, thereby causing the liability to become due and payable on demand, it must be classified as current at the end of the reporting period, even if the lender has agreed, after the end of the reporting period and before the authorisation of the financial statements for issue, not to demand payment as a consequence of the breach (i.e., to give forbearance to the borrower).
On the other hand, if the lender has granted an extension before the end of the reporting period (extending for at least one year from the end of the reporting period), then non-current classification would be warranted. Similarly, if the lender has agreed by the end of the reporting period to provide a grace period within which the entity can rectify a breach of an undertaking or covenant under a long-term loan agreement and during that time the lender cannot demand immediate repayment, the liability is to be classified as non-current if it is due for settlement, without that breach of an undertaking or covenant, at least 12 months after the reporting period and either.
Failure to rectify the breach confirms that current classification of the liability was warranted, and the financial statements would be adjusted to conform to that fact.
Long-term financial liabilities within 12 months of maturity are current liabilities in a classified statement of financial position. In some cases, the reporting entity has plans or intentions to refinance the debt (to “roll it over”) and thus does not expect its maturity to cause it to deploy its working capital. Under provisions of IAS 1, this debt must be shown as current when due to be settled within 12 months of the end of the reporting period, notwithstanding that its original term was for a period of more than 12 months; and that an agreement to refinance, or to reschedule payments, on a long-term basis is completed after the reporting period and before the financial statements are authorised for issuance.
However, if the reporting entity has the ability, unilaterally, to refinance or “roll over” the debt for at least 12 months after the end of the reporting period, under the terms of an existing loan facility, it is classified as non-current, even if it is otherwise due to be repaid within 12 months of the end of the reporting period, if a “rollover” is the entity's intent. This differs from the situation in which refinancing or “rolling over” the obligation is not at the discretion of the entity (as when there is no agreement to refinance), in which case the potential to refinance (which is no more than the borrowers hope in such instance) is not considered and the obligation is classified as current.
A lender may have the right to demand immediate or significantly accelerated repayment, or such acceleration rights vest with the lender upon the occurrence of certain events. For example, long-term (and even many short-term) debt agreements typically contain covenants, which effectively are negative or affirmative restrictions on the borrower as to undertaking further borrowings, paying dividends, maintaining specified levels of working capital and so forth. If a covenant is breached by the borrower, the lender will typically have the right to call the debt immediately, or to otherwise accelerate repayment.
In other cases, the lender will have certain rights under a “subjective acceleration clause” inserted into the loan agreement, giving it the right to demand repayment if it perceives that its risk position has deteriorated as a result of changes in the borrower's business operations, liquidity or other sometimes vaguely defined factors. Obviously, this gives the lender great power and subjects the borrower to the real possibility that the nominally long-term debt will, in fact, be short-term.
IAS 1 addresses the matter of breach of loan covenants, but does not address the less common phenomenon of subjective acceleration clauses in loan agreements. As to the former, it provides that continued classification of the debt as non-current, when one or more of the stipulated default circumstances has occurred, is contingent upon meeting two conditions: First, the lender has agreed, prior to approval of the financial statements, not to demand payment as a consequence of the breach (giving what is known as a debt compliance waiver); and second, that it is considered not probable that further breaches will occur within 12 months of the end of the reporting period. If one or both of these cannot be met, the debt must be reclassified to current status if a classified statement of financial position is, as is generally required under IAS 1, to be presented.
Logic suggests that the existence of subjective acceleration clauses convert nominally long-term debt into currently payable debt as the entity does not have an unconditional right to defer payment for 12 months from year-end. Such debt should be shown as current, with sufficient disclosure to inform the reader that the debt could effectively be “rolled over” until the nominal maturity date, at the sole discretion of the lender.
Under IAS 37, Provisions, Contingent Liabilities and Contingent Assets, those liabilities for which amount or timing of expenditure is uncertain are deemed to be provisions.
First and foremost, with the issuance of IFRS 15 applicable to entities from 1 January 2018, there are key impacts on IAS 37 as detailed hereunder:
IAS 37 provides a comprehensive definition of the term “provision.” It mandates, in a clear-cut manner, that a provision should be recognised only if:
Thus, a whole range of vaguely defined reserves found in financial statements in days past are clearly not permitted under IFRS. This includes the oft-manipulated restructuring reserves commonly created during the business combination process. Now, unless there is a present obligation as of the purchase combination date, such reserves cannot be established—in most instances, any future restructuring costs will be recognised after the merger event and charged against the successor entity's earnings.
