Students in Masters of Business Administration
Loyola University Chicago-Graduate School of Business
1 E. Pearson St., Maguire Hall
Chicago, IL 60611
May 3, 2010
International Accounting Standards Committee
Project: Measurement of Liabilities in IAS 37
Exposure Draft ED/2010/1
Dear Board Members,
Thank you for providing us with the opportunity to comment on specific questions
outlined in the exposure draft for proposed amendments to IAS 37. We are Master of
Business Administration students at Loyola University Chicago studying issues in
financial reporting. Currently, we are working full time and attending graduate classes at
night. Our full time positions are in the accounting field and we have over 5 years of
practical accounting experience. We understand the importance of ensuring that
contingent liabilities are correctly accrued and stated on a company’s financial
statements. Not having defined standards in place for contingent liabilities can lead to a
company misstating their financial position and have adverse effects in the future. We
hope that our response to the comment questions will help alleviate the ambiguity and
provide a clear definition for statement.
Sincerely,
Sally Saccomando
Sarah Young
Saccomando and Young
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 Boards reasons for
these proposals. Do you support the requirements proposed in paragraphs 36A-36F? If
not, with which paragraphs do you disagree, and why?
After reviewing the proposed dynamics of the re-evaluation, it is our opinion that
there is some ambiguity regarding the discount factor that should be used in the present
value calculation in paragraph 36C. We also feel that there is ambiguity in determining
exactly how interest income and interest expense should be reported. Paragraph 36C
reads as follows:
An entity might be unable to cancel or transfer some obligations within the scope
of this Standard. If there is no evidence that an entity could cancel or transfer an
obligation for a lower amount, the entity measures the liability at the present value
of the resources required to fulfill the obligation1
We will look at the historical use of different interest rates and the impact they have on
the calculation of Net Present Value for contingent liabilities. By examining different
rates such as the prime rate, 30-year mortgage rate, and market rate, we will demonstrate
how these rates can affect the results reported on a company’s financial records.
Currently the standard is to use prime rate as the benchmark. Statistically the
prime rate is consistent throughout the United States banking system. History of the
1
IASB Exposure Draft: Measurement of Liabilities in IAS 37
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prime rate indicates that there have been major economic fluctuations over specific time
periods that have drastically affected the prime rate This is evident in historical
economic events such as the oil crisis of 1974, and the recession of the 1980s. The
change in the prime rate during this time is shown below.
Source: Wall Street Journal2
Although these changes occurred a couple decades ago the prime rate has been
recently undergoing a similar fluctuation. The real estate markets increased, reaching a
climax in 2005 when the bubble burst, and then the markets collapsed.3 It is not clear if
the housing market crash has ended yet or not. It’s difficult to argue the factors that
caused the actual burst, but many argue it resulted in the sub-prime mortgages and loose
lending practices. The fact of the matter remains that the aforementioned events caused
drastic downward movement in the prime rate.
History has shown that mortgage rates can be as volatile as the prime rate;
however the 30-year fixed rate provides some stability. Although the rate primarily
2
Prime Rate History. http://www.wsjprimerate.us/wall_street_journal_prime_rate_history.htm
3
Laperriere, Andrew (2006-04-10). "Housing Bubble Trouble: Have we been living beyond our means?".
The Weekly Standard. http://www.weeklystandard.com/Content/Public/Articles/000/000/012/053ajgwr.asp.
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applies to mortgage lending and thus is a configured outcome from the prime rate, it does
remain consistent over the life of a loan. One of the key benefits of having companies’
value contingent liabilities using this rate for the net present value calculation is that it
would provide some consistency. This consistency is imperative considering the fact that
entities may need to accrue for a contingent liability over several years in the future;
using the a more stable interest rate when calculating Net Present Value will ensure that
the entity is accurately accruing for their contingent liabilities. Failure to use the 30 year
mortgage rate when calculating net present value may lead to an entity’s misstatement of
their contingent liabilities. We are aware of recent efforts to provide users with accurate
financial data that would increase investor confidence.4 Hence, the investor can feel
