The International Accounting Standards Committee (IASC) issued IAS37 Provisions, Contingent Liabilities and Contingent Assets in September 1998. It replaced parts of IAS10 Contingencies (IAS37 BV2008) and became operative for annual financial statements covering periods beginning on or after 1 July 1999 (IAS37, BV2008, IN23).
The objective of this standard is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is disclosed in the notes to enable users to understand their nature, timing and amount (International Financial Reporting Standards (IFRS), 2009). The key principle of IAS37 is that a provision should be recognized only when a liability exists. Planned future expenditures are not recognized as provisions or contingencies, even if the board of directors has authorized them.
IAS37 prescribes the accounting and disclosure for all provisions, contingent liabilities and contingent assets, except:
those resulting from executory contracts, except where the contract is onerous. Executory contracts are contracts under which neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent;
those covered by another Standard (IFRS, 2009).
A provision is a liability of uncertain timing or amount recognised when:
(a) a company has a present obligation as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation;
(c) a reliable estimate can be made of the amount of the obligation. The Standard notes that it is only in extremely rare cases that a reliable estimate will not be possible (IFRS, 2009).
a possible obligation depending on whether some uncertain future event occurs;
a present obligation but payment is not probable or the amount cannot be measured reliably (Deloitte, 2009a).
A company should disclose a contingent liability unless the possibility of an outflow of resources embodying economic benefits is remote.
a possible asset that arises from past events;
whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity ( Deloitte, 2009a).
When the realisation of income is virtually certain, then the related asset is not a contingent asset and its recognition is appropriate.
IAS 37 Major requirements
An entity should recognize a provision as a liability based on the following three criteria met simultaneously:
a) there is a present obligation or more likely than not that a present obligation exists at the end of the balance sheet date as a result of an obligating event;
b) it is probable (i.e. more likely than not; i.e. 50%–95%) that an outflow of the economic benefit of the entity will exist;
c) the amount of the outflow can be estimated reliably.
If the first criterion is met but it is possible (i.e.5%-50%) NOT probable that an outflow of economic benefit of the entity exists and the amount of the outflow cannot be measured reliably OR if possible obligation exists and the outflow of the economic benefit of the entity is not remote (i.e. 0%-5%), then contingent liability will arise.
In respect of contingent liability an entity should disclose it instead of recognizing unless the possibility of the outflow of the economic benefit of the entity is remote.
As regards a contingent asset, it should be just disclosed as well as contingent liability, unless the amount of the inflow of the contingent asset is virtually certain (i.e.95%-100%). When the inflow of the contingent asset is virtually certain, then it is appropriate to be recognized as an asset on the balance sheet.
When recognizing a provision, the amount of the outflow of the economic benefit of the entity should be based on the best estimate, i.e. this amount should be the same as the entity needs to pay to settle the obligation in due course.
When measuring a provision, things such as, risks and uncertainties, discounted provisions (if time value of money is material), changes in the law or other cases which can affect provisions, should be taken into account but do not take into account gains from the expected disposal of assets.
When reimbursement happens, an entity recognizes it if it is virtually certain and the amount recognized should not be more than the amount of the provision. The reimbursement should be recognized as a separate asset in the balance sheet. If the reimbursement and the expense relating to a provision are sustained in the same reporting period, then the expenses disclosed in the comprehensive P & L can be netted off by the amount recognized as a reimbursement.
The provision should be reviewed annually and adjusted according to latest best estimates. Changes in the provision can only be used for its original intention.
Provisions-three specific applications mentioned by this standard, namely: future operating losses, onerous contracts, restructurings. With regard to future operating losses no recognition should be made as a provision. In terms of onerous contracts, the unavoidable cost in excess of the benefit which can be received by the entity should be recognized as a provision. In related to restructurings, restructuring costs should be recognized when the criteria for provisions are met.
The importance of IAS37 requirements
In terms of the importance of the IAS37 requirement, the objectives of the standard will be discussed first. According to Deloitte, IAS37 aims to ensure that recognition of provisions, contingent liabilities and contingent assets are made by using the best methods and measurements, to ensure that users of financial statements receive adequate and appropriate information for investment decision-making processes. In addition, IAS37 aims to ensure that it only deals with the real obligation in the financial statements and future expenditure, even if excluded from recognition by the responsible board.
The importance of taking the criteria into account, when the entity recognises the provision, is to prevent any unnecessary provision from being recognised in order to enhance the entity’s value in subsequent periods in unsubstantiated ways, leading to provision of unreliable information to financial statement users (ACCA, 2009).
Under IAS37 the entity should disclose the contingent liability in its notes and not recognise it in statements, unless the probability is less than 5%, also the entity should act in the same way when facing contingent assets unless it is more than 95% probable. The importance of this requirement could be viewed as returning to the Conservatism Principle in accounting which advises on ignoring profits not yet achieved, taking all expected losses into account and not registering potential gains until they occur. In other words this requirement prevents an entity from providing unrealised profits and subsequent information that might mislead users.
