- redeliberation of the ED
Approach to re-deliberating the issues associated with the recognition principle proposed in the ED (agenda paper 10A))
In the February 2006 Board meeting it was agreed that an entity shall recognise a liability when:
- the definition of a liability has been satisfied; and
- the liability can be measured reliably.
Many respondents used litigation as an example to highlight their concerns with the ED. Staff believe that litigation is a problematic area because it often involves multiple points of uncertainty, and so may combine several recognition and measurement issues. As a result, litigation will be discussed as a standalone topic in the June meeting. The following topics will also be discussed in June:
- the Framework's recognition criteria;
- clarity of explanation within the ED;
- elimination of the term 'contingent liability'; and
- the interaction between the recognition principle in the ED and the recognition of liabilities following the guidance in other standards (e.g. business combinations).
From the comment letters on the proposed amendments to IAS 37, staff identified two main sources of uncertainty:
- 1. uncertainty about the outflow of resources embodying economic benefits associated with a present obligation; and
- 2. uncertainty about the existence of a present obligation.
1. Uncertainty about the outflow of resources embodying economic benefits associated with a present obligation
Respondents argued that the ED's proposals are not consistent with the Framework, because the Framework definition of a liability includes the words 'the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits'. Staff believe that the phrase 'expected to' has more than one definition, and has addressed this issue in paper 10B (see below).
Respondents were also concerned that the probability was only being considered when measuring a liability, whereas the Framework requires a probability assessment to determine whether a liability should be recognised. Staff believed that the only justification for not recognising a liability when there is little or no uncertainty that a present obligation exists is that it is not possible to identify a range of possible outcomes with sufficient reliability. Consequently staff propose to examine whether further guidance is needed in this area.
2. Uncertainty about the existence of a present obligation
Several respondents indicated that there are many situations in which it is not certain that a present obligation exists. This has been referred to by staff as 'element uncertainty'. Whilst this is not a new issue, the ED has highlighted it because it clarifies that an entity must first determine whether a present obligation exists. This issue is addressed in paper 10C (see below).
The meaning of the phrase 'expected to' in the definition of a liability (agenda paper 10B)
Comment letters on the ED indicated that different views exist on the meaning of 'expected to'. In particular, many are interpreting the phrase as meaning 'probable'. The issue arises as 'expected to' is often used in common English to mean more likely than not, or probable. If an outcome is less certain, the word 'possible' is often used. However, staff believe that the phrase 'expected to' in the Framework is not intended to imply a particular degree of certainty. Instead, they believe it is being used to indicate some potential outflow is necessary in order to meet the definition of a liability. The Board acknowledged that there is widespread confusion about the term, and there was comment that the phrase was being used here in more of a statistical context (where the probability of an out come is assessed by adding together all possible outcomes multiplied by their associated probabilities of occurring). It was also mentioned that the history of the phrase being used by the FASB was to avoid the assumption that there must be virtual certainty before a liability exists. The Board generally agreed with the staff conclusion that:
- 'expected to' is not intended to imply that there must be a particular degree of certainty that an outflow of benefits will occur before an item meets the Framework definition of a liability; and
- the Board's interpretation of 'expected to' in the IASB's definition of a liability does not increase divergence with US GAAP.
However, the Board felt this was important enough that this confusion should not simply be addressed in the Basis for Conclusions - it should also be included in the body of the standard.
Determining whether an entity has a liability when the existence of a present obligation is uncertain (agenda paper 10C)
Staff noted that element uncertainty is not a new issue. IAS 37 currently contains limited guidance and states that when uncertainty exists an entity must assess all available evidence to determine whether it is more likely than not that a present obligation exists. If so, a present obligation is deemed to exist, and if not, a contingent liability exists. However, IAS 37 also states that it is only in rare cases that it will not be clear whether a present obligation exists. The ED does not include any reference to 'more likely than not'.
Many respondents disagree with omitting this probability guidance in the ED, and support the Alternative View given. They argue that by omitting this guidance, there is insufficient guidance on what to do in situations where it is unclear whether a present obligation exists.
Staff agreed with respondents that more guidance in this area is necessary. Further, staff believe that element uncertainty arises with sufficient frequency across all industries to justify including additional guidance. Staff proposed five different options which may form the basis of additional guidance on element uncertainty:
- 1. reflect element uncertainty in measurement;
- 2. reinstate the 'more likely than not' guidance in paragraphs 15 and 16 of the current IAS 37;
- 3. reinstate the current probability recognition criterion;
- 4. provide a list of indicators to act as guidance in determining whether a present obligation exists; or
- 5. identify an alternate obligating event.
