Judgment demands challenge

Despite increases in data capture and measurement capabilities, judgment remains rife, and often controversial, in financial statements. This can be in much criticised impairment decisions (such as Coca-Cola’s continued reluctance to impair the Costa business it acquired despite the increasing evidence to the contrary – see my previous article ‘Coca-Cola’s plan goes flat’), or in how the useful lives applied to assets can have a dramatic effect on profit in companies such as Netflix (see my ‘Analysing amortisation at Netflix’ video). In addition to these, the intangible assets process rumbles on, trying to wrestle with key intangibles that could be recorded in financial statements without introducing even more judgment into the figures.

So judgment continues everywhere in the financial statements. And of course, wherever there is judgment, there is the scope for bias.

One of the longest-standing contentious judgments revolves around how entities account for provisions under IAS 37, Provisions, Contingent Liabilities and Contingent Assets. The omission or potential understatement of provisions is hardly new, and indeed brings back memories of tense arguments in industrial parks in my auditing past, but it is an ongoing project for the International Accounting Standards Board (IASB).

The IASB has released an exposure draft that proposes changes to definitions and recognition criteria. I initially discussed this in ‘Obligation clarification?’ but the draft has undergone some tweaks since.

Identifying an obligation

The first technical change related to clarifying some criteria for identifying when obligations exist. In the case of a legal obligation, it is proposed that an entity has no practical ability to avoid discharging a responsibility if either of the following conditions apply:

• the responsibility is legally enforceable – the counterparty has a right to ask a court to force the entity to discharge the responsibility or to pay a penalty or compensation for failing to do so
• the counterparty has a right to take another form of action against the entity for failing to discharge the responsibility and, as a result, the economic consequences for the entity are expected to be significantly worse than the costs of discharging that responsibility would have been.

There was debate over the use of the word ‘significantly’ and what this could mean in reality, but the IASB has decided to push ahead with keeping it.

Discount rates

Another technical change could lead to a change in IFRS 3, Business Combinations, in addition to the changes to be made to IAS 37.

The exposure draft proposes use of a risk-free rate, and specifically states that this does not reflect non-performance risk (ie the risk that the entity will not settle the obligation). However, IFRS 3 states that all assets recognised in a business combination should be recorded at their acquisition-date fair values. For liabilities, IFRS 13, Fair Value Measurement, explains that the fair value of a liability does reflect the effect of non-performance risk.

By recognising a provision initially at fair value under the principles of IFRS 13 and then subsequently under IAS 37, an entity would encounter what the IASB is referring to as a ‘day-two’ credit to the provision. This will result in a debit entry to either PPE (if the item relates to decommissioning) or in the statement of profit or loss.

This inconsistency could lead to post-acquisition losses that are nothing to do with the movements in provisions but due to the inconsistency in the rates used under the two scenarios.

As a result, the proposal is that an exemption be applied to IFRS 3 that would allow provisions arising on consolidation to be recorded under the principles of IAS 37 rather than IFRS 3. While this may seem a surprising concession, initial measurement exemptions already exist in IFRS 3 for several other types of assets and liabilities, including deferred tax items, employee benefit obligations, share-based payment instruments and assets held for sale. When a standard contains that many exemptions, it could be argued that there is a bigger problem with it, but that is a debate for another time.

Impact

The proposals rumble on. The discussions are all valid, and they are certainly technically accurate. However, the elephant in the room remains largely unaddressed. The problem that most accountants see with the accounting for provisions is not really a technical one about definitions or discount rates, but one about judgment. If management judges that an outflow is not probable, then it’s difficult to go against that.

It appears that standard-setting is not likely to change this any time soon. Perhaps the answer lies in auditors pushing back more and challenging more strongly. However, the rowback on audit reform in the UK would suggest this is also unlikely, at least in the UK.

So what does it mean? It feels like companies will continue to omit potential provisions until it is provable that the money is lost. Rather than looking at the provisions figures, many of us directing students to analyse financial statements will point them to the contingencies note and continue to ask them to be cynical.

It does not feel like the best way to look at a set of financial statements, but if history has taught us anything it is that it is perfectly OK to challenge management judgment in this area.