IAS 37 - Contingencies

IAS 37 - Contingencies

Executive summary • Both IFRS and US GAAP have similar recognition criteria for a liability. • Both require recognition of the best estimate of a probable loss; however, US GAAP defines probable as “likely” and IFRS defines probable as “more likely than not.” • When there is a range of possible provision requirements all with an equal probability of occurring, US GAAP requires the minimum amount in the range to be recorded, while IFRS requires the midpoint in the range to be recorded. • Generally, US GAAP only allows discounting when the liability and the timing of payments are fixed or reliably determinable. IFRS requires provisions to be discounted for the time value of money if the impact is material.

Executive summary

Progress on convergence The Boards both have current agenda items related to provisions and contingencies. The IASB’s objectives in this area are: To address inconsistencies with other IFRS To achieve global convergence of accounting standards. To improve measurement of liabilities in IAS 37 An IFRS working draft proposing a new IFRS to replace IAS 37 was issued in February 2010. The new IFRS will apply to all liabilities that are not within the scope of other standards. The proposed new IFRS would remove the requirement under IAS 37 for recognizing a liability when “it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation” (IAS 37, paragraph 14(b)). The result is that a company would recognize a liability for the amount it would rationally pay to be relieved of an obligation that can be reliably measured. The intent is to focus management on judging whether the company has an obligation rather than predicting the likely outcome. This proposed change will create a bigger difference between US GAAP and IFRS. The IASB has postponed this project to finish the convergence projects (this project is not part of the Memorandum of Understanding (MOU)). The IASB expects to resume work on this project after June 2011. A new IFRS, Liabilities, is expected to be issued in the latter half of 2011 or the beginning of 2012.

Progress on convergence The FASB has a project on its agenda to improve loss contingency disclosures. The FASB issued an ED, Disclosure of Certain Loss Contingencies, on June 5, 2008, and an ED of a proposed Accounting Standards Update (ASU), Contingencies (Topic 450): Disclosure of Certain Loss Contingencies, on July 20, 2010. The proposed ASU would expand and require new, enhanced disclosures about certain loss contingencies. This proposed change will create a bigger difference between US GAAP and IFRS. The FASB does not anticipate issuing the ASU during 2011.

Definition of current liabilities • Both US GAAP and IFRS define current liabilities similarly. • Both prohibit a provision for future operating costs.

Various specific liabilities • Most liabilities, unless otherwise noted, are generally accounted for in the same manner for US GAAP and IFRS.

Short-term obligations expected to be refinanced US GAAP IFRS Permits the reclassification of short-term obligations to long-term obligations if a company intends to refinance the short-term debt on a long-term basis, and the company can demonstrate its ability to consummate the refinancing. Similar

Short-term obligations expected to be refinanced US GAAP • Requires refinancing to be in place before the audited financial statements are issued. IFRS • Requires the refinancing to be consummated by the balance sheet date.

Example 1: Park Company had two short-term obligations. On December 1, 2011, the treasurer of Park Company was asked to refinance these obligations so they would appear as long-term obligations on the December 31, 2011, year-end balance sheet. Obligation A – This note for $10,000 was due on January 31, 2012. The treasurer was able to convince the noteholder to extend the maturity date until January 31, 2013. All required paperwork to reflect this change was signed on December 20, 2011. Obligation B – This note for $20,000 was due on December 31, 2012. Due to vacations, the treasurer was unable to contact the noteholder until January 2, 2012. The treasurer was only able to get the noteholder to extend the maturity until January 3, 2013. All required paperwork to reflect the extension was in place before the audited financial statements were issued. Refinancing short-term obligations example • Based on the following information, how should these two obligations be recorded at year-end using both US GAAP and IFRS? Show any required journal entries.

Example 1 solution: US GAAP Both obligations can be classified as long term in Park Company’s December 31, 2011, audited financial statements since the company was able to demonstrate its ability to refinance the short-term obligations prior to issuing its audited financial statements. Obligation A – short term $10,000 Obligation A – long term $10,000 Obligation B – short term $20,000 Obligation B – long term $20,000 IFRS Obligation A can be classified as long term because the refinancing was completed before year-end. Obligation B must be classified as short term because the refinancing was not completed before year-end. No entry is required for obligation B since it is already classified as current. Obligation A – short term $10,000 Obligation A – long term $10,000 Refinancing short-term obligations example

Long-term debt violations US GAAP IFRS Allows the classification of debt as long term if the debt violations are cured before year-end. Similar

Long-term debt violations US GAAP • Allows debt to be classified as long term if the violation is cured before the audited financial statements are issued. IFRS • Requires the violation to be cured before year-end to classify the debt as long term.

