The International Accounting Standards Committee (IASC) released IAS37 Provisions, contingent liabilities, and contingent Assets at the end of September in 1998. It substituted portions from IAS10 Contingencies (IAS37 BV2008) and was made effective for annual financial statements for dates beginning after July 1, 1999 (IAS37 BV2008 IN23, BV2008).
The goal in this norm is to make sure that the appropriate standards for recognition and measurement are used to recognize provisions as well as contingent liabilities and assets, and that adequate details are provided in the notes so that people to know their purpose as well as their timing and value (International Financial Reporting Standard (IFRS) 2009). The principal principle of IAS37 states that provisions ought to be acknowledged only when there is a risk. Future planned expenditures cannot be considered to be contingencies or provisions regardless of whether the board directors has approved them.
IAS37 defines the accounting and disclosure requirements for all provisions as well as contingent liabilities and assets, with the exception of:
the ones arising from executory contracts those arising from executory contracts, except when the contract is a burden. Executory contracts are contracts in where neither side has fulfilled one of its obligations, and both have completed their obligations to a comparable degree;
the ones covered by another Standard (IFRS 2009).
The term “provision” refers to a risk that is not certain in time or amount acknowledged in the event of:
(a) an organization has obligations that are due in connection with an event that occurred in the past;
(b) It is highly likely the outflow of funds that provide economic benefits will be needed to pay the debt;
(c) An accurate estimation can be made on the value of obligation. The Standard stipulates that it’s only in rare circumstances where a reliable estimate may not be feasible (IFRS 2009).
the possibility of a contract based on the likelihood that an uncertain future event takes place;
A present obligation, however payment isn’t likely or the amount is not determined with certainty (Deloitte 2009a).
A company must disclose any contingent liabilities unless the chance of an outflow in resources with economic value is unlikely.
an opportunity to earn a profit from the past;
The existence of the entity will be established only through the occurrence of or non-occurrence of one of other uncertain future events that are that are not entirely under that control company ( Deloitte, 2009a).
If the realization of income is nearly certain, the asset in question isn’t a contingent asset , and its recognition is justifiable.
IAS 37 Major regulations
A company should be able to recognize the liability of a particular provision by examining the following three conditions that are which must be met simultaneously:
A) there is a current obligation, or it is most likely that an existing obligation exists at the close day of balance sheet the result of an obligating incident;
B) it is likely (i.e. greater than likely, i.e. 50%-95 more likely than not; i.e. 50%-95) that there will be an outflow of economic benefit to the entity will occur.
C) the quantity of outflow can be accurately estimated.
If the first criteria is satisfied but it’s feasible (i.e.5%-50 percent) unlikely the outflow financial benefit to the entity occurs and the magnitude of the outflow can’t be quantified with confidence, or if an obligation exists and the amount of economic benefits of the entity is not insignificant (i.e. between 0% and 5 percent) the there is a possibility of a contingent liability.
In the case of contingent liability, an entity should declare it, not recognize it the liability unless the likelihood of an loss of the economic benefits of the entity is not remote.
When it comes to the intangible asset is best simply disclosed as a the contingent liability, except when of the inflow from the asset contingent is nearly certain (i.e.95%-100 percent). If the amount of inflow from the asset contingent to be nearly certain, it is suitable to be classified as an asset in the balance account.
In recognizing a provision the amount that is derived of the financial benefit of the entity must be determined using the best estimation, i.e. the amount should be exactly the same amount as the entity has to cover the obligation within the timeframe.
When assessing a provision, things like, risks and uncertainties and discounted provisions (if the time value of money is important) and changes to the law, or other instances that may affect provisions, should be considered, but not taken into account the gains that result from the anticipated disposal of assets.
If reimbursement occurs an organization recognizes it as if it’s virtually certain. The amount that is that is recognized must not be greater than what is in the payment. The reimbursement should be treated as a separate asset on the balance sheet. If the reimbursement and the cost related to the provision are sustained during the same period of reporting, then the costs reported in the complete P & L can be reduced by the amount that is recognized as reimbursement.