Many other previously employed reserves are likewise barred by the strict conditions set forth by IAS 37. However, the mere need to estimate the amount to be reflected in the provision is not evidence of a failure to qualify for recognition. If an actual obligation exists, despite one or more factors making the amount less than precisely known, recognition is required.
IAS 37 offers in-depth guidance on the topic of provisions. Each of the key words in the definition of the term “provision” is explained in detail by the standard. Explanations and clarifications offered by the standard are summarised below.
Other salient features of provisions explained by the standard include the following:
The concept of “expected value” can be best explained through an example:
Good Samaritan Inc. provides warranty for the machines sold by it, where customers are entitled to refunds if they return defective machines with valid proof of purchase. Good Samaritan Inc. estimates that if all machines sold and still in warranty had major defects, total replacement costs would equal €1,000,000; if all those machines suffered from minor defects, the total repair costs would be €500,000. Good Samaritan's past experience, however, suggests that only 10% of the machines sold will have major defects, and that another 30% will have minor defects. Based on this information, the expected value of the product warranty costs to be accrued at year-end would be computed as follows:
Expected value of the cost of refunds: | |||
Resulting from major defects: | €1,000,000 × 0.10 | = | €100,000 |
Resulting from minor defects: | €500,000 × 0.30 | = | 150,000 |
No defects: | €0 × 0.60 | = | – |
Total | = | €250,000 |
IAS 37 clarifies that the discount rate applied should be consistent with the estimation of cash flows (i.e., if cash flows are projected in nominal terms). That is, if the estimated amount expected to be paid out reflects whatever price inflation is anticipated to occur between the end of the reporting period and the date of ultimate settlement of the estimated obligation, then a nominal discount rate should be used. If future cash outflows are projected in real terms, net of any price inflation, then a real interest rate should be applied. In either case, past experience must be used to ascertain likely timing of future cash flows, since discounting cannot otherwise be performed.
The standard mandates that unavoidable costs under a contract represent the “least net costs of exiting from the contract.” Such unavoidable costs should be measured at the lower of:
Furthermore, the recognition criteria also require that the entity should have raised a valid expectation among those affected by the restructuring that it will, in fact, carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it. Thus, until all the conditions mentioned above are satisfied, a restructuring provision cannot be made based upon the concept of constructive obligation. In practice, given the strict criteria of IAS 37, restructuring costs are more likely to become recognisable when actually incurred in a subsequent period.
Only direct expenditures arising from restructuring should be provided for. Such direct expenditures should be both necessarily incurred for the restructuring and not associated with the ongoing activities of the entity. Thus, a provision for restructuring would not include costs like: cost of retraining or relocating the entity's current staff members or costs of marketing or investments in new systems and distribution networks (such expenditures are in fact categorically disallowed by the standard, as they are considered to be expenses relating to the future conduct of the business of the entity, and thus are not liabilities relating to the restructuring programme). Also, identifiable future operating losses up to the date of an actual restructuring are not to be included in the provision for a restructuring (unless they relate to an onerous contract). Furthermore, in keeping with the general measurement principles relating to provisions outlined in the standard, the specific guidance in IAS 37 relating to restructuring prohibits taking into account any gains on expected disposal of assets in measuring a restructuring provision, even if the sale of the assets is envisaged as part of the restructuring.
A management decision or a board resolution to restructure taken before the end of the reporting period does not automatically give rise to a constructive obligation at the end of the reporting period unless the entity has, before the end of the reporting period: either started to implement the restructuring plan, or announced the main features of the restructuring plan to those affected by it in a sufficiently specific manner such that a valid expectation is raised in them (i.e., that the entity will in fact carry out the restructuring and that benefits will be paid to them).
Examples of events that may fall within the definition of restructuring are:
Disclosures mandated by the standard for provisions are the following:
For the purposes of making the above disclosures, it may be essential to group or aggregate provisions. The standard also offers guidance on how to determine which provisions may be aggregated to form a class. As per the standard, in determining which provisions may be aggregated to report as a class, the nature of the items should be sufficiently similar for them to be aggregated together and reported as a class. For example, while it may be appropriate to aggregate into a single class all provisions relating to warranties of different products, it may not be appropriate to group and present, as a single class, amounts relating to normal warranties and amounts that are subject to legal proceedings.
