The IASB has published revised proposals to amend the measurement of non-financial liabilities (formerly provisions) under International Accounting Standard (IAS) 37, Provisions, Contingent Liabilities and Contingent Assets. The re-exposed proposals put forward a way of measuring provisions that is different from the method often used today. Some of these proposals are fundamental and could result in a significant increase to a provision. Steve Ralls of PricewaterhouseCoopers’ (PwC) Global Accounting Consulting Services central team explains.
Management currently measures most provisions for an obligation to deliver a service (for example, a warranty service or an asset decommissioning obligation) at the cost that it expects to incur in fulfilling the obligation. The exposure draft (ED) proposes to measure a provision according to the value of the resources required.
There is diversity in practice around the costs included in a provision. Direct costs are usually included; indirect costs are sometimes not included; and the profit margin that would be charged by a contractor is rarely included. The ED aims to address this diversity, but the changes it proposes raise some significant issues.
The ED proposes four fundamental changes:
1. Removing the recognition requirement for an outflow of resources to be probable
2. Removing the concept of contingent assets or liabilities
3. Requiring remeasurement of provisions using an expected value model rather than the current best estimate approach
4. Specifying what costs to include in the calculation of the provision
The changes result from the proposed change in the measurement guidance and are addressed below.
1. Removal of the requirement for an outflow of resources to be probable
IAS 37 currently requires a liability to be recognized when an obligating event has occurred and there is a probable outflow of economic benefits. “Probable” is interpreted in practice as more than 50% likely to occur. The proposals remove probability from the recognition equation. Liabilities arising from an obligating event are all, therefore, recognized: the uncertainty of the outflow is included in the measurement criteria, by applying a probability assessment to a range of possible outcomes.
This change addresses the inconsistency between IAS 37 and other standards, such as IFRS 3, Business Combinations, and IAS 39, Financial Instruments: Recognition and Measurement; these standards do not apply a probability-of-outflows criterion to liabilities. In practice, this means that liabilities for which an outflow of economic benefits was assessed as not probable may now be recognized.
2. Removal of the concept of contingent assets or liabilities
The new standard will not address assets, and the concept of a contingent asset will disappear. The removal of the recognition threshold for liabilities means that contingent liabilities, as we previously considered them, will also become things of the past. Contingent liabilities will continue to exist, but only in so far as the obligating event is considered unlikely to have occurred.
3. Remeasurement of provisions using an expected value model
The ED proposes that provisions should be measured at the present value of the amount an entity would rationally pay to be relieved of an obligation at the balance sheet date. Few provisions today are measured on a settlement basis. Management estimates the costs it will incur in the future to satisfy the obligation and discounts these back to the balance sheet date.
The measurement method is proposed in the ED as the “lowest of;
Cancellation of obligations without settlement seldom occurs in practice. It is even rarer to find a market in which a transfer/sale of the liability is possible to a third party. The lowest amount is likely to be the value of the resources required to fulfil the obligation. Many entities will, therefore, need to use the present value approach.
The present value approach measures the provision using the weighted average of all possible outcomes. This is rarely the amount eventually paid but reflects the uncertainty inherent in the estimate. The provision is discounted using a rate that reflects the time value of money; then it is increased by adding a risk adjustment for any risks specific to the obligation that are not reflected in the expected value calculation.
4. Specifying what costs to include in the calculation of the provision
The Board expects that contractor prices will provide a more objective basis for assessing liabilities than internal estimates based on cost. By specifying the use of contractor prices as an overall objective, the amended standard may reduce the current diversity in practice. Detailed guidance on what costs to include is considered unnecessary. Where contractor prices are not available, the entity should use fully absorbed costs and a profit margin in the provision assessment.
Management should look at the proposals carefully, assess the impact and consider responding to the Board’s proposals.
Partner Gail Tucker and senior manager, Dewald van den Berg, in PwC’s Accounting Consulting Services in the UK provide a summary of progress on the insurance contracts project.
The IASB is expected to issue an ED on insurance contracts in May 2010, a project that predates the IASB itself. A final standard (scheduled for June 2011) will be welcomed by preparers and analysts in the insurance industry, given the diversity of accounting today (as noted in PwC’s recent survey of insurance analysts, Making Sense of the Numbers). A new standard in 2011 will enable preparers in the EU to consider the new requirements alongside the changes in Solvency II, which will affect insurers in 2012.