The provisions should be reviewed each year and adjusted based on the most recent estimations. Any changes to the provision should only be used for the original purpose.
Three specific types of applications are mentioned in this standard, specifically future operating losses, onerous contracts and restructurings. In the case of future operating losses, there is no reason why they is required as provision. For onerous contracts, any unavoidable expense that is greater than the benefits taken by the entity must be considered to be an expense. When restructuring is involved these costs must be recognized when the requirements for provisions are met.
The importance of IAS37’s requirements
As for the significance of the IAS37 requirement, the goals that the standards are aiming to achieve will be addressed first. Based on Deloitte, IAS37 aims to ensure that the recognition of contingent liabilities, provisions and contingent assets are achieved with the most effective methods and measures, in order to ensure that those who use financial statements are provided with the relevant information to make informed investment decisions procedures. Additionally, IAS37 aims to ensure that it is only dealing with the actual obligation of the financial statements as well as future expenses, even if they are not it is not recognized by the board responsible for it.
The reason it is important to take the requirements into consideration, once the entity recognizes this provision is that it will avoid any unneeded provision from being recognized to increase the value of the entity in subsequent period in unsubstantiated ways which could lead to the provision of insufficient data to users of financial statements (ACCA 2009).
Under IAS37 , the entity has to be able to disclose the contingent liability on its notes and not recognize it in its statements in the event that the probability lower than 5 percent. as well as the entity must follow the same procedure in the event of contingent assets except when it is greater than 95% likely. This requirement could be seen as a return to the conservatism Principle in accounting that recommends ignoring any profits that are that are not yet realized and taking any anticipated losses into consideration and not recording potential gains until they actually occur. This requirement hinders an organization from providing the unrealized profits, and any other information that could mislead customers.
IAS37 gives guidelines on the how to estimate the best value of provisions in connection with its goals. It aims to provide a proper method to measure provisions so as to give sufficient and accurate information. The standard requires an entity to consider the process’s risks, uncertainties, and other factors to get the most accurate estimation of the amount. By following this rule, you can avoid inaccurate values from appearing in the financial statements. The need to solve the issue of reimbursement and showing the three applications are equally thorough and accountants will know what to do to fix these issues. In the absence of this, it is possible that each company will have its own approach to troubleshooting that is different from other in the face of such situations and result in an inability to compare organizations. In such instances, investors could be deceived when making investments.
The majority of countries are currently applying IAS (IASB 2010, 2010) and developed nations may be able to make changes to their accounting standards, and thus become more efficient and globalized. Countries in developing countries can benefit from this, and improve their accounting systems and is suitable for internationalization and prove the validity to IAS to be an internationally accepted standard. But, America considers that US GAAP (Generally Accepted Accounting Principles) is the most thorough and complete accounting standard in the world and is urging other nations to follow it.
There are a number of issues that could arise in GAAP. The first is that there is the fact that Financial Accounting Standards Board (FASB) and which is the Committee on Accounting Procedures (CAP) and the Accounting Principles Board (APB) have formulated numerous rules, and released thousands of pages since 1937. A problem is that, although it is simple for businesses to adhere to a particular standard, the entire system has become scattered and repetitive as a result of lengthy maintenance carried out by different institutions. The second issue is that with the rise of new developments and transactions including financial derivatives that were not previously seen and the three institutions were unable to not make changes to their standards at the time they needed to. As a result, accounting fraud is becoming more probable, like that of the “Enron bomb” that wiped out Enron and Andersen in 2001. Most importantly, there is a financial burden for any company that wants to sell its products in America since they must to convert their financial reports into GAAP standards. This complicated and costly task has caused some companies to be more cautious to enter into the American market.
