International Accounting Standards Board
Comments on Exposure Draft ED/2010/1
Measurement of Liabilities in IAS 37
April 7, 2010
Dear Sir or Madam,
As part of their Accounting Theory class, students at the University of Manitoba and I
discussed the merits and pitfalls we saw in the Proposed Amendments to IAS 37. Our
comments relate to the following four areas, which will be discussed in turn:
1) Measuring the contingent liability as the expected value of future cash outflows;
2) The measurement of outflows at the price at which an outside contractor would
perform the service;
3) The mechanisms by which risk would be taken into account; and
4) The distinction between future events that should or should not be taken into account
when assessing the liability.
Briefly, we agreed with the Board’s treatment of the first two points, and disagreed with
the latter two. Our major points are as follows:
1. Measuring the contingent liability as the expected value of future cash outflows
We are in agreement with the Board’s conclusions that current practice should be
clarified to recommend that entities measure the contingent liability as the expected value
of future cash flows. This is the most conceptually correct measure for decision makers
to use when assessing the future cash flows of the entity. We do not feel that the
calculations are too complex. We understand that some decision makers could be
confused by an expected value that is unlikely to be the actual realized value of the cash
flows. However, if various contingent liabilities are aggregated this would not even be
discernable to users. Furthermore, we suggest later (in issue 3), that the range of
outcomes also be disclosed to users which will help them to understand the relationship
between the expected value and the individual possible outcomes.
Students also noted, however, that in some industries it may be overly difficult to perform
an expected value calculation. In particular, many people feel quite comfortable
identifying the minimum, maximum and most likely losses, but it may be very difficult
and highly subjective to attach the probabilities to the outcomes required for the expected
value calculation. We believe the Board should give consideration to whether it would
be preferable in such a case to a) arbitrarily attach equal weights to the minimum,
maximum and most likely losses and proceed with the expected value calculation; b)
accrue the most likely loss; or c) disclose only, on the basis that the expected value is not
measurable.
2.
The measurement of outflows at the price at which an outside contractor would
perform the service
We agree with the Board’s views that measuring outflows for services at the price at
which an outside contractor would perform the service is likely to reduce divergences in
practice, thus improving comparability and reliability. Conceptually, we see that building
a profit margin into these numbers is effectively taking into account an opportunity cost
to the entity of deploying resources to satisfy these obligations rather than the entity’s
usual pursuits. While this is somewhat new to GAAP as opportunity costs are theoretical
costs, we see this as being consistent with new revenue recognition standards and
conceptually reasonable.
3.
Mechanisms by which risk would be taken into account
We agree that providing information about risk is important to decision makers. We
disagree with the recommendation that the amount of the liability be adjusted to reflect
this risk for several reasons: First, risk is generally captured by the standard deviation of
the distribution of outcomes. It is not statistically valid to change the mean (expected
value) of the distribution as a means of capturing the standard deviation. That being said,
one could argue that the committee is advocating an “expected utility” equivalent. For
example, I might feel that while the expected value of a bet where I have a 10% chance
of receiving $1,000 and a 90% chance of receiving nothing is $100, its equivalent value
to me is the same as $85 for sure. That is, the expected value is adjusted to reflect the
disutility of risk. There are two main difficulties of this approach. First, risk preferences
are individual, so management of the entity may price risk differently than the financial
statement users would. Secondly, from prospect theory, it is not clear that adding risk to
a liability increases it, rather than decreases it.
If people are asked to choose one option from Menu A, and one option from Menu B:
Menu A:
Menu B:
Receive $100 for sure OR
Give up $100 for sure OR
90% chance of 0, 10% chance of $1000
90% chance of 0, 10% chance of $1000
Many people will reliably pick the sure thing from Menu A, but the risky choice from
Menu B. That is, with respect to losses, many people are risk SEEKING, so they may
perceive a liability as being LESS onerous if there is a range of outcomes. This would
argue for subtracting a risk adjustment from the expected value of the liability otherwise
determined, rather than adding an adjustment. Perhaps similarly, it seems unintuitive to
adjust a discount rate for risk by lowering it (which will give a higher liability value)
rather than raising it. Finally, given that the adjustments seem quite arbitrary and not
grounded in statistical reasoning, we feel that they would give unwarranted latitude to
management to determine the amount of the liability, with little recourse for the auditors
to disagree.
As a result, we believe it would be preferable to recommend that entities disclose the
range of outcomes to allow users to assess the risk and adjust the liability according to
their own risk preferences. We also feel that this would be the preferable treatment as it
would provide information to decision makers that would not otherwise be discernable.
4.
The distinction between future events that should or should not be taken into
account when assessing the liability
As a group, we did not understand the distinction between future events that should be
taken into account (those that might affect the outflow of resources required to fulfill the
present obligation) versus those that should not be taken into account (those that change
the nature of the obligation by changing, discharging or creating a new obligation). As
an illustration, the Board suggested that management could consider advances in
technology but not changes in legislation.
The purpose of contingent liabilities is to enable an assessment of future cash
flows, and the Board, in its basis for conclusions states that “the management of an entity
knows more than the capital providers about the uncertainties surrounding a liability. So
capital providers benefit from knowing the amount at which the management of an entity
quantifies the entity’s obligations”. We did not understand the benefit of excluding the
impact of certain future events and not others, and in fact thought that management may
be better able to reliably assess future legislation more easily than future technology. We
also were not confident that we would be able to sort other illustrative examples into the
proper categories (those that change the amount of the cash flows versus those that
change the obligation).
Is the purpose of these provisions, and their support from respondents in the
original exposure draft, to relieve entities of the obligation to consider future legislation
on their current liabilities? If so, we believe that should simply be stated. If the purpose
is in fact to make a general distinction between events that affect an assessment of cash
flows versus events that change or discharge current obligations or create new
obligations, we felt that we would be well served with more extensive explanations and
more illustrations of the concept. We wondered if, for example, the Board would really
wants to separate future events that either create or discharge a liability, from events that
change a liability (i.e., it changes the cash flows attached to the liability). We would find
that understandable – to summarize, it would involve changing events that “those that
change the nature of the obligation by changing, discharging or creating a new
obligation” to events that “those that change the nature of the obligation by changing,
discharging or creating a new obligation
We hope that you find these comments to be useful in your deliberations, and we thank
you for the opportunity to respond to the exposure draft. Please do not hesitate to contact
me if you require any further clarification or elaboration.
Sincerely,
Janet Morrill, Ph.D., C.A, C.G.A., I. H. Asper School of Business
and students listed below:
Ritchie Arthurson
Michael Lindenburg
Joseph Sitholé
Lee Clement
Sarah Norget
Ying Tang
Kyle Hirschfeld
Michelle Pelech
Melissa Yamada
Nikita Klassen
Jaclyn Sault
Xiyin Li
Anthony Sawatzky
Yuhui Li
Komaljeet Sidhu