Example 2: Big International Corporation (BIC) is a December 31 year-end company. As of December 31, 2010, BIC had a $40,000 bond payable due on June 30, 2013. This bond has default provisions that allow the creditor to accelerate payment or waive the default provisions, depending on the circumstances. Long-term debt violation example In late January 2011, utilizing the preliminary financial statements for the year ended December 31, 2010, the controller determined that BIC was in technical default under certain of the bond payable default provisions. The controller asks you, the chief financial officer, what she should do now and what the ramifications are using US GAAP and IFRS.

Example 2 solution: Tell the controller to obtain a waiver from the bondholder as soon as possible. For US GAAP, if an acceptable waiver is received before the financial statements are issued, the bonds payable after one year would be classified as long-term debt. For IFRS, the entire amount of the bond would be classified as a current liability because there was no waiver received prior to year-end. Long-term debt violation example

ContingenciesDefinition US GAAP IFRS ASC 450-10-20 defines a contingency as “an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.” Similar, according to IAS 37.

ContingenciesGain contingency US GAAP IFRS Gain contingencies are defined as possible assets that arise from past events and 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. Similar, although the term “contingent assets” is used for “gain contingencies.” Requires that certainty exists regarding its realization before a gain contingency can be recorded. Similar

ContingenciesGain contingency US GAAP • A gain contingency for environmental liabilities can be recorded when it is probable it will be received. Probable in this instance means the recovery is likely to occur. Likely to occur has been generally interpreted as a chance greater than 70%. IFRS • A contingent asset, including a reimbursement such as for an environmental liability, is only recorded when it is virtually certain to be realized.

ContingenciesLoss contingency US GAAP IFRS • Requires a provision (liability) be recognized if: • As a result of a past event, the entity has an obligation to others. • It is probable that an outflow of resources will be required to settle the obligation. • The amount of the obligation can be reliably estimated. • The amount recognized as a provision should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date. When there is a large homogeneous population, the best estimate of the obligation is generally based on the expected value. Similar

ContingenciesLoss contingency US GAAP IFRS Requires information about a contingent liability whose occurrence is more than remote but did not meet the recognition criteria to be disclosed in the notes to the financial statements. Similar

ContingenciesLoss contingency – definition of probable US GAAP • Defines probable as “likely” (this has been generally interpreted as greater than a 70% chance of occurring). IFRS • Probable is defined as “more likely than not”(more than a 50% chance of occurring).

Example 4: After a wedding in 2011, 10 people died as a result of food poisoning from products sold by Kiss Catering Inc. (KCI). Legal proceedings started, seeking damages from the company. Up to the date of authorization of the financial statements for the year ended December 31, 2011, the company’s lawyers advised that it was 40% probable that the company would not be found liable. However, when the company prepared its financial statements for the year ended December 31, 2012, its lawyers advised that, owing to developments in the case, it was 85% probable that the company would be found liable. Probable liability example • Assuming the attorneys can arrive at a reasonable estimate of the potential damages, should KCI recognize a provision using US GAAP in 2011 and in 2012? • Should KCI recognize a provision using IFRS in 2011 and in 2012?

Example 4 solution: US GAAP: In 2011, you would not recognize a provision for this situation. The probability that KCI would be found liable at this point is 60%. The definition of probable is “likely to occur” (> 70%). Therefore, the 60% falls below the threshold. In 2012, you would recognize a provision for this situation. Due to new developments, the probability of a negative outcome rose to 85%, which is above the threshold. IFRS: In 2011 and 2012, you recognize a provision for this situation. Using IFRS, “probable” indicates that an outcome is more likely than not to occur (more than a 50% chance of occurring). Since this situation is above this threshold in both years, a provision would be required to be recognized. Probable liability example

ContingenciesLoss contingency – range of possible outcomes US GAAP • Where there is a continuous range of possible outcomes and each point in the range is as likely as any other to occur, under ASC 450-20-30-1, the minimum amount in the range is used to measure the provision. IFRS • The midpoint of the range is used to measure the provision.

Example 5: An entity sells webcams with a warranty under which customers are covered for the cost of repairs of any manufacturing defects that become apparent within the first six months after purchase. The company has only recently started operations and thus cannot estimate what percentage of webcams will likely be returned. They do know that if defects were detected in all products sold, repair costs would range from $2 million for minor repairs to $4 million for major repairs. Range of possible outcomes example • Assuming all other criteria are met, how much should the entity book related to warranty repairs using US GAAP and IFRS? • Show any required journal entries.