In the end, the Securities and Exchange Commission (SEC) and FASB are now cooperating in conjunction with IASC. GAAP and IAS have been harmonised and FASB, however, SEC has specific rules regarding IAS37. In the beginning, information on recognized provisions must be made public, along with additional information about their nature, types and amount being listed. Furthermore, “other provisions” should be labeled and described. The second is that provisions for estimated returns to product, in the event of recognizing revenue must be described in greater specific terms about the location and whether they’re declared. SEC will also be looking at the precise amount of the provision to be disclosed and the amount at the time the period of financial reporting began and ended, then the amount that was used in the course of the period. The third, SEC discovered that certain entities might not disclose certain obligations or provisions in their reports and financial notes and strongly recommends that all information regarding the estimated liabilities and provisions should be made clear. Fourth, losses and fines caused by currency allocation and pricing of forward sales, disclosure of these provisions as well as contingent liabilities is essential (Deloitte 2009b).
America has an almost comprehensive accounting standard system, which has more precise requirements, in comparison to IAS. Collaboration among GAAP and IAS can result in IAS more useful and prevent mistakes that are made by GAAP.
Being a developing country, Chinese accounting standards are not so well-designed as those in America. In 2007 China’s Ministry of Finance announced that the Chinese Ministry of Finance declared that all entities, whether listed within Shanghai or Shenzhen must use IAS and IFRS to prepare annual financial statements that reflect the true value of the business in accordance with an international standard for accounting and enhancing the international efficiency of the business.
The most important obligation is recording capital assets within the financial reports that provides investors with the real operating conditions and the market value of the entity listed. The second enhancement is related to IAS37. According to IAS37, Chinese Accounting standards a precise definition of provision doesn’t exist, which leads to misunderstandings of provision and bad debts and other reserves. It is obvious that provisions are liabilities with uncertain duration or value in accordance with IAS37. It has helped make reporting for Chinese companies more trustworthy and more forward-looking. Since China is a country that is not as developed it is a good idea to learn from countries that are more developed; Chinese accounting standards can be improved through learning as well as applying IAS.
The fundamental principle of accounting has to be true, but creativity in accounting is a possibility and can be the result of human error, a lack of ethical standards, unprofessional motives, and so on. The goal of accounting that is creative is to make false claims about profits. Creative accounting methods can be categorized into four areas:
1. Different accounting standards allow companies to select different measures. For instance, one measurement goal in the Chinese Enterprise Accounting Standards is liabilities, which are recognized through contingencies. But IAS37 requires the recognition of the provision as an obligation with uncertain timing or value, so different standards can indicate different profits.
2.Many accounting items require estimates and anticipates. The items listed in IAS37 are packed with uncertainties and arbitrariness. Even though IAS37 establishes rules for measuring that are not enforceable, under- or over-rating occurs. The accountant has the chance to use creative accounting when formulating the estimate. For instance, if an organization wants to estimate the future pension liability they’ll employ an actuary that is well-versed in the background of the business and can control the valuation in the way the accountant wishes to have it.
3. The most common method of creative accounting is creating transactions that can be recorded into the financial statements. This scenario requires the assistance of other entities, such as suppose that entity A is able in claiming indemnity to the entity B, which would allow them to be regarded as contingent assets, and then recognize these as assets.
4. Creative accounting can also play tricks on transactions that are real For instance, if an organization has a contingent liability of $50,000 The accountant could reveal this amount in the following year to ensure the financial condition of the year.
IAS37 is a key element in the development of accounting standards in general, there aren’t any major or frequent issues that are currently in existence however, it has some limitations that were discussed during in April’s IASB meeting.
In the first place, inconsistency between other standard, particularly the probabilities of recognition criteria Specifically that liabilities are only recognized when it is likely that the exodus of benefits from economics pursuant the IAS37 (IAS37 BV2008, p.5) will occur. Contrary to this other standards, like IFRS 3 Business Combinations, don’t require the probability recognition criteria to recognize potential liabilities when an enterprise is part of an arrangement with a business. This discrepancy could be confusing.
