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Liabilities — Amendments to IAS 37

Date recorded:

Uncertainty about the existence of a present obligation

The Board continued its deliberations on distinguishing uncertainty about the existence of a present obligation from a stand-ready obligation. The issue raised in the March 2007 meeting was whether the sale of a hamburger establishes a present obligation or whether it illustrates uncertainty about the existence of a present obligation (element uncertainty). The discussion was based on the following modified fact pattern:

Vendor sells hamburgers in a jurisdiction where the law stipulates that the vendor must pay compensation of £100,000 to each customer that purchases a contaminated hamburger. On 31 December 200X (the balance sheet date), Vendor has sold one hamburger to Customer. Past experience indicates that one in a million hamburgers sold by Vendor is contaminated. No other information is available.

The staff presented the following alternatives reflecting the views expressed by Board members in March:

View A

A present obligation arises when the hamburger is contaminated and all available evidence is used to determine whether or not a present obligation exists. Under the fact pattern outlined above no present obligation exists because the available evidence (here: past experience) does not indicate that Vendor sold a contaminated hamburger.

View B

The sale itself gives rise to a present obligation and all available evidence is used to reflect uncertainty in the measurement of that present obligation.

The Board remained nearly equally split between the two views. Some Board members holding view B made reference to incurred but not reported (IBNR) situations in the insurance industry, in which they saw the issue as a question of 'do I or do I not have a claim?'.

A member of the senior staff raised the question about what measurement implications the different views would have. He asked Board members whether, under View A, a liability of zero would be acceptable if it is concluded that no present obligation exists; and whether under view B, based on the degree of probability, a liability always has to be recognised (even if it is measured at a small amount). The Board discussed this issue for a while but did not reach an agreement.

After a lengthy discussion there seemed to be a consensus that the crucial question is to determine 'whether a contaminated hamburger has been sold' and the labelling as currently outlined under view A and view B is of less importance.

No conclusion was reached, but the staff was asked to redraft the paper by focusing on the identified crucial question.

Constructive obligations

The Board redeliberated the definition of a constructive obligation in order to reflect the outcome of the redeliberations regarding the distinction between a liability and a business risk.

In March 2007 the Board tentatively concluded that a present obligation exists when (a) an entity is irrevocably committed to act in a particular way and (b) an external party has an enforceable right to call upon the entity to act in that particular way. IAS 37 ED defines a constructive obligation as a 'present obligation that arises from an entity's past actions'.

Accordingly a constructive obligation is only a present obligation when the external party has an enforceable right to call upon the entity to act in a particular way.

The Board discussed five options to address the term 'enforceable right' in the tentative description of a present obligation in the definition/description of a constructive obligation.

Option 1:

Limit constructive obligations to those that a court would enforce.

Option 2:

Consider amending the tentative description of a present obligation in paragraph 13 and 15 of the IAS 37 ED to explain that an external party may have a right that is 'enforceable by legal or equivalent means'.

Option 3:

Use the explanatory text already in paragraph 15 of the IAS 37 ED as a proxy for explaining 'enforceable by equivalent means'.

Under this option paragraphs 13 and 15 of the IAS 37 ED could be amended in a manner similar to:

Paragraph 13

An essential characteristic of a liability is that the entity has a present obligation arising from a past event. A present obligation exists when the entity is irrevocably committed to act in a particular way and an external party has an enforceable right to call upon the entity to act in that particular way. An external party's right may be enforceable by legal or equivalent means. For a past event to give rise to a present obligation, the entity must have little, if any, discretion to avoid settling it. A past event that creates a present obligation is sometimes referred to as an obligating event.

Paragraph 15

In the absence of legal enforceability, particular care is required in determining whether an entity has a present obligation. that it has little, if any, discretion to avoid settling. In the case of a constructive obligation, tThis will be the case only if:

  • (a) the entity has indicated to other parties that it will accept particular responsibilities;
  • (b) the other parties can reasonably expect the entity to perform those responsibilities; and
  • (c) the other parties will either benefit from the entity's performance or suffer harm from its non-performance.

Option 4:

Continue developing the Board's tentative description of a present obligation in the Conceptual Framework project but drop the description in the IAS 37 project.

Option 5:

Revisit the Board's tentative conclusions in March to see whether it is possible to distinguish a liability from a business risk without introducing the idea of enforceability.

Some Board members raised the concern that a restriction to legally enforceable rights would be too narrow as there is 'something else' that can result in a present obligation. One Board member noted that such a restriction could even result in the necessity to re-exposure the IAS 37 ED.

The discussion focussed on 'what else' other than legal enforceability can establish a present obligation. Some Board members pointed out that in some circumstances economic compulsion could result in a present obligation, in particular when 'doing nothing' would mean that the entity has to give its business. For example, in case of participation contracts reducing payments to the contractual minimum would mean for the insurance company to be pushed out of the market. Other examples mentioned were pensions and jubilee bonus.

No decisions were made but the staff was asked to further elaborate this issue. In doing so options 1 and 3 should be taken into consideration. Eight and eleven Board members, respectively, were in favour of pursuing these options (multiple votes were permitted).