This comment letter was sent to the International Accounting Standards Board on 19 May 2010 by Brussels Worldwide Services BVBA, on behalf of BDO International.
Dear Sir
IASB Exposure Draft ED 2010/1: Measurement of Liabilities in IAS 37 Limited re-exposure of proposed amendments to IAS 37
We are pleased to comment, on the above limited re-exposure draft (the ED) issued by the International Accounting Standards Board (IASB), on behalf of BDO International.
We are supportive of the IASB’s efforts to promote high quality accounting standards, and its efforts to achieve international convergence. However, we do not support the proposals in the ED. We also disagree with the conclusions set out in the Staff Paper Recognising liabilities arising from lawsuits and have included comments at the end of the attached Appendix.
As noted in our detailed responses to your questions, we do not agree that an expected value approach is appropriate and have reservations as to its practicability. We believe that it would be more appropriate for the IASB to require an entity to focus on the manner of settlement of its obligations and to record a liability based on the nature of the cash outflows that are expected to arise. This would result in the probable cost of settlement being recorded as a liability where an entity will settle an obligation itself (including associated costs such as legal fees), and an expected value being recorded where the entity will settle the obligation by transferring it to a third party. This approach, which would result in obligations being measured on a basis consistent with how the entity manages its obligations, would be similar in principle to the business model approach set out in IFRS 9 Financial Instruments.
We are also disappointed that the IASB has not sought the views of its constituents on the whole package of changes to IAS 37, and agree with the observations set out in paragraph AV7 in the Alternative Views. While we acknowledge that the Board has discussed points raised in responses from constituents to its original 2005 exposure draft, we note that:
A significant amount of time has elapsed since the original exposure draft was issued. Consequently, there will be constituents now who did not comment on the original proposals, and we believe that it would have been appropriate for the IASB to give them the opportunity to do so. In this context, we note that many respondents to the original exposure draft expressed significant concerns and opposed a number of the proposals. We also note that six members of the Board dissented from certain of the proposals set out in the ED, with those aspects being fundamental to the proposed new standard. This suggests that further deliberation and comment on the entire proposed standard would have been helpful.
Again linked to the significant period since the original proposals were exposed for comment, given the extent of changes made to IFRSs and other IASB projects that are in progress, we consider that constituents should have been given the opportunity to review and comment on the entire package of changes.
A number of changes have been made to the proposals in the original ED, and it would have been helpful for these to have been exposed for comment, notwithstanding that the Board might feel that there was not, technically, a requirement for that re-exposure. A piecemeal approach brings the risk that the extracts that are re-exposed are not considered in the context of the overall requirements of the amendments, notwithstanding the publication of the IASB’s working draft.
The proposals will affect a very wide range of entities across almost all industry sectors. There is a risk that the limited re-exposure will result in some constituents having difficulty in evaluating the proposals and putting them into context.
Standard setting is under close scrutiny, and the IASB has shown excellent due process in other areas (notably the accounting for financial instruments), which we believe is not reflective of the process afforded to the proposals to amend IAS 37.
Our responses to the specific questions set out in the ED are set out in the attached Appendix.We hope that our comments and suggestions are helpful. If you would like to discuss any of them, please contact Andrew Buchanan at +44 (0)20 7893 3300.
Yours sincerely
Brussels Worldwide Services BVBA
Appendix
Question 1 – Overall requirements
The proposed measurement requirements are set out in paragraphs 36A-36F. Paragraphs BC2-BC11 of the Basis for Conclusions explain the Board’s reasons for these proposals.
Do you support the requirements proposed in paragraphs 36A-36F? If not, with which paragraphs do you disagree, and why?
Paragraph 36A
We agree that a liability should in some cases be measured at the amount that the entity would rationally pay at the end of the reporting period to be relieved of the present obligation. However, in other cases we believe that this measurement approach is inappropriate as, other than at the settlement date, the amount of the liability will not be the settlement amount other than by coincidence.
We also consider that the proposed approach of expected value will be onerous and costly for many IFRS preparers. We note from paragraph BC13(c) that responses to the original proposals in 2005 raised this concern. However, as noted in paragraph BC16, the Board concluded that these observations were unfounded because it believes that most preparers will have the models and inputs necessary to meet this measurement objective. We do not agree with the Board’s assessment. We consider that many entities will not have the models, inputs or internal expertise necessary to measure expected present values on a regular basis and, consequently, will need to obtain these values with the assistance of external advisers.
