The most notable modification to the accounting standard for provisions looks likely to come from a change in how they are measured, as Adam Deller reports
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This article was first published in the May 2019 international edition of Accounting and Business magazine.
The concept of an accounting standard for provisions is a long-standing feature of financial reporting, introduced to protect investors from companies engaging in profit-smoothing (because businesses with volatile earnings are regarded as riskier investments) by creating and releasing provisions to suit their situation.
The standard’s key principle is that a provision is recognised if there is a probable outflow of economic events arising from a present obligation. As long as there is a reliable estimate, a liability is recorded on the entity’s statement of financial position. If the outflow is possible, but not probable, a contingent liability is recorded in the notes to the entity’s accounts, but not shown as a liability in the statement of financial position.
Similarly, a contingent asset relates to a potential future inflow, and is also shown only as a disclosure note, rather than being recorded as an asset in the statement of financial position. The bar for recognising a contingent asset is higher than for a contingent liability.
The introduction of IAS 37, Provisions, Contingent Liabilities and Contingent Assets, in 1998 aimed to prevent entities from being able to simply record provisions (and related expenses) in good years where targets are exceeded, releasing the liabilities (and so reversing the expense) in lean years. This standard has stood largely unchanged for many years, acting as the gatekeeper for the recognition of uncertain liabilities in many cases.
In 2015, the International Accounting Standards Board (IASB) decided to conduct research on changes to IAS 37 pending the finalisation of the revised Conceptual Framework. Following the publication in March 2018 of the updated framework, the research project for IAS 37 is finally active.
The issues surrounding the research project and the discussion around the accounting for provisions will examine the definitions used and the recognition and measurement criteria. We’ll look at the issues and potential actions to be taken for each of these.
One of the issues is the definition of a provision, crossed with the definition of a liability. According to IAS 37, a provision is a liability of uncertain timing or amount, so the project was held back while the definition of a liability was under discussion for the revised Conceptual Framework.
The definition of a liability has now changed under the revised framework. Previously defined as ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’, a liability is now defined as ‘a present obligation of the entity to transfer an economic resource as a result of past events’.
This change is likely to result in some of the most significant discussions within the IAS 37 research project, as the definition of a liability no longer mentions expected outflow, whereas the standard continues to require a probable outflow of economic benefits to be recognised. Following the updates to the Conceptual Framework, the IASB believes the change is more of a recognition issue than a definition issue, so we will focus on the change in relation to possible recognition issues.
In addition, an explicit reference to prudence has now been included in the Conceptual Framework. It states: ‘Prudence is the exercise of caution when making judgments under conditions of uncertainty.’
IAS 37 has long applied the principle of asymmetric prudence, which can be highlighted by looking at an example of a legal case. Imagine that entity A is being sued by entity B for $100,000 and is likely to lose the case: entity A must record a provision for $100,000, but entity B can only record a contingent asset (disclosing it in the notes to the financial statements).
Even though the probabilities are the same on each side of the equation in this example, the treatment in the books of both entities is different. Entity A must be prudent by recording a liability, while entity B must be prudent by only disclosing the contingent asset rather than recognising an asset in its financial statements.
The IASB has concluded that asymmetric prudence is not an essential part of faithful representation, but that it is useful in certain contexts, such as in IAS 37. It will therefore remain in IAS 37 and is unlikely to change.
While the definition of a liability may have changed, it is unlikely that this will affect the recognition of a provision in this sense. IAS 37 has often employed different criteria from other standards through the use of the ‘probable outflow’ threshold and the asymmetric prudence mentioned above.
Many respondents to the initial research project were concerned that the probability criteria in IAS 37 would be removed in line with the changes to the Conceptual Framework, but the IASB appears to have little appetite for that. It believes the recognition of provisions is working reasonably well and there is no particular requirement for this to be changed.
Of all the areas to be looked at in the research project, the measurement of provisions seems most likely to result in notable changes to the standard. From initial research, there has been diversity noted in the measurement of provisions recorded, particularly on discount rates and which costs should be included in calculating the amount of a provision.
IAS 37 does not specify whether the rates used to discount future cashflows should take into account the risk of non-performance by the entity, sometimes called the entity’s own credit risk.
Nor does IAS 37 specify whether a provision should include only the incremental costs of fulfilling an obligation or also allow an allocation of directly attributable overheads. This situation is already under consideration in the form of an exposure draft that considers the costs to be included in the recognition of an onerous contract.
IAS 37 defines an onerous contract as one in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected under it. It also states that those unavoidable costs reflect the least net cost of exiting the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it.
It all sounds pretty sensible, and the rule for an onerous contract is that a provision is recognised in full for the loss to be made under the contract. The problem that has arisen is that IAS 37 does not specify which costs to include in determining the cost of fulfilling a contract, which is where the exposure draft comes in.
The IASB proposes to specify in IAS 37 that the cost of fulfilling a contract comprises the costs that relate directly to the contract, rather than only the incremental costs. The exposure draft goes on to suggest examples of such costs: direct labour, direct materials, cost allocations that relate to contract activities (such as supervision, insurance, depreciation), costs explicitly charged to the counterparty under the contract, and other costs incurred only because an entity entered into the contract.
The likely way forward is a change to some wording to reflect the updates to terminology in the Conceptual Framework, particularly the definition of a liability. It is also possible that some explicit reference to prudence will be incorporated. These changes are likely to be relatively minor and will not affect the process of accounting for provisions or contingencies for entities.
Despite the concern that the need for a probable outflow of economic benefits could be removed, this appears unlikely. The IASB has already concluded that while the definition of a liability no longer needs an expected outflow, the probability element is a recognition issue. It is therefore likely to remain in the standard, as the IASB has given no indication that any changes to the recognition are required or proposed.
The IASB will press on with the narrow-scope adjustments in relation to onerous contracts, which is likely to result in more specific guidance on the costs to be included. In addition, it will seek feedback on any other aspects of IAS 37 that stakeholders may feel need amending. Responses will be gathered in the first half of 2019, with the aim of developing recommendations in the third quarter.
Adam Deller is a financial reporting specialist and lecturer.
CPD technical article
"The definitions and recognition and measurement criteria of the accounting for provisions will be examined"