Litigation Liabilities

  • Does entity have present obligation in Disputed Lawsuits?
  • Whether Management primarily relies on ‘probability of outflow of resources’ while deciding existence of liabilities from lawsuit?
  • Should we recognise liability in following three cases?
    • the available evidence suggests that the entity has an obligation but the probability of any payment being required to settle the obligation is less than 50 per cent
    • entity intends to offer an out-of-court settlement as a cost-efficient alternative to defending the claim
    • entity expects a court judgement that is inconsistent with the evidence
  • whether start of legal proceedings gives rise to an obligation?
gavel
law-court

Mr. Arth, an accountant of a multi-national company, Peace Ltd, was a dynamic person. He had a passion for staying abreast with changes expected to occur in the field of accounting, taxation, and finance.

Peace Ltd was embroiled in constant litigation. One of the responsibilities that Mr. Arth’s handled was consulting their legal teams as well as legal advisors, regarding the status of various lawsuits.

Mr. Arth would then ensure that:

  • Budget reflected expected outcomes of lawsuits
  • Sufficient provisions were created for claims that may have to be paid.
  • Liabilities were recognised if and when they satisfied the recognition criteria.
  • The financial statements appropriately disclosed contingent liabilities.

Presently, entities use following evidence to analyse existence of liabilities arising from lawsuit:

  1. reports from those investigating the claim (which might provide evidence of whether alleged events occurred), and
  2. legal opinions (which might provide evidence of how the law applies to those events).

Mr. Arth was aware of the IASB’s proposal to make changes to recognition criteria, for liabilities, in IAS 37. He was curious to understand how this proposal will impact assessment of liabilities arising out of lawsuits against company.

Both IAS 37 and Ind AS 37 presently defines a liability as “a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits”.

Further, they lay down three criteria for recognition of a liability. The three criteria are:

  1. Entity has present obligation (legal or constructive) as a result of past event
  2. It is probable that an outflow of resources will be required to settle the obligation.
  3. A reliable estimate can be made of the amount of the obligation.

Mr. Arth knew that IASB had proposed to remove the second criteria. As a result, entities would recognise all present obligations that can be measured reliably, as liabilities.

Note – Removing second criteria would not require entities to recognise liabilities for all lawsuits. This is because the lawsuits might not satisfy the other recognition criteria. In particular, the existence of a lawsuit does not necessarily mean that the entity has a present obligation (first criteria). An entity has a present obligation only if, and to the extent that, the claim against it is valid.

Thus, under proposed amendment, liability would exist only if:

  1. In cases of lawsuits advanced to court, it is more likely than not that court will rule against the entity; or
  2. It is more likely than not that entity will offer an out-of-court settlement

This amendment was proposed to streamline the recognition of liabilities for:

  • Liabilities assumed under Business Combination (IAS 103) and
  • Liabilities arising otherwise (IAS 37)

Argument opposing above view – most relevant information for capital providers is the entity’s prediction of the most likely future cash flows. Consequently, an entity should recognise a liability only if a future payment is probable, ie only if second criteria is satisfied.

ICAI, however, has not yet proposed any such amendments to Ind AS 37.

Existing conceptual framework states that – liabilities should be recognised only if it is probable that an outflow of resources will result from the settlement of the obligation. Thus, subsequently, when ICAI would propose amendment to Ind AS 37, it would equally need to amend conceptual framework with respect to recognition of liabilities.

Let us go back to Peace Ltd. and understand scenarios faced by Mr. Arth.

Peace Ltd had to prepare IFRS compliant financial statements for consolidation with its holding company in the UK. So, Mr. Arth started analysing various facets of the proposed amendment to IAS 37, from the point of view of recognition of liabilities in respect of lawsuits.

His first point of consideration was to understand whether the existence of a lawsuit means an entity has a present obligation? (Criteria 1)

  • Entities are not expected to recognise liabilities for every lawsuit filed against it.
  • An obligation would arise only in case the plaintiff has a valid claim or that claim is more likely than not to be accepted by the judiciary.
  • In a case of dispute, there is uncertainty regarding the Court ruling in favour of/ against the entity.
  • Therefore, the recognition of liability will depend on the management’s judgment regarding the outcome of the lawsuit.
  • To reach a valid judgment, the management will have to take into account various factors such as reports from those investigating the claim, opinion of legal experts, its own assessment and experience.

In his extensive career as an accountant of Peace Ltd, Mr. Arth had experienced some peculiar scenarios while recognising liabilities in respect of lawsuits. Two of them were:

  • Criteria 1 satisfied, Criteria 2 not satisfied
    • There are situations when the entity has a present obligation on basis of evidence available. So Criteria 1 is satisfied.
    • However, the evidence available is insufficient for the court to rule against the entity. Therefore, there is no probable outflow of economic resources. Thus, Criteria 2 is not satisfied.
    • In such situations, entities did not recognise liabilities towards such lawsuits. But under ‘to be modified’ recognition criteria of IAS 37, a liability will be recognised.
  • Criteria 2 satisfied, Criteria 1 not satisfied
    • There are also some cases when the evidence does not establish a present obligation for the entity. Thus Criteria 1 is not satisfied.
    • But if the entity prefers to settle, instead of defending its claim in court, or if it expects the judgment to be inconsistent with the available evidence, then there will be the probable outflow of economic resources. So, Criteria 2 will be satisfied.
    • In most cases, a lawsuit that fails Criteria 2 will usually fail Criteria 1.
    • But, there might be some rare cases. Under the ‘to be modified’ recognition criteria of IAS 37, liability will not be recognised by the entity.