Paragraph 36B
We agree that the measurement of an obligation should be the lowest settlement amount.
However, we do not agree that, where an entity will physically settle an obligation itself (that is, without the purchase of any services from third parties such as legal advisers), the obligation should be measured at an amount which includes a profit margin (please see our comments in response to question 2 below). In this context, we note that gains represent increases in economic benefits to an entity; the release of a profit margin at the point that an entity carries out a service itself to settle an obligation does not result from any inflow of economic benefits, and we believe that it is inappropriate for the accounting, as proposed in the ED, to suggest that it has. We agree with the objections to this proposal which are set out in the alternative views.
However, we acknowledge that the IASB might continue with the proposals set out in the ED when finalising the amendments to IAS 37. In that case, entities might be required or permitted to disclose the savings that they estimate would be made in the event that they discharge their obligations themselves instead of employing an outside contractor. If such disclosure were to be required or permitted, this would need to be clear about which internal costs are and are not included.
We note that paragraphs B15 to B17 set out guidance for calculating a risk adjustment to reflect the fact that the actual outflow of resources required to settle an obligation might differ from those expected. Although we disagree with the proposals set out in the ED, we again acknowledge that the IASB might continue with them. In that case, we believe that the IASB should be explicit that an entity’s own credit risk is not to be taken into account in the calculation of this risk adjustment.
Suggested alternative approach
We believe that a more appropriate approach than that set out in the ED would be to measure liabilities in a way that reflects the manner in which an entity manages and settles its liabilities. The focus should be on the actual outflows that will arise in practice, and not on the current settlement amount of the obligation. As noted above, the current settlement amount of an obligation will never, other than by coincidence, equal the actual settlement amount other than where an entity will transfer that obligation to a third party instead of settling the liability itself.
The measurement of an obligation should instead include a primary filter, being whether it is probable that the obligation will result in an outflow of economic benefits. Consequently, an obligation that meets the definition of a liability will always be recognised in financial statements, but will only be measured at an amount greater than zero where it is probable that an outflow of economic benefits will be required to settle the obligation. Where an obligation does not meet the ‘probable’ threshold for measurement at an amount in excess of zero, that obligation should be included in the financial statements through disclosure. In our view, disclosures about the range of possible outcomes and the associated risks would provide better information to investors and lenders than the inclusion of a single expected value measure, as those disclosures would provide information about the outflows of economic benefits that are expected to arise in the business.
Where an entity, instead of settling an obligation itself (or by itself together with purchased services from third parties, such as legal advisers), will transfer that obligation to a third party, the probability test for measurement at an amount other than zero will be met, because it is probable that there will be an outflow of resources in return for the transfer of the obligation to the third party. In such cases, we agree that it will be appropriate to look to the current settlement amount (being the amount that would be obtained under the proposals in the ED). This approach reflects the way in which the entity is managing this obligation; there is a probable outflow equal to the current settlement amount expected to be paid to the third party.
We note that this approach might be viewed as being consistent with the approach set out in the first phase of IFRS 9 Financial Instruments, which makes a distinction between financial assets where the business model is to collect contractual cash flows, and those where the business model is to generate cash flows through the realisation of fair value gains and losses through the sale of the financial assets. The settlement of obligations within the scope of IAS 37 is typically managed through the expected cash (or other economic) outflows that will arise from the settlement of obligations. This settlement will be either the entity’s own economic outflows (the probable cost of settlement, whether the cost of its own inputs only, or the cost of those inputs combined with services purchased from third parties), or the outflows associated with the transfer of the obligation to a third party (current settlement value).
Where an entity can fulfil an obligation itself, the amount of the provision should be the entity’s own cost of fulfilment (including the cost of inputs provided by the entity itself without any profit margin, and any profit inclusive amounts charged by third parties, such as legal advisers), unless it is clear that the cost of transferring the obligation to a third party would be lower. That is, there would be a rebuttable presumption that the lowest cost of settlement would be the entity’s own cost of fulfilment.
Where an entity has a choice between settling an obligation itself and transferring the obligation to a third party, the amount of the liability should be the lowest amount among the alternatives as it would be expected that an entity would rationally choose to manage the settlement of its obligations at the least possible cost. The only exception to this approach should be where the entity is either contractually committed to a particular settlement route, or there is no realistic alternative approach to the approach being (or proposed to be) followed. The approach set out in this paragraph would reduce the scope for earnings management.
