New Clarity on Contingent Liabilities

In its first exposure draft of 2010, the IASB seeks to eliminate uncertainty in the measurement of contingent liabilities.
Marie LeoneJanuary 6, 2010

The International Accounting Standards Board started off the new year by proposing new guidance on measuring contingent liabilities related to legal settlements and the retirement and decommissioning of factories and other major assets. The draft guidance is intended to replace what the IASB calls “vague” measurement requirements in IAS 37, the international accounting standard that deals with contingent assets and liabilities.

The board’s exposure draft, issued on Tuesday, is a re-release of guidance first proposed in a 2005 exposure draft of amendments to IAS 37. It’s one piece of a much larger effort to replace the international financial reporting standard with a new one. A working proposal of the new IFRS will be released in February.

(Publicly held U.S. companies have good reason to keep an eye on the IASB rulemaking process, as they may someday file financial results using IFRS instead of U.S. generally accepted accounting principles. The Securities and Exchange Commission is expected to decide by 2011 whether U.S. companies will be required to switch to IFRS.)

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The IASB says certain “vague” requirements in the liability-measurement section of IAS 37 make it difficult for investors to compare financial statements. For example, the rule instructs companies to measure a contingent liability by using a “best estimate” of the outlay used to settle the obligation. But the board notes that the term can mean different things: “the most likely outcome, the weighted average of all possible outcomes, or even the minimum or maximum amount in the range of possible outcomes.”

Another uncertainty of IAS 37 is that it doesn’t specify the costs companies should include in the measurement of a liability, points out the IASB. As a result, some companies include only direct costs in the calculation, while others also factor in incremental costs, and still others add indirect costs and overhead fees. In other cases, companies use the prices they would pay contractors to fulfill the obligation on their behalf.

The draft guidance attempts to sweep away such ambiguity. For starters, it eliminates the notion of a “best estimate.” Instead, it requires companies to base their measurement of a contingent liability on the amount they would “rationally pay at the end of the reporting period” to relieve the obligation. In most cases, that means estimating the present value of the resources needed to fulfill the obligation, taking into account the expected outflows of resources, the time value of money, and the risk that the actual outflows may ultimately differ from the estimate.

When the outflows of resources needed to satisfy an obligation are uncertain, companies should calculate their expected value — “the probability-weighted average of the outflows for the range of possible outcomes.” That calculation needn’t be complex, says the IASB.

If a company has an obligation to pay cash to settle a legal dispute, the future outlays should be based on the expected cash payments plus associated costs, such as legal fees. In the case of shutting down a factory, the guidance encourages companies to use a service provider’s estimate, which would be a “more objective measure” of future outlays than internal company calculations. “By specifying an objective (contractor prices) the standard would not need detailed and arbitrary rules on which costs should be included,” states the exposure draft.

The exposure draft is open for public comment until April 12.


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