The following paragraphs provide examples of provisions that would need to be recognised, based on the rules laid down by the standard. It also discusses common provisions and the accounting treatment that is often applied to these particular items.
In some countries, it is required by law, for the purposes of obtaining a certificate of seaworthiness, that ships must periodically (e.g., every three to five years) undergo extensive repairs and incur maintenance costs that are customarily referred to as “dry-docking costs.” Depending on the type of vessel and its remaining useful life, such costs could be significant in amount. Before IAS 37 came into effect, some argued that dry-docking costs should be periodically accrued (in anticipation) and amortised over a period of time such that the amount is spread over the period commencing from the date of accrual to the date of payment. Using this approach, if every three years a vessel has to be dry-docked at a cost of €5 million, then such costs could be recognised as a provision at the beginning of each triennial period and amortised over the following three years.
Under the requirements set forth by IAS 37, provisions for future dry-docking expenditures cannot be accrued, since these future costs are not contractual in nature and can be avoided (e.g., by disposing of the vessel prior to its next overhaul). In general, such costs are to be expensed when incurred. However, consistent with IAS 16, if a separate component of the asset cost was recognised at inception (e.g., at acquisition of the vessel) and depreciated over its (shorter) useful life, then the cost associated with the subsequent dry-docking can likewise be capitalised as a separate asset component and depreciated over the interval until the next expected dry-docking. While the presumption is that this asset component would be included in the property and equipment accounts, in practice, some entities record major inspection or overhaul costs as a deferred charge (a non-current prepaid expense account) and amortise them over the expected period of benefit, which has the same impact on total assets and periodic results of operations.
Cleanup costs and penalties resulting from unlawful environmental damage (e.g., an oil spill by a tanker ship which contaminates the water near the seaport) would need to be provided for in those countries which have laws requiring cleanup, since it would lead to an outflow of resources embodying economic benefits in settlement regardless of the future actions of the entity.
In case the entity which has caused the environmental damage operates in a country that has not yet enacted legislation requiring cleanup, in some cases a provision may still be required based on the principle of constructive obligation (as opposed to a legal obligation). This may be possible if the entity has a widely publicised environmental policy in which it undertakes to clean up all contamination that it causes and the entity has a clean track record of honouring its published environmental policy. The reason a provision would be needed under the second situation is that the recognition criteria have been met—that is, there is a present obligation resulting from a past obligating event (the oil spill) and the conduct of the entity has created a valid expectation on the part of those affected by it that the entity will clean up the contamination (a constructive obligation) and the outflow of resources embodying economic benefits is probable.
The issue of determining what constitutes an “obligating event” under IAS 37 has been addressed, in a highly particularised setting, by IFRIC 6, Liabilities Arising from Participating in a Specific Market—Waste Electrical and Electronic Equipment. This was in response to a European Union Directive on Waste Electrical and Electronic Equipment (WE&EE), which regulates the collection, treatment, recovery and environmentally sound disposal of waste equipment. Such items contain toxic metals and other materials and have become a concern in recent years, due to the large quantities (e.g., obsolete computers) of goods being dumped by household and business consumers.
The EU Directive deals only with private household WE&EE sold before August 13, 2005 (“historical household equipment”). Assuming enactment of legislation by member states, it is to be mandated that the cost of waste management for this historical household equipment will be borne by the producers of that type of equipment, with levies being assessed on them in proportion to their market shares. This will be done with reference to those manufacturers that are in the market during a period to be specified in the applicable legislation of each EU member state (the “measurement period”).
The accounting issue is simply this: what is the obligating event that creates the liabilities for these producers of the defined historical household equipment, which of course all has already been sold by the producers in months and years gone by. IFRIC 6 concludes that it is participation in the market during the measurement period that will be the obligating event, rather than the earlier event (manufacture of the equipment) or a later event (incurrence of costs in the performance of waste management activities). Accordingly, initial recognition of the liability will occur when the measurement period occurs.
While IFRIC 6 was promulgated in response to a specific, and unusual, situation, it does illustrate well how significant making such determinations (the obligating event, in this instance) can be with regard to presentation in the financial statements.