The FASB joined this project in October 2008. Both boards have been discussing the proposals contained in the IASB’s 2007 discussion paper on insurance contracts. The discussions have been challenging, as many of the topics have parallels with other IASB projects, such as revenue recognition, financial instruments and non-financial liabilities (IAS 37 amendments). The timetable has been subject to many delays as a result of these complexities and because the FASB has had less time to debate the issues. The Boards have started holding joint meetings, including additional meetings outside of the normal monthly schedule. This is to enable the ED to be issued before three IASB board members retire in June 2010.
The 2007 discussion paper proposed a single “current exit value” approach for valuing insurance contracts based on a transfer notion to another party. The IASB has moved away from the current exit value notion. The Boards considered a number of measurement models. They have tentatively decided that the measurement should portray a current assessment of the insurer’s obligation, using the following building blocks, which are remeasured at each reporting date:
the unbiased, probability-weighted average of future cash flows expected to arise as the insurer fulfils the obligation;
a risk adjustment for the effects of uncertainty about the amount and timing of future cash flows; and
There are still a number of important areas being discussed by the boards before the ED can be issued. Informal notes of the tentative decisions made at each board meeting (and Making Sense of the Numbers, mentioned above) are available at pwc.com/insurance within the IFRS pages.
The Boards have not yet discussed the scope of the standard. IFRS 4, Insurance Contracts, defines an insurance contract as a contract where one party accepts significant insurance risk from another party. If this definition is not amended, companies other than insurers, such as service providers that issue fixed-price maintenance contracts, will need to follow the debate and consider the implications of this new model.
The IFRIC is to clarify guidance on distinguishing between a service condition, a performance condition and a non-vesting condition. The agenda decision a lack of clarity in the definition of vesting conditions and in the amendment to IFRS 2, Share-based Payment, on vesting conditions and cancellations. This may result in divergent practices when distinguishing between vesting and non-vesting conditions. The IFRIC decided to add the issue to its agenda and will discuss it in its meeting next month.
Peter Hogarth and Liza Therache in PwC’s Accounting Consulting Services in the UK and France explain the basics of lease accounting and where the controversy lies.
Many entities across all business sectors lease assets. These range from substantial, high-value items (such as real estate, aircraft and ships) to everyday equipment (such as cars, computers and copiers). Most readers of this article at some time will have leased a car or hotel room.
The decision of whether to lease or buy that management often faces is based on many factors, such as available financing, tax structuring opportunities and other services that may be obtained alongside a lease. The risks and rewards associated with using somebody else’s asset compared to outright ownership are also important. This analysis of risks and rewards also has accounting consequences, as will be explained later.
A lease is an agreement by which one party (the lessee) purchases the right to use an asset belonging to another party (the lessor) for an agreed period of time. Many leases are easy to identify. However, some may take the form of a purchase agreement for goods and services but contain a hidden lease.
Examples of these are some outsourcing contracts and take or pay arrangements, where the purchaser (lessee) controls the use of the asset needed to provide or produce the purchased goods or services. The underlying principle is that if an arrangement has the substance of a lease it should be accounted for as a lease.
Leases take many different forms. At one extreme is the rental of a car for a day; at the other, a complex arrangement for the lease of a machine for its entire useful life. Most leases lie somewhere in the middle.
The accounting for leases is driven by an analysis of who bears the risks and benefits of ownership of the leased asset. This analysis results in classification as a finance lease or an operating lease. If the lessee bears almost all of the risks and benefits, it is called a finance lease; otherwise, it is called an operating lease.
The accounting treatment for the two different types of lease is very different. From the perspective of a lessee, finance leases are accounted for in a similar way to the outright purchase of the leased asset with deferred payment terms; operating lease rentals are recognized as expenses over the lease term, and no asset or liability is recorded. This is explored below. The classification of a lease (that is, as an operating lease or a finance lease) should be determined at the beginning of the lease, based on the information available at that date. This is not subsequently amended for changes in estimates or circumstances. However, if changes (other than simple renewal) are made to the terms of the lease agreement, the revised lease should be regarded as a new agreement and its classification reconsidered.
