IAS 37 – Provisions & Contingencies Comparative Analysis with US GAAP

IAS 37 – Provisions & ContingenciesComparative Analysis with USGAAP December 2002 Stefaan Cloet – Senior manager IAS Service Line

Reasons for IAS 37 • ‘Big bath’ provisions • Undisclosed use of old provisions • Distortion of subsequent profits

Objective • To ensure that • appropriate recognition criteria and measurement bases are being applied • there is sufficient disclosure to understand the nature, timing and amount of provisions, contingent liabilities and contingent assets

Scope This Standard should be applied by all enterprises accounting for provisions, contingent liabilities and contingent assets, except: • those arising in insurance enterprises from contracts with policyholders • those resulting from financial instruments that are carried at fair value • those resulting from executory contracts* except when the contract is onerous • those covered by another IAS (for example, provisions addressed in IAS 12 Income Taxes, IAS 17 Leases, IAS 19 Employee Benefits) * Executory contracts - contracts where both parties either have not performed any of their obligations or have partially performed their obligations to an equal extent

What is a provision? Liability of uncertain timing or amount Present obligation arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits Obligating event creates is an event that: - Creates a legal or constructive obligation - Results in an enterprise having no realistic alternative to settling the obligation

OBLIGATION What is a provision? LEGAL VS. CONSTRUCTIVE OBLIGATION LEGAL Obligation that derives from: • a contract (explicit or implicit) • legislation

Constructive OBLIGATION What is a provision? LEGAL VS. CONSTRUCTIVE OBLIGATION Obligation that derives from an enterprise’s actions where: • the enterprise has indicated that it will accept certain responsibilities by • an established pattern of past practice • published policies • a sufficiently specific current statement • as a result, there is a valid expectation that the enterprise will discharge those responsibilities

Constructive OBLIGATION What is a provision? LEGAL VS. CONSTRUCTIVE OBLIGATION An enterprise cannot create a constructive obligation to itself or its owners • Board resolution to do periodic repairs and maintenance

Recognition of a provision • Recognise a provision if, and only if • present obligation (legal or constructive) • as a result of past event (obligating event) • probable (‘more likely than not’) transfer of economic benefits • reliableestimate can be made

Recognition of a provision • Only those obligations arising from past events existing independently of an enterprise's future actions are recognised as provisions.

What is a contingent liability? • Possible obligation depending on the occurrence/non-occurrence of uncertain future events, or • Present obligation but no probable outflow of economic benefits or amount can’t be reliably measured

Contingent liability • An enterprise should not recognise a contingent liability • Disclosure is required unless a cash outflow is remote

Provision or a contingent liability? Presentobligation from past event Outflow probable Able to measure = + + Provision Possibleobligation from past event Outflow is notprobable Unable to measure Contingent liability and/or and/or =

Decision tree START Present obligation as a result of an obli-gating event? Possible obligation? No No Yes Yes Yes Remote? Probable outflow? No Yes No Reliable estimate? No Rare Yes Provision Disclose contingent liability Do nothing 14

Contingent assets • Definition: a possible asset depending on the occurrence/non-occurrence of uncertain future events • Do not recognise contingent assets • disclosure is required if a cash inflow is probable

Case study 01 • Recognition of provisions

Measurement principles • Best estimate • the amount an enterprise would rationally pay to settle or transfer the obligation to a third party = fair value • use reports of independent experts where necessary

Measurement at best estimate • Multiple events expected value • Single event most likely outcome, adjusted if possible • Risks and uncertainties • Discounting, if effect is material • Future events

Case study 02 • Measurement at best estimate

Future events • Consider future cost reductions if increased experience in • applying existing technology • the expected costs of applying existing technology to more complex clean-up operation than previously carried out • Consider changes in legislation • when virtually certain to be enacted

Discounting • Pre-tax discount rate • Reflects current market assessments of • time value • risks specific to the liability • Cash flows/discount rate  beconsistent! • avoid double counting of risk • inflation

