The International Accounting Standards Committee (IASC) issued IAS37 Provisions, Contingent Liabilities and Contingent Assets in September 1998. It replaced parts of IAS10 Contingencies and became operative for annual financial statements covering periods beginning on or after 1 July 1999.
The objective of this standard is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is disclosed in the notes to enable users to understand their nature, timing and amount. The key principle of IAS37 is that a provision should be recognized only when a liability exists. Planned future expenditures are not recognized as provisions or contingencies, even if the board of directors has authorized them.
IAS37 prescribes the accounting and disclosure for all provisions, contingent liabilities and contingent assets, except those resulting from executory contracts, except where the contract is onerous. Executory contracts are contracts under which neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent; those covered by another Standard.
Since IAS 37 is published, companies obeying by international standards can solve the difficulty of how to recognize and measure provision, contingent liability and contingent asset. It provides an explicit direction for companies to disclose incurred transactions associated with liabilities. However, “probable” or “possible” such words are involved many times in this standard which can allow options and creative accounting for companies on whether to recognize it as a provision on the balance sheet or a contingent liability under the notes. This will further mislead investors’ decisions.
In the measurement of IAS 37, there are several ways to measure provisions in order to make best estimate. Owing to these different ways, companies could control the amount of their provisions. All the information about provisions, such as amount and timing, are realized and disclosed by the companies. So a company could make the number of provision larger on the balance sheet when it is making a profit during the period. In addition, a company could calculate the number of provision smaller to make sure their balance sheets still look good when it is losing money during the year. This is an option that companies can change a number from their balance sheets showing different operating conditions and improve financial performance. In this way, decisions of investors could be misled, because investors of a company will not be possible to discover a present obligation or the estimation of the amount of the payment, companies could use this potential option to hide their real operating condition and make creditors and shareholder believe the companies are performing well.
In the second place, contingent liabilities are disclosed in the financial statement, especially in the notes, while provisions are disclosed in balance sheet as provisions are recognized as liabilities. It is absolutely sure that balance sheet will be paid more attention by reports’ users than notes. In order to make balance sheet attractive, the company will prefer to disclose adverse cases as contingent liabilities in the note on which the information appears less transparent. This action may affect investors’ decisions. And this kind of action may not be discerned because in general, both provisions and contingent liabilities are uncertain in timing or amount. This is another option under IAS 37 that companies could use to produce an advantageous financial report for them.
Applicability of IAS37 Internationally
Companies from more than 100 countries have been required or permitted to use IFRS since 2001. Meanwhile, remaining countries, such as Japan, have established timelines for harmonization with IFRS. However, IAS 37 may face some difficulties when being applied world widely.
Owing to the different cultural attitudes, companies may not voluntarily disclose information about contingent liabilities and contingent assets in notes of their financial reports in some countries whose residents are secretive, such as Switzerland and Japan. On the contrary, Companies from transparent countries will disclose more detail information about their operation.
Additionally, some countries have more requirements about provisions, contingent liabilities and contingent assets than IAS 37 does. Because their accounting profession, as well as accounting standards, is well developed. For example, Securities and Exchange Commission (SEC) of America has special requirements about companies who use IAS37 instead of GAAP. First, more information about recognized provisions need to be disclosed with further details about the nature, types and amounts being reported. Additionally, “other provisions” should be labelled and explained. Second, provisions recorded for estimated product returns, when recognizing revenues, are required to be given in more detail regarding the amount and location, and whether they are properly disclosed. SEC also considers the exact amount of this kind of provision that should be included; the amount when the financial period began and ended, followed by the amount made and used during the period. Third, it is strongly recommended that all information about estimated provisions and liabilities should be disclosed clearly. Fines and losses owing to currency allocation and pricing about forward sales, disclosure about these provisions and contingent liabilities is necessary. In these countries where the accounting profession is fully developed, companies maybe prefer to use their own accounting standards. The application of IAS 37 could be easier in counties where accounting profession is less developed, such as Russia and Japan.
Opportunities for Creative Accounting
The essential rule of accounting is to be true; however creative accounting can occur and may be caused by human error, lack of professional ethics, squalid motives and so on. Simply put, the aim of creative accounting is to artificially state profits. Methods of creative accounting can be considered in four aspects:
- Options give companies opportunities to make creative accounting. Provisions should be reflected in balance sheet but contingent liabilities only be disclosed in the notes. People focus more on balance sheet than the notes. Therefore, accounts may prefer to disclose some contingent liabilities rather than recognize the provisions.
- Many accounting items need estimation and anticipation. Especially in IAS37, the items are full of uncertainty and arbitrariness. Although IAS37 makes rules for measurement, overrating or underrating still happens. As we mentioned before, the options allowed companies to control the amount of provisions. For instance, when a company wants to calculate the prospective pension liability, they will employ an actuary who should be familiar with the inside background and control the valuation on the basis of the financial performance.
- A common method of creative accounting is artificial transactions which can be reflected in the balance sheet. This case needs assistance from other entities, for example, supposing entity A pretends to claim indemnity from entity B, so they can form contingent assets and recognise them as assets.
- Creative accounting also plays tricks on real transactions, for example, suppose an entity has a contingent liability of $50,000, the accountant may disclose this item in the next year to guarantee the financial situation in that year.
Weaknesses of IAS37
There are no prevalent problems existing in IAS37, however, it still has limitations which were discussed at the April 2009 IASB meeting.
- First, inconsistency with other standards, especially the probability of recognition criteria; specifically, liabilities are recognized only if it is probable that an outflow of economic benefits according to IAS37 will occur. In contrast, other standards, such as IFRS 3 Business Combinations, have no requirement to use probability recognition criteria for contingent liabilities when an entity is in a business combination. This inconsistency is potentially confusing.
- Second, IAS37 does not clearly explain identification of liabilities; the term ‘contingent liability’ is used to describe both liabilities and non-liabilities in different situations. Specifically, it is puzzling to use one term to represent both possible obligations and unrecognised present obligations in the practical examples. The term ‘contingent liability’ is unnecessary, however removing it from the standard may hide some potentially significant risks, such as litigation, illegal acts, environmental laws and copyright. These potentially significant risks do not satisfy the definition of a liability because they are uncertain on the balance sheet date but they may be useful for decision making.
- Third, IAS37 focuses on legal obligations while neglecting constructive obligations. There is a difficulty for entities to discriminate constructive obligations from economic compulsion, such as pensions and jubilee bonuses which can establish a present obligation as constructive obligations.
- Fourth, IAS37 is ambiguous when measuring a single obligation. It is universally interpreted that the most likely outcome may be the best estimate of the liability when measuring a single obligation. This is contrary to the current settlement notion which states that expected value should be the base when entities measure all liabilities, which may mislead. Basically, the estimation technique of expected value has more merits since it obtains information about the range of possible cash flows and reflects new information about a liability as that information becomes available.
- Fifth, the term ‘provisions’ is useless and there is an existing risk if eliminated. At present, the standard defines a provision as ‘a liability of uncertain timing or amount’ therefore it is another form of liability. However, the difference between a provision, other liabilities and the new analysis of contingent liabilities is vague. The standard does not offer adequate explanation on how to distinguish them, for example, the uncertainty about timing or amount relates to cash flows so it is difficult to recognize a liability for a product warranty. In other words, there is a choice between a provision and a contingent liability.