The current lease accounting standard gives examples of indicators of when a finance lease transfers the risks and benefits of ownership of an asset to the lessee. These indicators all relate, directly or indirectly, to the value of the leased asset at the end of the lease term (the residual value risk). Where the lessee bears the residual value risk, or if this risk is not significant, the lease is classified as finance lease. For example, a lease is usually classified as a finance lease when:
In these situations, the lessor usually has little or no residual exposure to the leased asset itself, the rentals being set at such a level as to cover its investment, together with its funding costs and a reasonable profit. The lessor’s risk exposure would, therefore, be similar to that incurred in a financing transaction ― that is, exposure to the credit risk of the lessee.
The substance of an operating lease is that the lessee makes a series of payments for the right to use an asset. The lessee does not bear the risks or enjoy the benefits of ownership of the leased asset, so the asset is not recognized on the lessee’s balance sheet. Similarly, the lessee does not recognize a liability for its obligation to make rental payments. The arrangement is instead regarded as an uncompleted contract, committing the lessor to make the asset available for use in the future in return for payment. Described in this way, an operating lease resembles a service contract and the accounting is similar. A rental expense is recognized evenly over the lease term.
The substance of a finance lease is similar to the outright purchase of an asset with deferred payment terms. The lessee bears the risks and enjoys the benefits of ownership of the leased asset, so the asset is recognized on the lessee’s balance sheet. It is then accounted for in a similar way to other owned assets.
A liability is also recognized, representing the amount the lessee is committed to pay. This liability is treated in a similar way to a borrowing; this means that the amount recognized at the beginning of the lease takes account of the time value of money; it is measured at the present value of the payments that the lessee is required to make to the lessor over the lease term. The interest rate used in this calculation (called the interest rate implicit in the lease) should be the rate that makes the following equation work:
This is not only complex but requires information that the lessee may not know (such as the residual value at the end of the lease term or the costs incurred by the lessor). A lessor might make this information available, but if not, the lessee should use the rate that it would have to pay on a similar lease or borrowing (called the lessee’s incremental borrowing rate).
The above equation means that the present value of the lease payments should never exceed the leased asset’s fair value. Where this happens, it may suggest that an incorrect interest rate is being used. The accounting standard, therefore, requires the leased asset and lease liability to be measured initially at the lower of the present value of the lease payments and the fair value of the leased asset.
The payments in future periods are not described as rental but are treated as a combination of principal and interest on the outstanding liability. At the same time, the carrying amount of the leased asset is reduced (depreciated). Finance leases, unlike operating leases, result in two different types of expense − depreciation and interest.
An entity has leased an asset for two years. It is required to pay the lessor C100 at the end of each year.
If the lease is an operating lease, the total rental of C200 is recognized evenly over the lease term. An expense of C100 is, therefore, recognized each year.
If the lease is a finance lease, the accounting is more complex. First, the interest rate implicit in the lease needs to be estimated. In order to do this, the lessee would need to establish the fair value of the asset, its residual value at the end of the lease and the amount of any initial costs incurred by the lessor. The lessee might be able to get hold of this information from the lessor, or it may have to use its own incremental borrowing rate. For the purpose of this example, assume a rate of 10% is appropriate.
The present value of the lease payments at the beginning of the lease is C174 (calculated as C100/1.1 + CU100/1.12). Provided this does not exceed the fair value of the leased asset, it is the amount at which the leased asset and lease liability are recognized.
In the first year, the lessee makes a payment of C100 and recognizes interest on its liability of C17 (that is, 10% of C174). It also recognizes depreciation of the leased asset, resulting in an expense of C87 (that is, 174 x ½). The total expense in the first year is, therefore, C104; the carrying amount of the leased asset is reduced to C87; and the carrying amount of the lease liability is reduced to C91 (that is, C174 plus interest of C17 less payment of C100).
In the second year, the lessee again makes a payment of C100 and recognizes interest on its liability of C9 (that is, 10% of C91). It also recognizes depreciation of C87 on the leased asset. The total expense in the second year is, therefore, C96.
The key accounting differences between an operating lease and a finance lease are as follows:
The existing lease accounting standard, with its two types of lease (operating and finance), has been strongly criticized. Many leases are clearly of one type or the other, but some have features that could support either classification. This judgment has important accounting consequences, as described above.