An entity relocates its offices to a more prestigious office complex because the old office building that it was occupying (and has been there for the last 20 years) does not suit the new corporate image it wants to project. However, the lease of the old office premises cannot be cancelled at the present time since it continues for the next five years. This is a case of an onerous contract wherein the unavoidable costs of meeting the obligations under the contract exceed the economic benefits under it. A provision is thus required to be made for the best estimate of unavoidable lease payments.
An oil company installed an oil refinery on leased land. The installation was completed before the end of the reporting period. Upon expiration of the lease contract, seven years hence, the refinery will have to be relocated to another strategic location that would ensure uninterrupted supply of crude oil. These estimated relocation or decommissioning costs would need to be recognised at the end of the reporting period. Accordingly, a provision should be recognised for the present value of the estimated decommissioning costs to take place after seven years.
In 2004, the IASB's committee dealing with implementation issues (IFRIC) issued a final interpretation, IFRIC 1, Changes in Decommissioning, Restoration and Similar Liabilities, which provides further guidance on this topic. Specifically, this interpretation specifies how the following matters would be accounted for:
The interpretation holds that, regarding changes in either the estimated future cash flows or in the assessed discount rate, these would be added to (or deducted from) the related asset to the extent the change relates to the portion of the asset that will be depreciated in future periods. These charges or credits will thereafter be reflected in periodic results of operations over future periods. Thus, no prior period adjustments will be permitted in respect to such changes in estimates, consistent with IAS 8.
Regarding accretion of the discount over the asset's useful life, so that the liability for decommissioning costs reaches full value at the date of decommissioning, the interpretation holds that this must be included in current income, presumably as a finance charge. Importantly, the interpretation states that this cannot be capitalised as part of the asset cost.
Bonus payments may require estimation since the amount of the bonus payment may be affected by the amount of income taxes currently payable.
Compensated absences refer to paid vacation, paid holidays and paid sick leave. IAS 19 addresses this issue and requires that an employer should accrue a liability for employees' compensation of future absences if the employees' right to receive compensation for future absences is attributable to employee services already rendered, the right vests or accumulates, ultimate payment of the compensation is probable and the amount of the payment can be reasonably estimated.
If an employer is required to compensate an employee for unused vacation, holidays or sick days, even if employment is terminated, the employee's right to this compensation is said to vest. Accrual of a liability for non-vesting rights depends on whether the unused rights expire at the end of the year in which they were earned or accumulated and are carried forward to succeeding years. If the rights expire, a liability for future absences should not be accrued at year-end because the benefits to be paid in subsequent years would not be attributable to employee services rendered in prior years. If unused rights accumulate and increase the benefits otherwise available in subsequent years, a liability should be accrued at year-end to the extent that it is probable that employees will be paid in subsequent years for the increased benefits attributable to the accumulated rights, and the amount can reasonably be estimated.
Pay for employee leaves of absence that represent time off for past services should be considered compensation subject to accrual. Pay for employee leaves of absence that will provide future benefits and that are not attributable to past services rendered would not be subject to accrual. Although in theory such accruals should be based on expected future rates of pay, as a practical matter these are often computed on current pay rates that may not materially differ and have the advantage of being known. Also, if the payments are to be made some time in the future, discounting of the accrual amounts would seemingly be appropriate, but again this may not often be done for practical considerations.
Similar arguments can be made to support the accrual of an obligation for post-employment benefits other than pensions if employees' rights accumulate or vest, payment is probable and the amount can be reasonably estimated. If these benefits do not vest or accumulate, these would be deemed to be contingent liabilities. Contingent liabilities are discussed in IAS 37 and are considered later in this chapter.
In May 2013, IFRIC issued a new interpretation, IFRIC 21, dealing with levies imposed by a government (or similar body) on an entity. The interpretation addresses the timing of recognition of such a levy that would be within the scope of IAS 37. The interpretation does not apply to liabilities in the scope of other standards, such as IAS 12, Income Taxes, nor does it apply to liabilities arising from commercial transactions between government and an entity. The interpretation also explicitly scopes out liabilities arising from emissions trading schemes, presumably since the emissions trading scheme project is still incomplete. The interpretation addresses six specific issues relating to the timing and recognition of levies, but does not address measurement of the liability arising from the levy. Once the levy meets the recognition criteria, measurement thereof is the same as for any other liability within the scope of IAS 37.
The first issue deals with identification of the obligating event. The interpretation concludes that the obligating event that gives rise to a liability to pay a levy is the activity that triggers the payment of the levy, as identified by the relevant legislation.