IAS37 provides guidelines regarding best estimates of provisions associated with its objectives, aiming to provide an appropriate way of measuring provisions in order to represent sufficient and appropriate information. The standard requires the entity to take into account estimating process risks, uncertainties and other elements in order to achieve the best estimate for the provision. Following this requirement can prevent unrealistic values in the financial statement. The requirement for solving the problem of reimbursement and illustrating the three specific applications are equally comprehensive, so that accountants know how to resolve them. Otherwise, it is likely that each entity might adopt its own method of troubleshooting which differs from others when facing such cases in reality, resulting in a lack of comparability among entities. In these instances investors may be misled when making investment decisions.
Most countries are now applying IAS (IASB, 2010); developed countries may find opportunities to update their existing accounting standards and in this way be less inopportune and more globalized. Developing countries can learn from it, improve their accounting systems, which will be suitably international, thus proving the applicability of IAS as an international standard. However, America believes that the US GAAP (Generally Accepted Accounting Principles) is the most detailed and comprehensive accounting standard worldwide, urging other countries to adopt it.
There are potential problems with GAAP. First, the Financial Accounting Standards Board (FASB), the Committee on Accounting Procedures (CAP) and Accounting Principles Board (APB) have established hundreds of rules and published thousands pages since 1937. One problem is that although it is easy for companies to follow a specific rule, the whole standards system has become dispersed and repetitious owing to long-term maintenance by different institutions. Second, with the emergence of new transactions and events, especially financial derivative instruments not seen before, the three institutions could not update their rules in time. In this situation, accounting fraud has become more possible such as the “Enron bomb”, which bankrupted both Enron and Andersen in 2001. Last and most important, there is a financial cost for any entity wanting to list in America, as they need to translate their financial report to GAAP standards. This complex and expensive work has made entities more irresolute about entering the American market.
As a result, the Securities and Exchange Commission (SEC) and FASB have started to co-operate with the IASC. GAAP and IAS have been harmonized, whereas SEC still have special requirements about IAS37. First, more information about recognized provisions need to be disclosed with further details about the nature, types and amounts being reported. Additionally, “other provisions” should be labelled and explained. Second, provisions recorded for estimated product returns, when recognizing revenues, are required to be given in more detail regarding the location, and whether they are properly disclosed. SEC also considers the exact amount of this kind of provision that should be included; the amount when the financial period began and ended, followed by the amount made and used during the period. Third, SEC has identified that some entities may miss some provisions or contingent liabilities in their financial reports and notes, strongly recommending that all information about estimated provisions and liabilities should be disclosed clearly. Fourth, fines and losses owing to currency allocation and pricing about forward sales, the disclosure about these provisions and contingent liabilities is necessary (Deloitte, 2009b).
America has an almost complete accounting standard system, with more specific requirements, compared to the IAS. Co-operation between GAAP and IAS may make IAS more applicable and avoid mistakes made by GAAP.
As a developing country, Chinese accounting standards are not as well-designed as those of America. In 2007, the Chinese Ministry of Finance declared that every entity, listed in Shanghai or Shenzhen, should use IAS and IFRS to produce annual financial reports showing the real value of the entity to an international accounting standard, improving the international competitiveness of the entity.
The first important requirement is the recording of capital assets in the financial report, providing investors with real operating conditions and market value of the listed entity. The second improvement is about IAS37. In Chinese accounting standards, an accurate definition of provision does not exist, resulting in misunderstands of provisions and bad debts or other reserves. It is clear that provision is a liability of uncertain timing or amount according to IAS37. This standard has made reporting from Chinese entities more reliable and forward-looking. As a less-developed country, it is absolutely correct to learn from developed countries; Chinese accounting standards can be enhanced by learning and applying IAS.
The essential rule of accounting is to be true; however creative accounting can occur and may be caused by human error, lack of professional ethics, squalid motives and so on. Simply put, the aim of creative accounting is to artificially state profits. Methods of creative accounting can be considered in four aspects:
1. Different accounting standards allow entities to choose different measurements. For example, a measurement objective in Chinese Enterprise Accounting Standards is liabilities, which are recognised by contingencies. However, IAS37 requires recognising a provision which is a liability of uncertain timing or amount, therefore differing standards indicate differing profits.
2.Many accounting items need estimation and anticipation. The items in IAS37 are full of uncertainty and arbitrariness. Although IAS37 makes rules for measurement, overrating or underrating still happens. The accountant has the opportunity for creative accounting in making the estimate. For instance, when a company wants to calculate the prospective pension liability, they will employ an actuary who should be familiar with the inside background and control the valuation as the accountant wants them to be.