Example 5 solution: US GAAP The minimum point of the range, $2.0 million, should be recorded. Warranty expense $2,000,000 Warranty liability $2,000,000 IFRS The midpoint of the range, $3.0 million, should be recorded. Warranty expense $3,000,000 Warranty liability $3,000,000 Since the entity only had a range to work with, the treatment using the two sets of standards is different. If no particular outcome within the range is better than another, then for US GAAP the entity would book the minimum of the range, whereas for IFRS the entity would book the midpoint range. Range of possible outcomes example

Example 6: Use the same facts in example 5, except now assume the entity is able to perform an analysis on the historical data of returns and estimates (based on historical data), finding that 75% of the goods sold will have no defects, 20% of the goods sold will have minor defects and 5% of the goods sold will have major defects. Range of possible outcomes example • Assuming all other criteria are met, how much should the entity book related to warranty repairs using US GAAP and IFRS? • Show any required journal entries.

Example 6 solution: For both US GAAP and IFRS, $600,000 should be recorded. The most likely outcome is $600,000 explained as follows: (20% of $2 million for minor repairs = $400,000) + (5% of $4 million for major repairs = $200,000) + (75% without defects and, therefore, no impact on the estimate). Warranty expense $600,000 Warranty liability $600,000 Probable liability example

ContingenciesDiscounting US GAAP • Provisions may be discounted only when the amount of the liability and the timing of the payments are fixed or reliably determinable. IFRS • Provisions should be recorded at the estimated amount to settle or transfer the obligation, taking into consideration the time value of money (utilizing a pretax discount rate).

Example 7: The CFO of Out of Luck Company (OLC) has determined OLC needs a $100,000 provision for a contingent liability. The CFO is uncertain when OLC must make this payment but believes it will be sometime in the next year. The current pretax discount rate is 8%. Discounting provisions example • Show the required journal entries using both US GAAP and IFRS.

Example 7 solution: US GAAP: The payment is not fixed nor reliably determinable, therefore, the undiscounted liability should be recorded. Legal expense $100,000 Legal liability $100,000 IFRS: The time value of money needs to be considered if it is material. Based on the information provided, it is reasonable to use the midpoint (six months) as the expected payment date. The provision should be made for $96,154, as shown below: $100,000/(1 + (8% x ½ year)) Legal expense $96,154 Legal liability $96,154 Discounting provisions example

Restructuring costs US GAAP IFRS IAS 37 similarly limits restructuring programs to those that either change how business is conducted or change the scope of the business. ASC 420 limits restructuring programs to those that relate to exit or disposal activities.

Restructuring costs US GAAP • ASC 420 addresses the accounting and reporting for costs associated with exit or disposal activities. ASC 420 establishes an accounting model for costs associated with exit or disposal activities based on the FASB’s conceptual framework for recognition of liabilities and fair value measurements. IFRS

Restructuring costs US GAAP • Under this model, a liability for costs associated with an exit or disposal activity should be recognized and initially measured at fair value only when it is incurred, that is, when the definition of a liability in SFAC No. 6, Elements of Financial Statements, is met. IFRS

Restructuring costs US GAAP • Costs covered by ASC 420 include, but are not limited to, the following: • One-time involuntary termination benefits provided to employees under the terms of a benefit arrangement that, in substance, are not an ongoing benefit arrangement or a deferred compensation contract. IFRS

Restructuring costs US GAAP • Costs covered by ASC 420 (continued): • One-time involuntary termination benefits (continued): • A one-time benefit arrangement is deemed to exist at the date the plan of termination meets certain criteria and has been communicated to employees (referred to as the communication date). IFRS

Restructuring costs US GAAP • Costs covered by ASC 420 (continued): • One-time involuntary termination benefits (continued): • The timing and amount of liability recognition are dependent on whether employees are required to render future service in order to receive the termination benefits. If employees are required to render service until they are terminated and that service period extends beyond a “minimum retention period,” the liability (expense) should be recognized ratably over the future service period, even if the benefit formula used to calculate the termination benefit is based on past service. IFRS

Restructuring costs US GAAP • Costs covered by ASC 420 (continued): • Certain contract termination costs, including operating lease termination costs. • Other associated costs. IFRS

Restructuring costs US GAAP • ASC 420 also addresses the accounting for: • Costs to terminate a contract before the end of its term. • Costs that will continue to be incurred under the contract for its remaining term, without economic benefit to the entity. IFRS

Restructuring costs US GAAP • ASC 420 also addresses the accounting for (continued): • Liabilities for these costs are to be recognized and measured at fair value in the period in which the liability is incurred (generally, when the entity terminates the contract pursuant to the contractual terms or ceases to use the rights conveyed under the contract). IFRS

Restructuring costs US GAAP • ASC 420 requires that a liability (expense) for other costs associated with exit or disposal activities, such as costs to consolidate or close a facility, be recognized in the period in which the liability is incurred (generally, upon receipt of the goods or services, e.g., security services incurred during the closing of the facility), not at a commitment date. IFRS

Restructuring costs US GAAP IFRS • Using IFRS, once management is “demonstrably committed” to a detailed exit plan and the plan and its main features have been communicated, the general provisions of IAS 37 apply: • This means that a provision is recognized when an entity is committed to a restructuring plan and has raised a valid expectation in those affected that it will carry out the restructuring. Also, the cost must be reasonably estimable and the plan must be carried out within a reasonable period of time. Once the conditions for recognition are satisfied, a provision is recognized for the cost of the restructuring.

