James B. Milholland
2800 Windrush Lane
Roswell, GA 30076
USA
May 19, 2010
Submitted via internet
International Accounting Standards Board
30 Cannon Street
London EC4M 6XH
United Kingdom
Dear Board Members
Re: Comments on the IASB Exposure Draft Measurement of Liabilities in IAS 37
In response to the request for comments on the Exposure Draft Measurement of
Liabilities in IAS 37 (the ED), I am pleased to submit my comments and
recommendations. I am an actuary with over thirty years of experience in insurance
accounting. I am submitting my comments not only because of my interest in the
measurement of liabilities, but principally because of the possible influence of the
concepts for liability measurement on accounting for insurance contracts and for pension
plans.
I appreciate the opportunity to comment on the ED. If, after reading these comments you
wish to discuss any part of my letter, please contact me at the address above or by email
at actuary@milholland.com.
Sincerely,
James B. Milholland, FSA, MAAA
Comments on the January 2010 Exposure Draft
May 19, 2010
Measurement of Liabilities in IAS 37
General Comments
My views are closely aligned with those of the six members of the Board who voted
against the proposal. I am particularly concerned with the adjustment for uncertainty that
is proposed for the measurement of the resources required to fulfill the obligations. I
share the concern of the dissenting members regarding a margin in a liability that arises
outside of contracts with customers, as expressed in paragraph AV2(b) of the ED,
namely
“It is a hypothetical amount that does not represent a payment of cash or an actual
outflow of the entity’s resources. Including a hypothetical margin in the
measurement of the liability would reduce the net profit at the initial recognition
of the liability and release a profit in the period in which the liability is
derecognised. These Board members believe that such accounting creates
inappropriate performance information for both periods and does not provide
useful information to the users of financial information.”
I expand on my views in my responses to the specific questions, which follow.
Responses to Questions
Question 1 – Overall requirements
The proposed measurement requirements are set out in paragraphs 36A–36F.
Paragraphs BC2–BC11 of the Basis for Conclusions explain the Board’s reasons for these
proposals.
Do you support the requirements proposed in paragraphs 36A–36F? If not, with which
paragraphs do you disagree, and why?
Response: I do not support the requirements. The concept of resources that are
required to fulfill the obligations is ambiguous. I believe that users would tend to
construe this term to mean the cost to the entity and that they are better served by
estimates of the cost
.
Uncertainty in estimates
I agree that the treatment of uncertainty is a central issue in the measurement of
liabilities. I also agree that a price-based measurement, such as a fair-value
measurement, requires a margin because market participants require a margin. I believe
that a cost-based measurement that includes a margin is less decision useful and not
representationally faithful. I believe that the inclusion of a margin results in a bias in the
measurement of liabilities and in the recognition of expenses that is contrary to the
qualitative characteristics that the FASB has articulated in its project on the Conceptual
Framework.
James B. Milholland
2800 Windrush Lane
actuary@milholland.com
Roswell GA 30076 USA
2
Comments on the January 2010 Exposure Draft
May 19, 2010
Measurement of Liabilities in IAS 37
The existence of uncertainty is characteristic of many items and creates the necessity for
accounting estimates. There is no real concern that users of financial statements will see
no difference between a certain payment and an uncertain one. Engaging in business
requires dealing with uncertainty. Users understand, from disclosures and from review of
past experience, that many liabilities are uncertain.
Uncertainty is not diminished by the inclusion of a margin in the measurement of the
liability. Including a margin in the measurement of a liability reduces the possibility that
there will be a loss associated with the development of the liabilities while increasing the
possibility of gains, but the uncertainty of the cash flows is no different. In fact, when the
liability includes a margin, the probability that the outcome will be different from the
recorded liability is increased. The mean variance –in the cost-accounting sense of
variance as the difference between the estimated amount and the ultimate outcome- will
be a significant positive number, rather than zero as one would intuitively expect for an
accounting estimate. It will in fact be equal to the margin.
The effects of the margins on the profit and loss in the period in which the loss is
recognized and its impact on profit and loss in subsequent periods are more likely to
confuse users than to edify them. The inclusion of a margin is a way to normalize the
future outcome around the amount of the margin rather than accept a distribution of
outcomes around the estimate. In the period in which the expense is recognized, the
profit and loss reflects an adjustment to the norm. Future periods then reflect
performance against the norm. The underlying profitability of the business is obfuscated
by this process. Separate disclosures of the movement in the margin can make it possible
for users to discern the effects, but the inclusion of the margin in the first place creates
the need for users to adjust the reported results to understand the underlying profitability.
What does a margin represent?
It is not clear what a margin is intended to represent. In discussion related to the
insurance project, it has been suggested that it is the cost for bearing risk or an element of
prudence for the protection of policyholders.
The cost of bearing risk can be seen as either a cost to the policyholder that is reflected,
to the extent the market will bear, in the consideration, or as a cost of capital. If it is the
price included in the premium, then the recognition of the margin is a matter relating to
revenue recognition, not to the measurement of liabilities.
If the margin is the cost of capital, then it is misplaced. It does not matter that entities
have specific reasons for needing capital. The cost of capital is more properly reflected in
accounting for the sources of capital, primarily debt and equity, rather than in the
insurance liabilities. It is not appropriate to “reserve for” the cost of capital by a provision
in the liabilities.
If the margin is an element of prudence, then the measurement of the liability is biased to
attain a predetermined result; namely, that the losses will run out favorably. This bias is
James B. Milholland
2800 Windrush Lane
actuary@milholland.com
Roswell GA 30076 USA
3
Comments on the January 2010 Exposure Draft
May 19, 2010
Measurement of Liabilities in IAS 37
the very thing that the Board has objected to in its publication Objectives of Financial
Reporting and Qualitative Characteristics of Decision-Useful Financial Reporting
Information - Preliminary Views (para. S8).
Question 2 – Obligations fulfilled by undertaking a service
Some obligations within the scope of IAS 37 will be fulfilled by undertaking a service at
a future date. Paragraph B8 of Appendix B specifies how entities should measure the
future outflows required to fulfil such obligations. It proposes that the relevant outflows
are the amounts that the entity would rationally pay a contractor at the future date to
undertake the service on its behalf.
Paragraphs BC19–BC22 of the Basis for Conclusions explain the Board’s rationale for
this proposal.
Do you support the proposal in paragraph B8? If not, why not?
Response: No. The measure of future outflows should be the expected cost. If the
entity would normally pay a contractor to undertake the service on its behalf, then this
amount is the expected cost. If the entity expects to undertake the service on its own,
then the cost of a contractor is irrelevant.
Question 3 – Exception for onerous sales and insurance contracts
Paragraph B9 of Appendix B proposes a limited exception for onerous contracts arising
from transactions within the scope of IAS 18 Revenue or IFRS 4 Insurance Contracts.
The relevant future outflows would be the costs the entity expects to incur to fulfil its
contractual obligations, rather than the amounts the entity would pay a contractor to fulfil
them on its behalf.
Paragraphs BC23–BC27 of the Basis for Conclusions explain the reason for this
exception.
Do you support the exception? If not, what would you propose instead and why?
Response: No. I believe that there is no reason for an exception and I recommend that
the measurement of liabilities in IAS 37 be consistent with the concepts in the proposals
for accounting for onerous contracts. I ask that, before adopting the proposal, the Board
consider the implications to pension liabilities if accounting for pensions were made
consistent with IAS 37. I believe that general consistency is desirable and I also believe
that a risk margin is inappropriate for the measurement of pension liabilities.
James B. Milholland
2800 Windrush Lane
actuary@milholland.com
Roswell GA 30076 USA
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