The second issue clarifies that, although an entity may be compelled to continue to operate in a future period from an economic perspective, an entity may claim to have a constructive obligation to pay a levy that will only be triggered by operating in a future period.
The third issue follows on from the second by confirming that an entity that asserts that it is a going concern does not have a present obligation to pay a levy that will only be triggered by operating in a future period.
The fourth issue deals with the timing of recognition of the liability—if the obligating event that gives rise to the levy occurs over a period of time (i.e., if the activity that triggers the payment of the levy, as identified by the legislation, occurs over a period of time), the levy would likewise be recognised as a liability over time. By implication then, if the obligating event occurs at a singular point in time, then the liability is also only recognised when that event occurs, which is consistent with the conclusion reached in issue one.
Some levies may only be payable once a minimum threshold of economic activity has been reached, such as a minimum level of sales during a particular period. The fifth issue reiterates that the previous principles established in the first four issues of the interpretation apply in such cases as well. As a result, a levy will be recognised as a liability only when the minimum threshold (the obligating event) has been reached.
The sixth and last issue addresses those entities that publish interim financial statements. The same principles that are applied in an entity's annual results must be applied to the interim results. This means that if the obligating event has not yet occurred as of the end of the reporting period, no liability may be recognised. The entity may also not recognise a liability for a levy in anticipation of the obligating event being reached by the end of the reporting period.
Any amounts that an entity may have prepaid in respect of a levy must be presented as an asset if the entity does not yet have a present obligation to pay the levy.
The following are further examples of estimated liabilities, which also will fall within the definition of provisions under IAS 37.
Premiums are usually offered by an entity to increase product sales. They may require the purchaser to return a specified number of box tops, wrappers or other proofs of purchase. They may or may not require the payment of a cash amount. If the premium offer terminates at the end of the current period but has not been accounted for completely if it extends into the next accounting period, a current liability for the estimated number of redemptions expected in the future period will have to be recorded. If the premium offer extends for more than one accounting period, the estimated liability must be divided into a current portion and a long-term portion.
Product warranties providing for repair or replacement of defective products may be sold separately or may be included in the sale price of the product. If the warranty extends into the next accounting period, a current liability for the estimated amount of warranty expense anticipated for the next period must be recorded. If the warranty spans more than the next period, the estimated liability must be partitioned into a current and long-term portion.
IAS 37 defines a contingent liability as an obligation that is either:
Under IAS 37, the reporting entity does not recognise a contingent liability in its statement of financial position. Instead, it should disclose in the notes to the financial statements the following information:
Disclosure of this information is not required if the possibility of any outflow in settlement is remote, or if it is impracticable to do so.
Contingent liabilities may develop in a way not initially anticipated. Thus, it is imperative that they be reassessed continually to determine whether an outflow of resources embodying economic benefits has become probable. If the outflow of future economic benefits becomes probable, then a provision is required to be recognised in the financial statements of the period in which the change in such a probability occurs (except in extremely rare cases, when no reliable estimate can be made of the amount needed to be recognised as a provision).
Contingent liabilities must be distinguished from estimated liabilities, although both involve uncertainties that will be resolved by future events. However, an estimate exists because of uncertainty about the amount of an event requiring an acknowledged accounting recognition. The event is known and the effect is known, but the amount itself is uncertain.
In a contingency, whether there will be an impairment of an asset or the occurrence of a liability is the uncertainty that will be resolved in the future. The amount is also usually uncertain, although that is not an essential characteristic defining the contingency.
It is tempting to express quantitatively the likelihood of the occurrence of contingent events (e.g., an 80% probability), but this exaggerates the degree of precision possible in the estimation process. For this reason, accounting standards have not been written to require quantification of the likelihood of contingent outcomes. Rather, qualitative descriptions, ranging along the continuum from remote to probable, have historically been prescribed.
IAS 37 sets the threshold for accrual at “more likely than not,” which most experts have defined as being a probability of very slightly over a 50% likelihood. Thus, if there is even a hint that the obligation is more likely to exist than not to exist, it will need to be formally recognised if an amount can be reasonably estimated for it. The impact will be both to make it much less ambiguous when a contingency should be recorded and to force recognition of far more of these obligations at earlier dates than they are being given recognition at present.