Additionally, IAS37 doesn’t provide a clear explanation for the identification of liabilities. The term “contingent liability” can be used to define both liabilities and non-liabilities various scenarios. Particularly, it’s confusing to use one word to describe both potential obligations and present obligations that are not recognized in the examples of practical use (Broad 2006. p.14)”Contingent liability “contingent liability” is not necessary but eliminating its use from IAS37 might conceal significant risks like legal actions, litigation as well as environmental laws and copyright. These risks, which could be significant, do not meet the definition of risk because they’re not known when the balance sheet is due however they could be helpful to make a decision.
The third, IAS37 focuses on legal obligations and does not take into account constructive obligations. The definition of an obligation that is constructive isn’t adequate, in particular in section 15(b) from the 2005 ED which was discussed during the Feb. 2007 IASB meeting. It is difficult for organizations to differentiate the distinction between constructive obligations and economic compulsion for example, pensions or the jubilee bonus, which can be used to make a present obligation constructive obligations (Deloitte 2009c).
Fourth, IAS37 is unclear when measuring one obligation. It is generally believed as indicating that the best result could be the most accurate estimate of the liability when measuring just one obligation (IAS37 BV2008, 17. 17).This is in contrast to the current concept of settlement which says that the anticipated value is the primary factor for determining the totality of liabilities, which could lead to misinformation. In essence, the method of estimation using expected value offers greater advantages since it provides details about the possible range of possible cash flows , and provides new information on the liability when that information is accessible (Broad, 2006 p.19).
The term “provisions are meaningless and there exists a risk to be avoided. The current law defines the term ‘provision’ as a risk with uncertain timing or value’ (IAS37 VB2008, p.10) thus it is a different kind of liability. The distinction between the definition of a provision as well as other liabilities and the analysis that is being conducted of contingent liability is ambiguous. The standard fails to provide sufficient explanation of how to differentiate from them, for instance, the uncertainty regarding time or the amount of liability is a concern for cash flows. Therefore, it can be difficult to distinguish a liability for a warranty on a product. Also you have a choice between the two types of obligation.
To improve the quality of the standard IAS37 some suggestions could be offered:
First, you must eliminate the likelihood of the recognition criteria.
The second step is to eliminate the term “contingent liability,” and then update the guidance to assist companies to determine the nature of their the potential liability. Pay attention to potential liabilities in different scenarios where an event is the source of an obligation. In the event of this type of situation IASB panel should IASB panel should be able to make known and make new additions to the IAS standard for liability to help companies apply it to particular situations.
Third, complete, general guideline on recognizing constructive obligations by enhancing its definition and specifying that an entity must be bound by an obligation to a third-party who can benefit from the company’s actions.
Fourth, clarify that organizations should determine the most basic measures of all liabilities on the basis of value, not on the most likely outcomes
Fifth, get rid of the word “provision” and substitute it with a different term, such as “non-financial liability,” which helps to make an obvious distinction between liabilities.
ISA37 is a step forward in accounting standards because there was no specific rules or rules before. The principle that drives it is that a provision be acknowledged when the following requirements are satisfied simultaneously:
There is a current obligation or an obligation that is in place at your balance sheet the result of an obligating incident,
there could be a possible outflow of the benefit from economics,
The outflow can be calculated with confidence.
In these terms, IAS37 ensures recognition is done using the right measures and provides useful information for those using financial statements. A majority of countries are now using IAS. The developed countries might have the opportunity to revise their accounting standards , while developing nations can improve their own. The different standards of different countries provides an entity with the choice of selecting a accounting standard that will yield more profit. In addition, certain elements included in IAS37 require estimation and anticipation, and offer the possibility of creative accounting because of this, IAS37 is not perfect. Inconsistencies with other standards and the vapourous explanations of constructive and liabilities serve as the basis for some suggestions to improve the ISA37. The likelihood of recognizing requirements could be reduced. In the meantime, we may should pay close attention to liabilities that could be incurred and revise the guidelines to aid companies to determine their liabilities.