Some consider that this reduces comparability and transparency for investors; users regularly adjust the financial statements in order to take into account operating leases (considered as a form of off-balance sheet financing).
The IASB and the FASB are working on a joint project, with the aim of issuing a new standard in 2011. They propose to eliminate the distinction between operating leases and finance leases; lessees would treat all leases in a manner similar to finance leases today. All leases would, therefore, be on-balance sheet. This seems a fitting response to one famous critic of the current model.
Accounting technical partners (GACS – Global Accounting Consulting Services in PwC) are keen observers of and participants in the standard setting process. Many spend as much time thinking about what’s coming in IFRS as advising on what today’s standards say. 2009 is a year that many might want to forget – those involved in accounting standards may well be among them.
We asked the three global topic team leaders in PwC’s Global Accounting Consulting Services to reflect on the year that was, what change is coming in 2010 and, finally, what they would like the standard setter to do. The three topical areas are: financial instruments (FI – including leasing and real estate), business combinations (BC – all non-financial assets, business combinations, joint ventures, equity accounting and consolidations) and revenue liabilities and other (RLO – everything to do with presentation, deferred tax, employee benefits, provisions, revenue recognition, etc.).
How would you sum up the standard setting activity in your area in 2009?
John Althoff (FI): Intense. We had the challenging combination of a lot of proposals (DPs and EDs – see box below) and short comment periods in which to respond. The IASB and FASB were given a mandate to “fix” accounting for financial instruments, and they were to do it quickly and ideally on a converged basis. In a perfect world, you would approach the accounting for a broad area, such as financial instruments, in a methodical way with the goal of delivering a single comprehensive package. Instead, what we got was probably the opposite of that: a piecemeal approach, where different pieces were separately debated and exposed for comment in compressed time frames. Having politicians interested in the outcome and weighing in with their viewpoints on the best accounting has added an interesting dimension to what some think is an otherwise dull world of standard setting.
Mary Dolson (BC): Waiting. We seemed to spend the year waiting for a joint venture standard, then waiting for a consolidation standard – like buses in a London snowstorm neither ever appeared. We also spent the year waiting for the changes to the business combinations and consolidation standards to become effective for our calendar year companies. We had plenty of work to do anyway in looking at impairments of goodwill, intangibles and fixed assets − both the impairments that were recorded and the might-have-been impairments that weren’t recorded. We had a year to bed down the adoption of IAS 23 (revised) but it was a very quiet year for “new GAAP.”
Tony Debell (RLO): Unfinished. None of the major projects – see box below – have been finalized; all are still at the discussion and drafting stages. And the outlook will be the much same for this year. We have possibly had the opposite of the financial instruments experience – too much time for discussion. However, we also have the sense that projects aren’t being approached in a holistic way.
What are you expecting from the IASB in 2010 in the way of standard setting activity?
FI: Again, intense, or do I have to use a different word?! There are more EDs on their way, with quick turnaround likely. We will probably see EDs on the classification and measurement of financial liabilities and hedge accounting for financial instruments at the end of the first quarter, along with a request for views on the FASB proposed package for financial instrument classification, measurement, impairment and hedge accounting. In the second quarter, we can probably look forward to EDs on debt versus equity classification, leases, derecognition, insurance and hedge accounting for non-financial items. If all goes well, we should see final standards addressing financial instrument classification, measurement, impairment and hedge accounting by the fourth quarter, as well as fair value measurement.
BC: We’re still expecting the joint venture (JV) standard and the consolidation standard. The JV standard is more likely to appear, but we’d be surprised to see it in Q1, as the IASB website predicts. We think they’re still drafting, and at this point, that would make it a challenge for the end of March. The consolidation standard has become a convergence project with the FASB – so I wouldn’t stand out in the cold and wait for that one. It may appear as a 2010 Christmas gift though. I think the Thursday before Christmas is a working day this year. The fair value measurement standard falls in the FI area (see above), although it has a big impact on non-financial asset measurement as well.
RLO: There is nothing new in the pipeline for this year that will be mandatory. The projects mentioned above will be debated and finalized, but nothing new is expected to be added to the Board’s agenda. Preparers will have a challenge digesting what has been issued so far. We’re all just relieved we don’t have the new model for deferred tax, although we understand that IASB is considering some limited amendments to IAS 12 to address current practice issues. This brief quiet period will also be welcomed by the first-time adopters.