When a loss is probable and no estimate is possible, these facts should be disclosed in the current period. The accrual of the loss should be made in the period in which the amount of the loss can be estimated. This accrual of a loss in future periods is a change in estimate. It is not to be presented as a prior period adjustment.
With the exception of certain remote contingencies for which disclosures have traditionally been given, contingent losses that are deemed remote in terms of likelihood of occurrence are not accrued or disclosed in the financial statements. For example, every business risks loss by fire, explosion, government expropriation or guarantees made in the ordinary course of business. These are all contingencies (though not necessarily contingent liabilities) because of the uncertainty surrounding whether the future event confirming the loss will or will not take place. The risk of asset expropriation exists, but this has become less common an occurrence in recent decades and, in any event, would be limited to less developed or politically unstable nations. Unless there is specific information about the expectation of such occurrences, which would thus raise the item to the possible category in any event, thereby making it subject to disclosure, these are not normally discussed in the financial statements.
The most difficult area of contingencies accounting involves litigation. In some nations, there is a great deal of commercial and other litigation, some of which exposes reporting entities to risks of incurring very material losses. Accountants must generally rely on attorneys' assessments concerning the likelihood of such events. Unless the attorney indicates that the risk of loss is remote or slight, or that the impact of any loss that does occur would be immaterial to the company, the accountant will require that the entity add explanatory material to the financial statements regarding the contingency. In cases where judgements have been entered against the entity, or where the attorney gives a range of expected losses or other amounts, certain accruals of loss contingencies for at least the minimum point of the range must be made. Similarly, if the reporting entity has made an offer in settlement of unresolved litigation, that offer would normally be deemed the lower end of the range of possible loss and, thus, subject for accrual. In most cases, however, an estimate of the contingency is unknown and the contingency is reflected only in footnotes.
Guarantees are commonly encountered in the commercial world; these can range from guarantees of bank loans made as accommodations to business associates to negotiated arrangements made to facilitate sales of the entity's goods or services.
IFRS provides guidance on the accounting for all financial guarantees—those which are in effect insurance, the accounting for which is therefore to be guided by the provisions of IFRS 4, and those which are not akin to insurance and which are to be accounted for consistent with IFRS 9.
According to IAS 37, a contingent asset is a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events that are not wholly within the control of the reporting entity.
Contingent assets usually arise from unplanned or unexpected events that give rise to the possibility of an inflow of economic benefits to the entity. An example of a contingent asset is a claim against an insurance company that the entity is pursuing legally.
Contingent assets should not be recognised; instead, they should be disclosed if the inflow of the economic benefits is probable. As with contingent liabilities, contingent assets need to be continually assessed to ensure that developments are properly reflected in the financial statements. For instance, if it becomes virtually certain that the inflow of economic benefits will arise, the asset and the related income should be recognised in the financial statements of the period in which the change occurs. If, however, the inflow of economic benefits has become probable (instead of virtually certain), then it should be disclosed as a contingent asset.
An entity should disclose, for each class of contingent liability at the end of the reporting period, a brief description of the nature of the contingent liability and, where practicable, an estimate of its financial effect measured in the same manner as provisions, an indication of the uncertainties relating to the amount or timing of any outflow and the possibility of any reimbursement.
In aggregating contingent liabilities to form a class, it is essential to consider whether the items are sufficiently similar in nature such that they could be presented as a single class.
In the case of contingent assets where an inflow of economic benefits is probable, an entity should disclose a brief description of the nature of the contingent assets at the end of the reporting period and, where practicable, an estimate of their financial effect, measured using the same principles as provisions.
Where any of the above information is not disclosed because it is not practical to do so, that fact should be disclosed. In extremely rare circumstances, if the above disclosures as envisaged by the standard are expected to seriously prejudice the position of the entity in a dispute with third parties on the subject matter of the contingencies, then the standard takes a lenient view and allows the entity to disclose the general nature of the dispute, together with the fact that, and reason why, the information has not been disclosed.
The issue addressed by IAS 10 is to what extent anything that happens between the entity's end of the reporting period and the date the financial statements are authorised for issue should be reflected in those financial statements. The standard distinguishes between events that provide information about the state of the entity existing at the end of the reporting period and those that concern the next financial period. A secondary issue is the cutoff point beyond which the financial statements are considered to be finalised.