Mr. Arth realised that the removal of Criteria 2 would shift the focus to Criteria 1

Usually, entities evaluate the probability of outflow of resources to decide whether the entity has any present obligation.  If Criteria 2, regarding outflow of economic resources, is eliminated, then the focus will shift to whether a liability exists. Thus, an entity will be required to take into account all possible outcomes of the case, and not the probable outcome.

It was apparent to Mr. Arth that management’s judgment and intention play a key role in deciding whether liabilities arising from lawsuits are to be recognised or not.

But Mr. Arth knew that, as the case progresses, new evidence may come forth, or it may become apparent that the outcome of the lawsuit may be worse than earlier anticipated. But it does not mean that the earlier judgments made by management were incorrect or inappropriate

Mr. Arth also realised that this would turn out to be an important area of evaluation for auditors of an entity. The Auditors would have to ensure that the management’s assessment and intention, regarding the outcome of the lawsuits, is reflected in the Financial Statements of the entity.

During his research on proposed amendments to IAS 37, he came across some concerns raised by stakeholders.

The first concern is, in an early stage of the litigation, there may not be sufficient evidence, to judge objectively, whether there is a present obligation. In such cases, the entities may choose to not identify a liability due to an insufficiency of evidence.

But the counter-view is that even if there is no conclusive evidence, the management should make a judgment on basis of the prevalent circumstances and evidence available.

This concern has arisen because the criteria of “probable” outflow of economic is proposed to be eliminated.

The concept of probability implied that the outflow of economic resources was more likely than not (more than 50% chance). This threshold also helped in judging the existence of a present obligation. However, as discussed above, there are multiple factors – including merits of the claim – that help establish the existence of a present obligation.

The second concern is, in cases where an entity prefers to settle a dispute by paying off the plaintiff instead of defending its claim in the court, there may be uncertainty regarding acceptance of the settlement offer by the plaintiff. This, in turn, creates uncertainties about the settlement amount, and the timing of settlement payment.

But Mr. Arth realised that a liability would be identified if an entity (defendant) has an intention to settle. Intention to settle points towards the existence of a present obligation. If there is uncertainty about settlement amount and timing, an entity should create a provision for such settlement obligation.

Mr. Arth also found that the IASB has proposed certain amendments to Conceptual Framework for Financial Reporting. As per the tentative decision on amendments to recognition criteria for liabilities, the IASB may not prescribe the probability criteria. So, liabilities, with a low probability of economic outflows, would have to be recognised (assuming other recognition criteria are satisfied), which otherwise are not recognised as liability under prevailing norms.

ICAI has not yet proposed any amendments in respect of Ind AS 37 or Framework for Preparation and Presentation of Financial Statements. Therefore, recognition of liabilities will continue as per existing recognition criteria under Ind AS 37.

Let us discuss two more examples to understand the impact on financial statements, of amendment to IAS 37.

Example 1: For Criteria 1 satisfied, but Criteria 2 not satisfied.

Peace Ltd was a telecom company. It had offered promotional offers to its new customers, which helped it increase its market share.

One of its competitors had filed a lawsuit against Peace Ltd alleging disruptive marketing practices.

Peace Ltd was of the view that the court would rule in its favour, and there would be no outflow of economic resources.

In this case, Peace Ltd had a present obligation, so Criteria 1 was satisfied but it did not anticipate outflow of resources, so Criteria 2 was not satisfied.

Therefore, Peace Ltd would not recognise any liability, while preparing financial statements under Ind AS 37. However, while consolidating Financial Statements of Peace Ltd, the Parent Company, based in the UK, would have to recognise liability towards the lawsuit under proposed (revised) IAS 37.

Example 2: For Criteria 2 satisfied, but Criteria 1 not satisfied

Truce Ltd was a UK based subsidiary of Peace Ltd. One of the employees sued Truce Ltd for wrongful termination. Even though the circumstantial evidence available, and legal precedents, indicated that Truce Ltd would probably win the lawsuit, the management intended to make an offer for settlement to the employee.

In this case, there is no present obligation, since the facts of the case indicate that the employee has not been wrongfully terminated. So Criteria 1 is not satisfied. But Truce Ltd intends to settle the dispute, and the employee is likely to accept the settlement offer. Therefore, there is a probable outflow of economic resources and Criteria 2 is satisfied.

In such a case, Truce Ltd would not recognise the settlement amount (assuming it was reliably measurable) as a liability under proposed (revised) IAS 37. But under Ind AS 37, the liability would be recognised, because the probable outflow of economic resources would acknowledge/ establish the existence of a present obligation.

Therefore, while consolidating the Financial Statement of Truce Ltd, Peace Ltd would have to recognise an additional liability towards the wrongful termination lawsuit filed by the employee.

One of the major takeaways for Mr. Arth was after changes are made to IAS 37, Peace Ltd may have a difference in lawsuits recognised as liabilities under IFRS compliant Financial Statements and under Ind AS compliant Financial Statements.

 

Particulars

Liability under Revised IAS 37

Liability under Ind AS 37

Criteria 1 satisfied, Criteria 2 not satisfied

Yes

No

Criteria 2 satisfied, Criteria 1 not satisfied

No

Yes

He also realised that the likely outcome and the existence of an obligation both depend upon the same factor, ie the strength of the claim against the entity.

An entity would recognise a liability when applying the new IFRS that it does not recognise when applying IAS 37 only if:

  1. First criteria is satisfied—the available evidence suggests that the entity has an obligation to the plaintiff; but
  2. Second criteria is not satisfied—the probability of any payment being required to settle the obligation is less than 50 per cent.

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