Reduction of obligation • Gains from the expected disposal of assets should not be taken into account • Reimbursements should be recognised when, and only when, it is virtually certain that reimbursement will be received if the enterprise settles the obligation • Treated as separate asset • Amount recognised should not exceed the amount of provision • Expense relating to the provision may be presented net of the amount of reimbursement in the income statement

Changes and use of provisions • Review and adjust provisions at each balance sheet date • if outflow no longer probable  reverse provision • A provision should be used only for expenditures for which the provision was originally recognised

Specific illustrations • IAS 37 includes 3 specific application of its requirements • future operating losses • onerous contracts • restructuring provisions • IAS 37 also apply to environmental liabilities

Future operating losses • Provisions should not be recognised for future operating losses • general prohibition: no present obligation no liability • specific prohibition: future operating losses up to the date of a restructuring

Onerous contracts • Present obligation under onerous contracts should be recognised and measured as a provision • an onerous contract is a contact in which the unavoidable costs of meeting the obligations exceed the economic benefits expected to be received under the contract

Restructuring, definition • Planned & controlled by management • Materially changes either • the scope of a business undertaken, or • the manner in which that business is conducted

Restructuring provisions • What constitutes a restructuring • sale or termination of a line of business • closure of business locations • changes in management structure • fundamental reorganisations

Restructuring provisions • Requirements for recognition • detailed formal plan • business and locations affected • employees who will be compensated • expenditure undertaken • timeframe for implementation • valid expectation of implementation

Restructuring provisions • Requirement for a valid expectation • actually start to implement plan • announce main features of the plan to those affected by it • management or board decision will not, by itself, constitute a constructive obligation to restructure

Restructuring provisions • Sale of an operation • no obligation for the sale of an operation until a binding sale agreement • Expected disposal of assets • no offsetting with expected gains • review assets for impairment

Restructuring provisions • Restructuring provisions should include only direct expenditures • necessarily entailed by the restructuring • not associated with the ongoing activities of the enterprise See case example:

Restructuring provision on acquisition • Revised IAS 22 links with IAS 37 • Liabilities resulting from acquirer’s intentions not recognised • Specific conditions for the recognition of a provision when the provision was not a liability of the acquiree

Asset recognition from a provision • The other entry for a provision is not always an expense • Some expenditure incurred to settle an obligation related to an asset may form part ofthe cost of the asset See cases:

Asset recognition from a provision • IAS 16 – PP&E • Costs to dismantle and remove an asset and restore its site are included in the cost of an item of PP&E to the extend that it is recognised as a provision under IAS 37 • SIC 23 – Major Inspection or Overhaul Costs

Reconciliation Opening balance Additions Used Reversals Increases for passage of time Closing balance No prior year! Brief description of Nature Timing Uncertainties Assumptions Reimbursement Main disclosures (for each class of provision)

Examples of disclosures

Case studies • Case study others

Appendix Comparative analysis between IAS & US GAAP

Provisions - Comparative analysis between IAS & US GAAP • Source of comparison • the IASC - U.S. comparison project: a report on the similarities and differences between IASC and USGAAP - Second edition - Edited by Carrie Bloomer • Differences exist in: • scope • definitions • recognition and measurement criteria • disclosure

Definitions • Constructive obligation • USGAAP does not provide a set of criteria with which to judge whether a recognizable constructive obligation exists • IAS 37 provides a set of criteria and examples of applying those criteria • Probable • IAS 37: • the outcome is more likely than not to occur • statistical chance greater than 50% • USGAAP: • statement 5: the outcome is likely to occur • probable: requires an 80% or greater chance of occurrence, others might suggest 70% or 90% • more likely than not: any statistical chance greater than 50%  IAS 37 will result in earlier recognition of liabilities than USGAAP

