Which of the following is a difference between IAS 37 and U.S. GAAP with respect to restructuring provisions?

From the IFRS Institute - February 28, 2019

A provision is a liability of uncertain timing or amount. The very nature of this uncertainty presents challenges in determining when to recognize a provision and how to measure it. Here we reconsider the IFRS requirements specific to legal claims, identify some of the practical implications, and outline differences between IFRS and US GAAP.

With IAS 371, IFRS has one-stop guidance to account for provisions, contingent assets and contingent liabilities. Therefore, there is a single recognition, measurement and disclosure model for obligations such as legal claims and litigation, onerous contracts, restructuring2, assurance warranties, non-income tax exposures, environmental provisions and decommissioning.

This contrasts with US GAAP, which has a number of Codification topics that, in combination, cover the same overall scope as IAS 37. For example, separate Codification topics deal with asset retirement obligations, environmental obligations, exit and disposal obligations and guarantees. After these exclusions, many loss contingencies and gain contingencies fall under the general model in ASC 450.3 It is this general model that is the subject of this article, focusing on legal claims.

When should a provision for a legal claim be recognized?

IFRS and US GAAP have similar, but not identical, recognition thresholds.

Applying these principles to a legal claim, the past event is the event that gives rise to the litigation, rather than the claim itself. For example, in the case of a legal claim filed by a customer injured by a company’s product, the past event is the actual incident in which the injury happened, which is when the provision (loss contingency) should be recognized – not when the claim was filed – assuming the other recognition criteria are met. Before an actual claim is made, the provision or loss contingency represents an ‘unasserted claim’.

In some cases, it may not be clear whether a present obligation exists, even if there is a past event – e.g. a legal claim that is disputed by the company. In such cases, subject matter experts may be required to estimate the likelihood of an outflow of resources. The assessment considers all available evidence, including post-reporting date events and any other precedents.

How is the best estimate determined?

Under both IFRS and US GAAP, the amount recognized as a provision is the best estimate of the expenditure to be incurred. This is the amount that a company would rationally pay to settle the obligation, or to transfer it to a third party, at the end of the reporting period. Given the uncertainties inherent in determining an estimate, best estimates are based on management’s judgment of all possible outcomes and their financial effect, and should also factor in relevant past experience with similar transactions.

Differences between IFRS and US GAAP become apparent when applying the measurement principle. The following is in the context of a legal claim – i.e. a single obligation.

• The most likely outcome is generally taken as the measurement; however, other outcomes may affect the measurement if they are mostly higher or mostly lower than the most likely amount. For example, if the most likely outcome is that a legal claim will be settled for $100, but the other possible outcomes are mostly higher than $100, then the provision should be measured at some amount higher than $100. Unlike IFRS, under US GAAP the single most likely outcome within the range is used without consideration of the other possible outcomes.
• If there is a continuous range of possible outcomes and no one point in the range is considered more likely than another point, the mid-point of the range is taken as the best estimate under IFRS. Unlike IFRS, under US GAAP the low end of the range is used if no estimate is better than any other.

These differences are illustrated in the following example.

What costs to include?

For a legal claim, a significant consideration may be the related costs that a company expects to incur – e.g. lawyers’ and experts’ fees. IFRS does not provide specific guidance on recognizing related costs. However, under US GAAP, the accounting for related legal costs is subject to an accounting policy election. Acceptable accounting policies include expensing related costs as incurred or accruing related costs when they are deemed probable and reasonably estimable.

For legal claims, under IFRS we believe that if there is no past obligating event, then no provision for the legal claim would be recognized and legal costs to be incurred in defending the claim should be expensed as incurred. In contrast, if there is a past obligating event, anticipated incremental costs that are related directly to the settlement of the claim should be included when measuring the provision for the legal claim. In our view, allocating future salaries of claims department personnel (‘full cost’ approach) to the provision would not be appropriate because they are unlikely to be incremental for any specific claim. However, if an external adviser is engaged to negotiate the settlement of a specific legal claim, the associated cost would be incremental and included in the measurement of the related provision.

Risk and discounting

Under IFRS, discounting is generally required for provisions that are expected to be settled in the longer term, where the time value of money has a material effect. The unwinding of the discount is recognized in profit or loss as a finance cost when it occurs.

IFRS also requires risks that are specific to the liability to be reflected in the best estimate. This can be done by (1) adjusting the cash flows for risk, or (2) using a risk-adjusted discount rate. In our experience, it is generally easier to incorporate risk factors into the estimate of the cash flows and use a pre-tax risk-free discount rate. Because a risk-adjusted discount rate should reflect the risks specific to the liability, the use of an entity’s incremental borrowing rate would not be an appropriate proxy. Therefore, adjusting the discount rate for risk can be challenging due to the complexity and high degree of judgment involved.

Although US GAAP does require discounting for certain obligations (e.g. asset retirement obligations), the general model in ASC 450 does not permit it unless the amount and timing of the cash outflows are fixed or reliably determinable. It is unlikely that a contingency related to a legal claim would meet these criteria.

Reimbursements

Certain legal claims may be subject to reimbursement, in the form of insurance proceeds, indemnities or reimbursement rights, such as in these examples.

• Under IFRS, the related reimbursement is recognized as a separate asset when recovery is virtually certain. The reimbursement asset cannot exceed the related provision amount.
• Unlike IFRS, under US GAAP a recovery of a loss contingency (i.e. up to the amount of the loss), is recognized as a separate asset when recovery is ‘probable’ – i.e. a matching recognition threshold. However, any amount in excess of the loss contingency is a gain contingency that is recognized only when realized.

Reimbursement assets are not netted against the related provision (loss contingency) on the balance sheet. However, the expense and related reimbursement may be netted in profit or loss under both IFRS and US GAAP.

Disclosures and exemption

One important IFRS disclosure requirement that differs from US GAAP is the requirement to disclose movements in each class of provision (e.g. legal claims) during the reporting period. This rollforward schedule should distinguish amounts reversed and unused from amounts used. These amounts are computed claim by claim and cannot be netted against other provisions increases or decreases.

However, IFRS also provides an exemption that is particularly relevant to legal claims. The otherwise mandatory disclosures are not required in the extremely rare case that they would seriously prejudice a dispute. Whether this high threshold is met depends on the specific facts and circumstances.

US GAAP has a disclosure exemption for unasserted claims if certain criteria are met, but in any event the disclosures under ASC 450 are less detailed than IFRS.

The takeaway

Given the uncertainty about the timing or amount of future expenditures needed to settle legal claims, the recognition and measurement of a provision can often require companies to make significant judgments and assumptions. It is therefore important for companies to be cognizant of the IFRS measurement requirements and to have robust processes and controls in place to ensure timely recognition and appropriate measurement of provisions, including subsequent changes.

For dual preparers, differences in the IFRS and US GAAP requirements related to recognition and measurement may result in different liability amounts.

1 IAS 37, Provisions, Contingent Liabilities and Contingent Assets. IAS 37 has limited scope exclusions – e.g. rights and obligations under insurance contracts, income tax uncertainties, employee benefits, share-based payments.

2 KPMG’s article, Restructuring: understanding the IFRS requirements, covers specific application issues related to restructuring provisions.

3 ASC 450, Contingencies

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.

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