The determination of the authorisation date (i.e., the date when the financial statements could be considered legally authorised for issuance, generally by action of the board of directors of the reporting entity) is critical to the concept of events after the reporting period. It serves as the cutoff point after the reporting period, up to which the events after the reporting period are to be examined in order to ascertain whether such events qualify for the treatment prescribed by IAS 10. This standard explains the concept through the use of illustrations.
The general principles that need to be considered in determining the authorisation date of the financial statements are set out below.
Consider the following examples:
Given these facts, the date of authorisation of the financial statements of Xanadu Corp. for the year ended December 31, 20XX, is February 18, 20XX+1, the date when the Board approved them and authorised them for issue (and not the date they were approved in the AGM by the shareholders). Thus, all post-reporting period events between December 31, 20XX, and February 18, 20XX+1, need to be considered by Xanadu Corp. for the purposes of evaluating whether or not they are to be accounted or reported under IAS 10.
In this case the date of authorisation of financial statements would be February 16, 20XX+1, the date the draft financial statements were issued to the supervisory board. Thus, all post-reporting period events between December 31, 20XX, and February 16, 20XX+1, need to be considered by Xanadu Corp. for the purposes of evaluating whether or not they are to be accounted or reported under IAS 10.
Two types of events after the reporting period are distinguished by the standard. These are, respectively, “adjusting events after the reporting period” and “non-adjusting events after the reporting period.” Adjusting events are those post-reporting period events that provide evidence of conditions that actually existed at the end of the reporting period, albeit they were not known at the time. Financial statements should be adjusted to reflect adjusting events after the reporting period.
Examples of adjusting events, given by the standard, are the following:
Commonly encountered situations of adjusting events are illustrated below.
In contrast with the foregoing, non-adjusting events are those post-reporting period events that are indicative of conditions that arose after the reporting period. Financial statements should not be adjusted to reflect non-adjusting events after the end of the reporting period. An example of a non-adjusting event is a decline in the market value of investments between the date of the statement of financial position and the date when the financial statements are authorised for issue. Since the fall in the market value of investments after the reporting period is not indicative of their market value at the date of the statement of financial position (instead it reflects circumstances that arose subsequent to the end of the reporting period) the fall in market value need not, and should not, be recognised in the financial statements at the date of the statement of financial position.
Not all non-adjusting events are significant enough to require disclosure, however. The revised standard gives examples of non-adjusting events that would impair the ability of the users of financial statements to make proper evaluations or decisions if not disclosed. Where non-adjusting events after the reporting period are of such significance, disclosure should be made for each such significant category of non-adjusting event, of the nature of the event and an estimate of its financial effect or a statement that such an estimate cannot be made. Examples given by the standard of such significant non-adjusting post-reporting period events are the following:
Dividends on equity instruments proposed or declared after the reporting period should not be recognised as a liability at the end of the reporting period. In other words, such declaration is a non-adjusting subsequent event. While at one-time IFRS did permit accrual of post-balance sheet dividend declarations, this has not been permissible for quite some time. Furthermore, the revisions made to IAS 10 as part of the IASB's Improvements Project in late 2003 (which became effective 2005) also eliminated the display of post-reporting period dividends as a separate component of equity, as was formerly permitted. Footnote disclosure is, on the other hand, required unless immaterial.
A further clarification has been added by the 2008 Improvements, a collection of major and minor changes made in 2008. It states that, if dividends are declared (i.e., the dividends are appropriately authorised and no longer at the discretion of the entity) after the reporting period but before the financial statements are authorised for issue, the dividends are not recognised as a liability at the end of the reporting period, for the very simple reason that no obligation exists at that time. This rudimentary expansion of the language of IAS 10 was deemed necessary because it had been asserted that a constructive obligation could exist under certain circumstances, making formal accrual of a dividend liability warranted. The Improvements language makes it clear that this is never the case.
Deterioration in an entity's financial position after the end of the reporting period could cast substantial doubts about an entity's ability to continue as a going concern. IAS 10 requires that an entity should not prepare its financial statements on a going concern basis if management determines after the end of the reporting period that it either intends to liquidate the entity or cease trading, or that it has no realistic alternative but to do so. IAS 10 notes that disclosures prescribed by IAS 1 under such circumstances should also be complied with.