Staff recommended that option 4 be pursued. The Board agreed that further guidance was needed and justified. There were a variety of views about which of the above options was the best route to follow. There was general agreement that providing a list of indicators as to whether a present obligation exists (that is, option 4) would be useful. Some Board members felt that in addition, the 'more likely than not' guidance should be reinstated. Several Board members stated that it was difficult to judge without seeing the list of indicators. There was some discussion about whether entities would use the 'more likely than not' guidance in practice, even if the words were not reinstated. There was also discussion about whether it is appropriate to use probability to determine whether an event has occurred, as either the event has occurred, or it hasn't. Some Board members stated it might be helpful to also give some examples of situations in which there is no element uncertainty.
Stand ready obligations (agenda paper 10D)
The ED proposes introducing the concept of a stand ready obligation. Many respondents stated that the explanation of what a stand ready obligation is too broad and will result in recognising far more liabilities. Based on an analysis of the comment letters staff believe that there are two potential improvements that could be made:
- improve the explanation of the notion of a stand ready obligation; and
- provide additional examples to illustrate the distinction between scenarios in which there is a stand ready obligation and in where there is just business risk.
The Board agreed with the staff plans for improvement. Staff then asked the Board to consider four examples and to give an indication on whether there is a liability, and if so what is the obligating event. The examples given are duplicated from the observer notes.
Example 1
Entity X operates a store that sells CD players. Entity X sells its CD players with a product warranty. The product warranty requires the entity to replace or repair any CD players that develop a fault within one year from the date of sale. Entity X operates in a jurisdiction in which no consumer protection legislation applies. Entity X has made no promise to replace or repair any CD players that develop a fault unless the fault is covered by the terms and conditions of the product warranty.
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There was general agreement that a liability does exist in example 1, and the obligating event is selling the warranty (rather than selling the CD player and warranty, as proposed by staff). There was some discussion about whether this was consistent with the impairment model in IAS 39 for receivables, where an incurred (rather than expected) model is used. There was also discussion about how in practice some entities link warranty provisions with revenue. For example, if history indicates that warranty claims are made on 5% of sales, the warranty provision is booked when the sales are booked.
Example 2
Entity Z sells identical CD players to Entity X, but without a product warranty. Entity Z operates in a jurisdiction that has enacted consumer protection legislation. This legislation requires all goods sold to retail customers to be sold fit for purpose. Entity Z does not replace or repair any CD players that develop a fault unless the CD player sold is subject to the consumer protection legislation.
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Staff put forward two views. The first was that examples 1 and 2 are not different in substance. The second is that they are different, and that in this scenario there is only a liability fro CD players that have faults at the time of sale. The Board debated this example for a while, with most Board members stating the facts were not conclusive and that more information was needed to give a view. For example, the consumer legislation could require the vendor to write an identical warranty to that in example 1. Alternatively, it could require a different warranty, or it could just give protection for CD players with a fault at the point of sale (that is, if a fault developed on day 2, the customer would not be protected by the legislation). The remaining two examples deal with non-contractual situations.
Example 3
Entity Y is a construction company operating in a jurisdiction with occupational health and safety regulations. These regulations require an entity to pay any medical costs associated with a workplace injury caused by a breach of the health and safety regulations. Entity Y has no policy or pattern of past practice which creates an expectation that it will bear the financial consequences of workplace injuries over and above that required by the health and safety regulations.
As at 31 December 20X0 the management of Entity Y are not aware of any hazards on its building sites (in breach of the health and safety regulations) and there have been no accidents.
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Generally, most Board members agreed with the staff that Y does not have a liability. This is because the available evidence indicates the company has complied with health and safety regulations.. Therefore there is no present obligation and there is no potential outflow of resources.
Example 4
Entity Y continues to operate in the construction industry. There have been no changes in the jurisdiction's occupational health and safety regulations since 31 December 20X0.
As at 30 June 20X1 the management of Entity Y are aware of a problem with its scaffolding. This problem meets the definition of a hazard and is a breach of the health and safety regulations. As at 30 June 20X1 no accidents as a result of this hazard have been reported.
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Staff again put forward two views. View A is that Y has no liability until an accident occurs. As at 30 June 20X1, the available evidence indicates that no accidents have occurred as a result of the hazard and therefore there is no potential outflow of resources.
View B is that Y does have a liability because the existence of a hazard creates a stand ready obligation to accept the financial consequences of the hazard causing an accident. There were a variety of views on this example, although the Board did generally agree that there could never be a stand ready obligation unless there is a breach of the health and safety regulations. It was also generally agreed that the answer might depend on how long it would take to rectify the breach.