Topic Addressed IAS 37 Recognition and Measurement U.S. GAAP Criterion a. Existence of a present obligation More likely than not For contingent liabilities – probable b. Outflows of resources More likely than not For contingent liabilities – probable confirming event c. Contingent assets Virtually certain Statement 5 addresses contingent gains, which are generally not recognised d. Reimbursements by insurance Virtually certain Probable enterprises and other outside enterprises e. Assets acquired in the course of Not addressed Not addressed settling a provision f. Amounts attributable to other Amounts expected (presumably more Probable enterprises when liability is joint and likely than not) to be paid by others are several not recognised as part of the provision g. Changes in the amount of a provision, More likely than not Not addressed, but in practice subject to including derecognition the same evaluation of probability applied at initial recognition h. Future events that may affect the Where there is sufficient objective Probable amount required to settle an obligation evidence that the events will occur i. Costs and related inflows from an Costs – unavoidable costs of meeting the Similar approach onerous contract obligation Inflows – benefits expected to be received Recognition and Measurement Criteria - Differences in recognition rules

Recognition and Measurement Criteria • IAS • a range of recognition criteria are prescribed in IAS 37 to elements that have similar effects on the financial position • example: a company establishes a provision for 1,000 and a number of possible factors might decrease the effect of that provision on the financial statements: • an expected reimbursement of 100 would be recognized if it is virtually certain to be realized; • if the liability is joint and several, the effect of participation by another enterprise for 100 would be recognized if the other enterprise is expected (more likely than not) to pay its 10% share; • a future event that reduces the provision by 100 would be recognized based on the existence of sufficient objective evidence; • a 100 change in the estimated outflow would be recognized if it is more likely than not • a change in estimate that reduces the chance of a future outflow from 51% to 49% would result in derecognition of the entire provision

Recognition and Measurement Criteria • US GAAP • it is unlikely that such a range of recognition criteria would be applied on elements with a similar effect on financial position

Other Measurement Issues: settlement vs. cost accumulation • IAS 37: • settlement of the present obligation at the balance sheet date is the clear measurement objective • settlement: price of a current transaction that would extinguish the liability  fair value • the enterprise can be released by paying the obligation or by transferring the obligation to another enterprise with the counter's party permission

Other Measurement Issues: settlement vs. cost accumulation • USGAAP: • many US pronouncements do not have settlement price as an objective in measuring liabilities; • often the objective is unstated and the guidance describes an accumulation of the enterprise’s cost estimates • This leads to a difference in estimation techniques and is likely to produce significant differences in the amount of the recorded liability

Other Measurement Issues: Best Estimate • Current settlement or transfer is rarely an alternative for provisions  necessity to develop best estimate for the settlement price (fair value of the provision) • If a range of estimates is present with each equal chances: • IAS 37: look to the midpoint of such a range; • US GAAP: the minimum amount should be used • IAS 37 employs the statistical notion of expected value in estimating the settlement value: • e.g.: 40% probability of 100 and 60% probability of 10  expected cost is 46 • under a cost-accumulation approach, that result is not viewed as representative; in US GAAP the most likely outcome (10) would be recorded

Other Measurement Issues: Present Value • IAS 37: • required the use of present value whenever the effect on measurement of the liability is material • the change in provision attributable to the passage of time is recorded as interest expense • USGAAP: • applying present value to measure "liabilities of uncertain timing or amount" represents a significant departure from US pronouncements • SOP96-1 restricts the use of present value to situation in which "the aggregate amount of the liability… and the amount and timing of cash payments for the liability… are fixed or reliably determinable" • the interest element usually is portrayed as part of the related expense

Other Measurement Issues: Future Events • IAS 37: • requires to consider future events that may effect the amount required to settle the obligation • This is different from US GAAP, the latter are often more specific: • the effect of new legislation => not until enacted • IAS: if it is virtually certain to be enacted

Other Measurement Issues: Restructurings • Restructurings and discontinued operations: • IAS 37: • applies to provisions recorded as a consequence of any restructuring, incl. discontinued operations • a restructuring, "a programme that is planned and controlled by management and materially changes either: (a) the scope of a business undertaken by an enterprise; or (b) the manner in which that business is conducted" • USGAAP: distinction is made between the recognition and measurement of • discontinued operations (Opinion 30) • disposal of a segment of a business (Opinion 30) • other restructurings (EITF 94-3)

IAS 37 – Provisions & Contingencies Comparative Analysis with US GAAP