Any obligations which the entity is not capable of settling itself should be measured at the current settlement amount, which is the amount that the guidance as proposed would require for all obligations.
We note that our suggested approach might appear to be inconsistent with IFRS 3, as that standard requires what are currently termed contingent liabilities (ie those which do not meet the ‘probable’ threshold) to be recognised at their fair value in a business combination. However, we do not believe there is a conflict. An ongoing business will manage its contingent liabilities on a cash flow basis, while an acquirer in a business combination will be interested in the fair value of those liabilities (because the acquirer will undertake a comparison of the fair value of the consideration being given with the fair value of what is being acquired). We also note that the guidance in IFRS 3 was introduced as a result of the requirement to recognise a bargain purchase gain as at the date of a business combination, where the purchase consideration is lower than the fair value of the identifiable net assets acquired, as not to have done so would have brought the risk of credits being recognised in the statement of comprehensive income when an entity with significant contingent liabilities is acquired.
Question 2 – Obligations fulfilled by undertaking a service
Some obligations within the scope of IAS 37 will be fulfilled by undertaking a service at a future date. Paragraph B8 of Appendix B specifies how entities should measure the future outflows required to fulfil such obligations. It proposes that the relevant outflows are the amount that the entity would rationally pay a contractor at the future date to undertake the service on its behalf.
Paragraphs BC19-BC22 of the Basis for Conclusions explain the Board’s rationale for this proposal.
Do you support the proposal in paragraph B8? If not, why not?
We do not support the proposal in paragraph B8, for reasons included above in our response to question 1.
The inclusion of a profit margin in the carrying amount of obligations that an entity will fulfil itself is inconsistent with the measurement objective (being the lowest amount that an entity would rationally pay to be relieved of an obligation). Payment in settlement of an obligation is consistent with the amount of cash outflows, and not with a hypothetical amount inclusive of opportunity costs.
We note that paragraphs BC20 – BC22 set out the arguments for and against the inclusion of a profit margin, with the Board relying primarily on the reasons set out in BC21, noting at BC21a) that ‘there is a market for most types of service’. This would indicate that the Board’s view is that the guidance in B8(a) will apply in most cases, and it would only be in rare circumstances that an entity would need to use the guidance in B8(b). We are not convinced that the position is as clear cut as the Board suggests, However, if this is the Board’s view, we consider that a rebuttable presumption should be included within the standard that a market based price can be obtained.
Question 3 – Exception for onerous sales and insurance contracts
Paragraph B9 of Appendix B proposes a limited exception for onerous contracts arising from transactions within the scope of IAS 18 Revenue or IFRS 4 Insurance Contacts. The relevant future outflows would be the costs the entity expects to incur to fulfil its contractual obligations, rather than the amounts the entity would pay a contractor to fulfil them on its behalf.
Paragraphs BC23 – BC27 of the Basis for Conclusions explain the reason for this exception.
Do you support the exception? If not, what would you propose instead and why?
We agree with this proposal. We note that this exemption is needed because of the measurement proposals for other liabilities within the scope of the standard.
Staff Paper Recognising liabilities arising from lawsuits
As noted in our covering letter, we disagree with the Staff Paper. In our view, the example set out in paragraph 5, where five people die while taking a new drug, and the accompanying analysis that concludes that, because the pharmaceutical company believes the subsequent claims from families of the people who died do not represent valid claims for compensation, no liability is recognised, are flawed.
We consider that a present obligation arises from the death of the people who took the new drug. While the pharmaceutical company might believe the claims from the families are without merit, the company might well reach an out of court settlement because it believes that the time and cost involved in defending the case, and the potential for negative publicity, would be greater than the cost of an immediate settlement. We note that our suggested approach, which looks to the actual cash outflows that will arise from settlement of an obligation, would result in the pharmaceutical company recording a liability for the out of court settlement amount if that was the manner in which the claims were expected to be settled.
We also note that a third party would be unlikely to be prepared to assume all potential obligations, arising from the claims from families of the people who died, for nil consideration even if there was evidence that the claims were without merit, as there would be a risk that a court might nevertheless award compensation.
ED-2010-1 Measurement of Liabilities in IAS 37.pdf
ED-2010-1 Staff Paper.pdf
BDO Comment Letter 2010 03.pdf