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:
Presently, entities use following evidence to analyse existence of liabilities arising from lawsuit:
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:
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:
This amendment was proposed to streamline the recognition of liabilities for:
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)
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:
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.
|Liability under Revised IAS 37||
Liability under Ind AS 37
|Criteria 1 satisfied, Criteria 2 not satisfied||
|Criteria 2 satisfied, Criteria 1 not satisfied||
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:
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