3. A common method of creative accounting is artificial transactions which can be reflected in the balance sheet. This case needs assistance from other entities, for example, supposing entity A pretends to claim indemnity from entity B, so they can form contingent assets and recognise them as assets.
4. Creative accounting also plays tricks on real transactions, for example, suppose an entity has a contingent liability of¿¡50,000, the accountant may disclose this item in the next year to guarantee the financial situation in that year.
IAS37 plays a significant role in the development of accounting standards, where generally, there are no serious or prevalent problems existing, however, it still has limitations which were discussed at the April 2009 IASB meeting.
First, inconsistency with other standards, especially the probability of recognition criteria; specifically, liabilities are recognized only if it is probable that an outflow of economic benefits according to IAS37 (IAS37 BV2008, p.5) will occur. In contrast, other standards, such as IFRS 3 Business Combinations, have no requirement to use probability recognition criteria for contingent liabilities when an entity is in a business combination. This inconsistency is potentially confusing.
Second, IAS37 does not clearly explain identification of liabilities; the term ‘contingent liability’ is used to describe both liabilities and non-liabilities in different situations. Specifically, it is puzzling to use one term to represent both possible obligations and unrecognised present obligations in the practical examples (Broad, 2006, p.14) The term ‘contingent liability’ is unnecessary, however removing it from the standard may hide some potentially significant risks, such as litigation, illegal acts, environmental laws and copyright. These potentially significant risks do not satisfy the definition of a liability because they are uncertain on the balance sheet date but they may be useful for decision making.
Third, IAS37 focuses on legal obligations while neglecting constructive obligations. The definition of a constructive obligation is not tight enough, especially, paragraph 15(b) of the 2005 ED which was identified at the February 2008 IASB meeting. There is a difficulty for entities to discriminate constructive obligations from economic compulsion, such as pensions and jubilee bonuses which can establish a present obligation as constructive obligations (Deloitte, 2009c).
Fourth, IAS37 is ambiguous when measuring a single obligation. It is universally interpreted that the most likely outcome may be the best estimate of the liability when measuring a single obligation, (IAS37 BV2008, p. 17).This is contrary to the current settlement notion which states that expected value should be the base when entities measure all liabilities, which may mislead. Basically, the estimation technique of expected value has more merits since it obtains information about the range of possible cash flows and reflects new information about a liability as that information becomes available (Broad, 2006, p.19).
Fifth, the term ‘provisions’ is useless and there is an existing risk if eliminated. At present, the standard defines a provision as ‘a liability of uncertain timing or amount’ (IAS37 VB2008, p.10) therefore it is another form of liability. However, the difference between a provision, other liabilities and the new analysis of contingent liabilities is vague. The standard does not offer adequate explanation on how to distinguish them, for example, the uncertainty about timing or amount relates to cash flows so it is difficult to recognize a liability for a product warranty. In other words, there is a choice between a provision and a contingent liability.
In order to improve the standard IAS37, several suggestions can be made:
First, eliminate the probability of recognition criteria.
Second, eliminate the label ‘contingent liability’, and update the guidance in order to help entities to identify liabilities. Attention should be paid to potential liabilities in various scenarios in which a transaction embodies the nature of a liability. In response to this kind of special case, the IASB panel should publicise and add new applications to the IAS liability standards to help entities apply it to special cases.
Third, complete general guidance on recognizing constructive obligations, by perfecting its definition and stating exactly that entities must have a present duty to a third party who will benefit from the entity’s performance.
Fourth, clarifiy that entities should establish basic measurements of all liabilities based on value, not on most likely outcome
Fifth, eliminate the terminology ‘provision’ and replace it with another phrase such as ‘non-financial liability’ which is important to make a clear distinction between liabilities.
ISA37 improves accounting standards as there were no specific regulations or provisions previously. Its key principle requires that a provision should be recognized when the following conditions are met simultaneously:
there is a present obligation or a present obligation exists at the end of the balance sheet date as a result of an obligating event,
there is a probable outflow of the economic benefit,
the outflow can be estimated reliably.
Within these stipulations, IAS37 ensures recognition is made using appropriate measurements and provides valuable information for users of financial statements. Most countries in the world now apply IAS. Developed countries may find opportunities to update their existing accounting standards and developing countries can learn and improve theirs. Differing standards in different countries gives an entity options to choose accounting standard which indicate more profit. Furthermore, some items in IAS37 need estimation and anticipation and provide opportunities for creative accounting, for these reasons, IAS37 is not perfect. The inconsistency with other standards and vapoury explanations of liabilities and constructive obligations provide the basis for some suggestions to improve ISA37. The probability of recognition criteria may be eliminated. Meanwhile, we probably need to pay some attention to potential liabilities and update the guidance in order to help entities to identify liabilities.