The following disclosures are mandated by IAS 10:
Exemplum Reporting PLC Financial Statements For the Year Ended 31 December 20XX |
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35.1 Flood damage | ||
A widget manufacturing factory was severely damaged in a flash flood on January 17, 20XX. The value of the factory and its contents were insured in full and claims put forward to the insurers are being processed. The group was, however, not insured for the loss of business due to factory downtime. The loss of business is estimated to result in financial losses of €X. | IAS10 p21 | |
35.2 Acquisition of a subsidiary | ||
After the reporting period but before the financial statements were authorised for issue the group acquired 100% of the share capital of Subsidiary D Ltd. The fair value of assets acquired and liabilities assumed on the acquisition date of February 1, 20XX were as follows: | IFRS3 Pb64 | |
€ | ||
Cash | X | |
Inventories | X | |
Trade receivables | X | |
Property, plant and equipment | X | |
Trade payables | X | |
Long-term debt | X | |
Total net assets | X | |
Goodwill | X | |
Total fair value of consideration paid | X | |
Less: Fair value of shares issued | X | |
Cash | X | |
Less: Cash of Subsidiary D Ltd | X | |
Cash flow on acquisition net of cash acquired | X | |
Goodwill represents the value of the synergies arising from the vertical integration of the group's operations. These synergistic benefits were the primary reason for entering into the business combination. The total amount of goodwill that is expected to be deductible for tax purposes is €X. |
In June 2005, the IASB issued an Exposure Draft (ED), Proposed Amendments to IAS 37: Provisions, Contingent Liabilities and Contingent Assets. On January 5, 2010, the IASB published a second ED, Measurement of Liabilities in IAS 37, that contains revised proposals for measuring liabilities within the scope of IAS 37. This project was a major project but has since been changed to a research project. This project has since not been added to the active agenda of the IASB and no new documents have been issued. The conceptual framework project is proposing some changes to the definition of liability and the recognition and measurement that might result in changes to IAS 37 in the future.
A major project which will affect the accounting in terms of IAS 37 is IFRS 16, which has been issued, but is only effective from 1 January 2019. Once this standard is applied, it will have an impact on IAS 37. The key implication is detailed here:
There are substantial differences between US GAAP and IFRS with regard to provisions. US GAAP does not use the term “provisions.” The term “accrual” is used instead.
Under US GAAP, constructive obligations are only recognised for environmental obligations, decommissioning obligations, post-retirement benefits and legal disputes. Discount rates used to measure provisions at present value are a risk-adjusted risk-free rate that reflects the entity's credit standing.
To recognise a contingency under GAAP, a loss must be “probable.” Although a percentage is not assigned, it generally means a high likelihood. Under IFRS, “probable” is interpreted as more likely than not, which refers to a probability of greater than 50%.
When a range of estimates is available for a provision, the minimum amount is accrued under US GAAP when other estimates are equally probable, including zero. IFRS uses the single most likely estimate to measure a provision.
Under US GAAP, joint and several liability arrangements for which the total amount of the obligation is fixed at the reporting date are recognised as the sum of the amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors and any additional amount the reporting entity expects to pay on behalf of its co-obligors. However, this measurement attribute does not apply if the obligations are addressed within existing US GAAP.
Onerous contracts are not recognised as provisions. The effects are recognised upon settlement of the obligation. Exit costs are provided for only when a detailed plan is in place and recipients of severance have agreed to the terms. Costs for which employees are required to work are recognised as the work is performed.
Asset retirement obligations (AROs) are largely the same, but the difference in the discount rate used to measure the obligations creates an inherent difference in the carrying value. To discount the obligation, US GAAP uses a risk-free rate adjusted for the entity's credit risk. IFRS uses the time value of money rate adjusted for specific risks of the liability. Also, period-to-period changes in the discount rate do not affect an accrual that has not changed. The discount rate applied to each increment of an accrual, termed “layers” in US GAAP, remains within that layer. Also, AROs are not recognised under GAAP unless there is a present legal obligation and the fair value of the obligation can be reasonably estimated.
Under US GAAP, provisions may be discounted when the liability's amount and timing are fixed or reliably determinable or when the obligation is at fair value. The discount rate depends on the nature of the accrual.
Regarding restructuring costs, under US GAAP, once management has committed to a restructuring plan, each type of cost is examined to determine when it should be recognised. Involuntary employee terminations costs under a one-time benefit arrangement are expensed over the future service period. If no future service is required, the costs are expensed immediately. Other exit costs are expensed when incurred.