Restructuring costs US GAAP IFRS • Focus is on the exit plan as a whole and, as a result, costs are generally recognized earlier. • Focus is on the individual cost components and, as a result, costs are generally recognized later.

Example 8: In the fourth quarter of 2011, management and the board of directors publicly announced a plan to close its telemarketing division in Chicago and move it to India. The impacted employees in Chicago were notified that their jobs would be eliminated. To ensure an orderly transition, management promised “stay pay” of $10,000 to any Chicago office employee who remained until they were terminated by the Company in the third quarter of 2012. Restructuring costs example • How should the stay pay be accounted for using US GAAP and IFRS? For purposes of this example, ignore any impact of the present value since it would be immaterial.

Example 8 solution: US GAAP: ASC 420-20-25-9, states in part, “If employees are required to render service until they are terminated in order to receive the termination benefits and will be retained to render service beyond the minimum retention period, a liability for the termination benefits shall be measured initially at the communication date based on the fair value of the liability as of the termination date. The liability shall be recognized ratably over the future service period.” The minimum retention period is generally defined as 60 days. The stay pay, thus, should be accrued in the fourth quarter of 2011 with an offsetting debit to a deferred expense account. The stay pay would then be amortized to expense over the period from the announcement to the termination period in the third quarter of 2012. IFRS: The formal restructuring plan would appear to create a constructive obligation using IAS 37. Thus, the estimated stay pay should be accrued and expensed in the fourth quarter of 2011. Restructuring costs example

Restructuring costs convergence The proposed IFRS, Liabilities, will specify how certain normal restructuring costs (e.g., employee termination costs) should be accounted for similar to US GAAP.

Onerous contracts • Both US GAAP and IFRS require consideration of the accounting for a contract when the costs exceed the expected future benefits as follows: • For IFRS, IAS 37, paragraph 12, defines an onerous contract as “a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.” • In order to recognize an obligation under an onerous contract, the entity generally would cease benefiting under such contract. • Once the conditions for recognition are satisfied, a provision will be recognized for the unavoidable costs of the contract, which are the lower of the cost of fulfillment and the penalty that would result from non-fulfillment under the contract. • IAS 37 currently provides little guidance as to when a provision for an onerous contract should be recognized. If a contract becomes onerous as a result of an entity’s own actions, the liability should be recognized when that action is taken. • For US GAAP, ASC 420-10-25requires recognition of a liability for the cost that an entity will continue to incur under a contract without economic benefit when the entity has ceased using the right conveyed by the contract. The resulting provision is measured at its fair value.

Onerous contracts US GAAP • Timing of recognition: • A provision can only be recorded when the entity ceases to use the rights conveyed by the contract. • Amount of recognition: • A provision is recorded at its fair value. IFRS • Timing of recognition: • A provision can only be recorded when the costs exceed the expected benefits. • Amount of recognition: • The unavoidable costs (the lower of the cost of fulfilling the contract and any penalties that result from nonfulfillment) are recorded.

Example 9: Company Best’s (CB) Board approved a restructuring plan on November 1, 2010. On December 1, 2010, CB issued a press release announcing it was consolidating its facilities. The New Jersey facility to be shut down is currently leased. CB accounts for the facility as an operating lease with annual lease payments of $10,000. CB is currently in the fifth year of a 10-year lease. The restructuring plan has committed CB to using the New Jersey facility through January 1, 2012, which completes the sixth year under the lease term, at which time the remaining lease rentals will be $40,000 ($10,000 per year for the remaining four years). Due to the specialization of the manufacturing process, there are no options to sublease the facility. The present value of the remaining lease rental at December 1, 2010, is $45,000. The present value of the remaining lease rentals at January 1, 2012, is $36,000. Onerous contracts example • Using US GAAP and IFRS, when and what amount, if any, should be recorded for this operating lease? • Show any required journal entries.

Example 9 solution: US GAAP: The liability is recognized upon the cessation date of January 1, 2012, at its then fair value. On January 1, 2012, record the following entry: Restructuring expense $36,000 Operating lease liability $36,000 IFRS: The liability is recognized when the company has knowledge of and has committed to no longer use the facility (i.e., December 1, 2010). Again, the general recognition provisions of IAS 37 apply: The entity has a present obligation as a result of a past event. It is probable that an outflow of resources will be required to settle the obligation. A reliable estimate can be made of the amount of the obligation. On December 1, 2010, record the following journal entry: Restructuring expense $45,000 Operating lease liability $45,000 Onerous contracts example

IAS 37 - Contingencies