What’s the big thing that will be “newly applicable” (mandatory) in 2010 in your area?
FI: Although there will be some relatively minor amendments and narrow IFRIC issues applicable in 2010, none of the big ticket financial instruments standards will be mandatory this year. IFRS 9 is available for early adoption outside of the EU, but it is hard to say how many companies will be interested until they see the complete financial instruments package from the IASB in the fourth quarter.
BC: Finally, something for business combinations, IFRS 3 (revised) is applicable from January 1, 2010 for all calendar year entities, and March 31, 2010 for those fiscal year-ends – prospectively, to transactions occurring after that date. The June and September year-ends were swept up last year by the revised standard. Of course, the revisions to the consolidation standard around accounting for non-controlling interest are applicable at the same date. The presentation aspects of IAS 27 (revised 2008) are retrospective, but the measurement aspects are largely prospective.
Both of these are convergence projects, and the US has been applying them for a year now. It has given us some insights into the issues and helped us prepare our IFRS clients for what’s coming. Income statement volatility is looking like the biggest challenge from the changes in IFRS 3; it is a further iteration of the acquisition approach but not a radical change. Moving to the economic entity approach under IAS 27 is a bigger conceptual change, as minority shareholders are now treated as equity participants. We may see big debits and credits moving through equity, particularly, as there are no transition provisions for first-time adoption.
RLO: We don’t expect there to be any significant new guidance that is mandatory in 2010.The biggest projects that might be finalized in 2010, but mandatory in later years, will be the amendments to the guidance for provisions, the statement of comprehensive income and the revisions to the accounting for termination benefits. The IFRIC has also decided to address the definitions of vesting and non-vesting conditions in IFRS 2.
Wave your magic wand and change one big thing and one small thing in IFRS. What are they?
FI: My big wish is so big that I’ll forego my small wish: For the FASB and IASB to work at the same pace on the same projects drawing the same conclusions so they all apply at the same time. I’m talking complete convergence.
BC: The big thing would be to decide what equity accounting is and then sort out the standard on that basis. Is it fundamentally a financial asset or is it a “collapsed consolidation”? This is particularly important, as the changes we’re expecting from the new JV standard will widen the use of equity accounting. The small thing – can we call things by the old fashioned and simple names – so income statement, balance sheet, minority interest and perhaps even negative goodwill instead of ”excess of the net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed over the consideration transferred.”
RLO: I tried to settle on one big thing but I’m stuck on three, so I’m ignoring the guidance in the question. 1. For regulators and standard setters only to go public on the decisions that have legal standing, and not to issue their unauthorized views, which muddy the waters and do not help the debate. 2. A consistent model for recognizing, measuring and derecognizing credits that can be applied to revenue and liabilities. 3. A simplified model for deferred taxes that properly reflects the underlying economics.
IASB activity in 2009*
Amendments to IFRIC 14 IAS 19 − The Limit on a Defined Benefit Asset, Minimum Funding Requirements and their Interaction
|IFRS 9, Financial Instruments||
|Amendment to IAS 24, Related Party Disclosures||
|Amendment to IAS 32 on classification of rights issues||
|Amendment to IFRS 2, Share-based Payment – esting conditions and cancellations||
|Amendments to IFRS 2 and IFRIC 11, Share-based Payments – group cash settled||
|Amendments to IFRIC 9 and IAS 39 on embedded derivatives||
|Amendments to IFRS 7, Financial instruments: Disclosures||
|IFRIC 18, Transfers of Assets from Customers||
Amendment to IAS 37 on liabilities
Limited exemption from comparative IFRS 7 disclosures for first-time adopters (proposed amendment to IFRS 1)
|Financial instruments: Amortized cost and impairment||
|D25, Extinguishing Financial Liabilities with Equity Instruments||
|Fair value measurement||
|Amendments to IFRS 5 (discontinued operations)||
|Amendments to IAS 39 and IFRS 7 on derecognition||
|Credit risk in liability measurement||
Comment period ends: June 19, 2009
Comment period ends: April 2009
|*Not a definitive list of IASB activity|