AASB paper discusses accounting for liabilities

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15 Oct 2013

The Australian Accounting Standards Board (AASB) has published a paper providing a conceptual analysis of the principal issues concerning the financial reporting of liabilities. The paper advocates a broad definition of 'liabilities', that liabilities be recognised on the basis of meeting the definition alone rather than separate recognition criteria, and that liabilities be measured at current value measurement on initial recognition and in most cases in subsequent periods.

The AASB Occasional Paper series is published by the AASB Research Centre and is designed to provide an avenue for in-depth consideration of financial reporting issues to facilitate debate and provide thought leadership in accounting standard-setting. The inaugural paper in the series, AASB Occasional Paper No. 1 Liabilities – the neglected element: a conceptual analysis of the financial reporting of liabilities was written by Warren McGregor, an independent financial reporting consultant and member of the International Accounting Standards Board from its initial formation until 2011.

The paper argues that there has been a historical focus on assets by accounting standard-setters and others, which may be due to the nature of some liabilities and the sometimes counter-intuitive effects of measuring liabilities on a current value basis (e.g. higher discount rates resulting in lower recognised liabilities, and the impacts of adjusting for changes in credit risk). In particular, the paper makes the following observations regarding 'non-exchange' liabilities:

Unlike most assets, liabilities will often arise without an exchange transaction having taken place; for example, litigation liabilities, asset retirement liabilities, taxation liabilities, social policy liabilities and liabilities arising from the receipt of government grants. There is no commensurate inflow (or more precisely ‘exchange proceeds’) relating to these liabilities... Assessing whether, and identifying when, an obligation arises in relation to ‘non-exchange’ liabilities and consequently measuring them is sometimes highly problematic.

Because of the various difficulties arising, the paper argues that many issues remain unresolved and conclusions reached are often inconsistent and "lack conceptual rigour". Accordingly, the paper endeavours to address the main issues concerning the definition, recognition and measurement of liabilities, and also deals with specific disclosure issues arising.In terms of the definition of a liability, the paper settles on a preference for the IASB and FASB's recent definition of "a liability of an entity is a present economic burden for which the entity is obligated", which is considered to be a 'mirror image' of the definition of an asset which is "a present economic resource to which the entity has a right or other access that others do not have". The paper explores various liability-related projects of the IASB, FASB and IPSASB, and considers some of the issues surrounding the nature of obligations and when an entity becomes obligations, the concepts of legal and constructive obligations and the additional difficulties in determining the existence or otherwise of an obligation in the case of non-exchange transactions in both the for-profit and public sectors. It provides the author's view on topics such as accounting for levies, government grants, emissions trading schemes, rate regulation, litigation liabilities and unvested employee benefits, and the interaction of liability existence with asset recognition and impairment, the introduction of the 'performance obligation' concept in the revenue recognition project, and the unconditional nature of options.

In discussion the recognition of liabilities, the paper again explores existing literature, focusing on the the probable recognition and reliable measurement criteria currently adopted in many conceptual frameworks. The author concludes that the probable recognition criteria creates 'cliff-edge' accounting that has no conceptual rationale, whilst seeing the reliable measurement criterion as 'less egregious'. Nonetheless, the paper concludes that additional recognition criteria are unnecessary:

... concerns about reliable measurement or faithful representation arise from uncertainties relating to the amount and timing of future resource transfers, and I believe these concerns can be overcome by selection of an appropriate measurement basis and disclosure of appropriate information related to the measurement process, rather than by not recognising a liability at all.

In turning to measurement, the paper explores what the correct characterisation of an obligation should be, and the correct basis for measuring that obligation. It contrasts the notions of 'liability' and 'deferred income', arguing the latter is conceptually insupportable and that "transactions that are revenue (or income) generating should be accounted for on initial recognition consistent with the definition of liabilities", whilst relying on measurement to ensure an appropriate margin for risk is recognised in the period in which entity performs its obligations. It then asserts that the measurement basis for the initial recognition of a liability must be a current value basis, considers exit price (fair value), 'historical proceeds' (entry price) and entity-specific values as possible approaches to determine that current value, before recommending exit price (fair value) as "the most comprehensive and objective measure of a liability".

Moving to the subsequent measurement of liabilities, the author notes a preference for "a current measurement basis for all liabilities both at initial recognition and subsequently", before acknowledging a cost-based measurement may be appropriate on cost-benefit grounds for some liabilities and that "there is a great deal of resistance to the use of exit price in measuring liabilities subsequent to initial recognition", citing concerns about the use of a transfer value and the inclusion of non-performance risk. Furthermore, the author notes he does not support a 'fulfilment value' concept, but instead argues that an entity-specific value should be used where an exit price is considered unsuitable or unacceptable for subsequent measurement, and explores in detail the 'building blocks' of measurement for each of the concepts.

In closing, the paper considers the various disclosures that should be considered in the content of the recommendations and preferences outlined in the paper. It focuses on the topics of existence uncertainty, conditional obligations and estimation uncertainty, before recommending "standard setters should exercise extreme caution in modifying required disclosures on the grounds that the disclosures might be prejudicial to a reporting entity".

Click for access to the paper (link to the AASB website).

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