confident that the amount accrued for the contingent liability is accurate.
The last rate that we will examine is the market rate, which is commonly referred
to as cost of capital. Previously, we mentioned how the market place can affect the
different rates, but there are other factors to be. Companies may be using different
market rates purely based on when their fiscal year ends. If the fundamental natures of
the interest rates are changing then we will be chasing stability while the reality is that the
effective market of today is not stable. Our belief is that using the changing interest rates
over time is not an appropriate method.
Example 1 demonstrates that a small difference in the current prime rate and the
current rate offered on student loans through the government on the same contingent
4
Financial Accounting Standards Board. Accounting Standards Board of Japan Meets with
Financial Accounting Standards Board to Discuss Global Convergence, CT. October 22, 2009.
http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB/FASBContent
_C/NewsPage&cid=1176156521410
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liability cause a difference of approximately 13% in the measurement of the liability. We
choose to use the student loan rate just to illustrate a comparison point being that we are
currently students and this rate currently applies to some of our own personal liabilities.
As demonstrated the entity has discretion on how the liability is stated and can potentially
understate or overstate the contingent liability. We feel that ambiguity exists and should
be addressed as to not leave it to the preparers’ discretion.
Aside from the rate used to calculate Net Present Value, we also felt that we
needed to address the portion in paragraph 36F, which reads:
Changes in the carrying amount of a liability resulting from the passage of time
are recognized as a borrowing cost.5
The question arises as to what constitutes a change that would be required to be
recognized. If a nominal change occurs, does it need to be reported in the financial
statements or simply addressed in the notes? We feel that the ambiguity that exists in
paragraph 36F needs to be addressed in the financial statements in the interest of full
disclosure.
As the previous examples have demonstrated, it is important to ensure that the
correct discount rate is being used when calculating present value. Not defining which
discount rate to use will lead to a fluctuation in the present value of the contingent
liability reported on the statement of financial position. Further, determining the rate will
help determine when interest income and expense should be reported.
5
IASB Exposure Draft: Measurement of Liabilities in IAS 37
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EXAMPLE 1:
An entity undergoes a law suit and an unfavorable outcome has been handed down. A judge
determines that the the entity is to pay the plaintif $0.5 Million at the end of each year for a period
of 5 years.
Company A
Company A uses the current prime rate as the discount rate to be used for the Net Present
Value Calculation
Amount Due per yr: $
Current Prime Rate:
Number Years:
500,000
3.25% Source: www.federalreserve.gov
5
Outflow
Factor
(500,000)
0.969
PV of yr 1
(500,000)
0.938
PV of yr 2
(500,000)
0.909
PV of yr 3
4
(500,000)
0.880
PV of yr
5
(500,000)
0.852
PV of yr
NPV of Contingent Liability
PV
(484,262)
(469,018)
(454,255)
(439,957)
(426,108)
(2,273,600)
Company B
Company B uses 8.5% as their cost of capital discount rate to be used for the Net Present Value
Calculation
Amount Due per yr: $
Cost of Capital Rate:
Number Years:
500,000
8.50%
5
PV of yr
PV of yr
PV of yr
PV of yr
PV of yr
1
2
3
4
5
Outflow
(500,000)
(500,000)
(500,000)
(500,000)
(500,000)
Factor
0.922
0.849
0.783
0.722
0.665
PV
(460,829)
(424,728)
(391,454)
(360,787)
(332,523)
NPV of Contingent Liability
(1,970,321)
Difference
Exhibit A
Exhibit B
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$
$
$
(2,273,600)
(1,970,321)
(303,279)
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Question 2#
Some obligations within the scope of IAS37 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 fulfill such obligations. It proposes that the relevant outflows
are the amounts that the entity would rationally pay a contractor at the future date
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?
We like the overall proposal set forth in paragraph B8; we again feel that there is
some ambiguity that the board should address prior to the proposal being accepted. The
idea of basing the future liability on the price to hire a contractor to perform the service at
a future date makes sense. Entities are not always equipped to perform the services
themselves and may wish to outsource the work to another company. There is always the
possibility that the entity may desire to perform the service in–house. With that being
said, the issues that we feel require further clarifications in this proposal are the
following:

How to determine cost if there are no suppliers for the service

How to ensure that investors will receive actual cash flow information

How to compensate for the profit margin in a contractor’s proposal if the entity
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decides to perform the service themselves

How to obtain fee estimates to benchmark from the contractors
Paragraph B8 part b of the proposal addresses the issue of how an entity measures the
outflows for the obligation if there is no market for the actual service. The proposal
requires the company to not only estimate the cost the entity expects to incur but also the
amount of money they would charge another company to provide this service at a future
date; hence, this price would include all cost and profit margin. This portion of the
proposal gives the entity a lot of leeway in determining the cost for a service that there is
no market. If no supplier or market exists then the company would have no standards for
profit margins and cost relevance. With that being said, they would be able to put
themselves in a position to underestimate the contingent liability. We understand there is
a potential that the liabilities may in fact become overstated, but for our purposes we will
assume the liabilities would be understated. If an entity does not accurately determine all
the factors that make up the cost of the service; then the liability will be inaccurate on the
balance sheet as well as effect the income statement to show inaccuracy. A way to ensure
that all that the entity is estimating the contingent liability to the best of their knowledge
is to require that paragraph B8 of the proposal has a stipulation that the factors for
determination are included in the foot notes of the balance sheet. Another issue is how to
determine the correct profit margin that should be included in the accrual of the cost, as
cost structures can have variability among different companies. The proposal stipulates
that the margin that an entity would charge another entity for the service should be
factored into the price. However, since profit margins vary industry to industry, and even
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between companies within the same industry.6 If there is no established market for these
services, the entity could potentially have leeway in setting the profit margin, especially
with varying levels of competition. We feel this concept of profit margin needs to be
addressed in the IAS 37 provision to ensure that the profit margin is not too high or too
low. Our thought on how the profit margin could be addressed in the provision is to give
a multiplier of their current core business to determine profit margin. Although, for most
services there is actual market for the service that needs to be performed this proposal
addresses the possibility that there is not a market.
Investors are concerned with ensuring that future cash flows are accurate, not the
possible opportunity cash flows as stated in BC20 part b of the exposure draft. Assuming
there is a market for the service, the liability is estimated based on the price that a
contractor would charge for the service. Although there is a way to estimate the liability
we are concerned with the outcome if the entity decides to perform the service itself.
There is a possibility that there will be a gain recognized due to the fact that the company
may be able to perform the service at a lower cost. Our assumption is the company
would have outsourced the obligation if a lower rate was available. Many companies
perform “make or buy” analysis before undertaking a major project. This analysis may
not be performed until the time that the project is actually scheduled to take place. Under
paragraph B8 the entity would accrue for the liability based upon contractor prices, but
when it comes time to actual start the project their analysis may reveal that it has become
McClure, Ben. “The Bottom Line On Margins.”
http://www.investopedia.com/articles/fundamental/04/042804.asp
6
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financially advantageous to perform the services in house. Contractor pricing has a built
in profit and the make or buy analysis may show that the entity is able to execute the
services at a lower cost basis than what the contractor is able to do. If the entity
determines performing the obligation themselves has a lower cost a gain will be realized
once the obligation is fulfilled resulting from an over-accrued liability. A provision
should be applied to IAS37 that addresses how the gain will be accounted for. As of right
now, IAS does not address contingent assets; therefore, they are not reported.7
Benchmarking is often used to refer to the continuous process of measuring products,
services, and activities against the best levels of performance. These best levels of
performance are often found in competing organizations or in other organizations having
similar processes.8 The notion of benchmarking is mentioned in section BC31 part c. In
this part it is referenced the entities would not have to obtain quotes from contractors, but
would be able to benchmark data that they obtained to help perform a make or buy
analysis for services. Our impression is that there is little guidance on how
benchmarking is actually done and is left to the manager’s approach, although it is
understood benchmarking provides benefit we feel that there needs to be guidelines in
place when using this as a measurement technique. Prices that contractors quote even
among the same industry change from company to company can very drastically.
Therefore, the question that is raised is how the entity determines what the benchmark
is for the different prices provided by contractors. Each contractor may have a different
level of quality, soft skills, etc. Therefore, it is assumed that it is left up to the company to
7
http://www.iasb.org/NR/rdonlyres/94C8F2F5-FC68-43E5-86AC-211C9B701FE5/0/IAS37.pdf
8
Horngren, Foster, Datar, Cost Accounting A Managerial Emphasis, ed. 10 (Prentice Hall, 2000), 236.
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determine their level of comfort with each contractor and pick what they feel is the
appropriate price. Once again this could potentially give the company leeway in
determining the benchmark price. The leeway provided to entities has the potential to
have adverse effects if they state the liabilities as a benchmark from an in-house estimate
and then decide to outsource. If they had chosen an average priced benchmark then it
would have been to their advantage to perform the service within the company and not
outsource. Benchmarking standards should be put in place to ensure that the contingent
liability is being appropriately accounted for.
Furthermore, there is a prospect that the agreement may have multiple components.
A prime example of an agreement with multiple components is a maintenance service
contract. Service or maintenance contracts are can provide an economical method for
servicing or maintaining equipment. Our concern is when these agreements indicate
different components that require separate benchmarking.
Part D of paragraph BC21 reads:
“The overall measurement objective in IAS 37 is to estimate the amount the entity
would rationally pay to be relieved of an obligation. If an entity has an obligation
to undertake a service in the future, the amount that it would rationally pay to
avoid that obligation would reflect the value – not just the cost – of the resources
that it will have to sacrifice to fulfil the obligation…”11
This idea of rationality is vague and can vary among people. For years Toyota was rated
among the safest vehicles. As of February 2010 Toyota is facing criminal investigation
by the federal government. Its beleaguered U.S. dealerships are facing repairs to
potentially millions of customer vehicles that have been recalled. The company is
11
IASB Exposure Draft: Measurement of Liabilities in IAS 37
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offering customers new reimbursements for rental cars and other expenses.9 Therefore,
what people would rationally pay for the Toyota brand name has greatly diminished due
to the recent challenges that Toyota is incurring. Our concern is how this idea of
rationality is to be measured. In looking at the stock price of Toyota we can begin to
draw conclusions about what consumers are rationally paying compared to just a few
years ago.
Year
Toyota Avg. Stock Price
2010
77.95
2009
76.19
2008
90.12
2007
120.65
2006
111.95
2005
82.06
Source: http://finance.yahoo.com 10
We feel that this idea of rationality should include further clarification when applying
benchmarking techniques.
Overall the proposals in suggested in the IAS 37 paragraph B8 are a good idea, but
there are some concepts that we feel need further clarification before it is adopted. These
issues include:

How to determine cost if there are no suppliers for the service

How to ensure that investors will receive actual cash flow information

How to compensate for the profit margin in a contractor’s proposal if the entity
decides to perform the service themselves
“Toyota's Problems Shift into New Gear,” CBSN News Business, Feb. 25, 2010.
http://www.cbsnews.com/stories/2010/02/25/business/main6241698.shtml?tag=mncol;lst;2
9
10
Toyota Motor Corp. Historical Prices. http://finance.yahoo.com/q/hp?s=TM
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
How to obtain the fee estimates to benchmark from the contractors
Addressing these points, in our opinion, will make for a proposal containing little room to
question the intentions or method outlined to use.
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Question #3
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?
We support the proposed measurement for onerous contracts. We believe that the
liabilities should be measured based on the future cash flows that the obligation will
incur. However, in paragraph BC 23 it states,
“entities would measure some onerous contracts on a different basis – they would
measure contractual obligations to undertake a service by reference to a contractor
price for, rather than the cost of, the service.”
In our opinion, the future cash flows should be mandated to read that the costs to fulfil
the onerous contracts should be used not the price the entity would pay a contractor to
fulfil the obligation.
Per IAS 18 Revenue, it states how revenue should be measured, and we feel that
this should also be applicable to the proposed exception.
Revenue shall be measured at the fair value of the consideration received or
receivable. Fair value is the amount for which an asset could be exchanged, or a
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liability settled, between knowledgeable, willing parties in an arm’s length
transaction.11
We further note that the exception should be temporary as the Board is in tandem with a
revenue recognition and insurance contract project that will most likely eliminate the need for
this exception.
The Board’s proposal for measurement of onerous contracts is in line with our belief
as to how liabilities should be stated. It is important that future cash flows reflect the cost to
fulfil the onerous contracts and not the price the entity would pay a contract to fulfill the
obligation. Further, IAS 18 Revenue should be applicable to proposed exception regarding
fair value, as it is only temporary as the Board works on the revenue recognition and
insurance contract project which will ultimately eliminate this exception.
11
http://www.iasb.org/NR/rdonlyres/1A3771B8-5627-44E4-984E-AC90FEE1A971/0/IAS18.pdf
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Works Cited
Federal Reserve Statistical Release. April 13, 2010.
http://www.federalreserve.gov/releases/h15/update/
Financial Accounting Standards Board. Accounting Standards Board of Japan Meets
with Financial Accounting Standards Board to Discuss Global Convergence, CT.
October 22, 2009.
http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB/FA
SBContent_C/NewsPage&cid=1176156521410
Horngren, Foster, Datar, Cost Accounting A Managerial Emphasis, ed. 10 (Prentice Hall,
2000), 236.
Laperriere, Andrew (2006-04-10). "Housing Bubble Trouble: Have we been living
beyond our means?". The Weekly Standard.
http://www.weeklystandard.com/Content/Public/Articles/000/000/012/053ajgwr.a
sp
McClure, Ben. “The Bottom Line On Margins.”
http://www.investopedia.com/articles/fundamental/04/042804.asp
Merriam Webster's Online Dictionary;
http://www.merriamwebster.com/dictionary/prime%20rate
Prime Rate History.
http://www.wsjprimerate.us/wall_street_journal_prime_rate_history.htm
Toyota Motor Corp. Historical Prices. http://finance.yahoo.com/q/hp?s=TM
“Toyota's Problems Shift into New Gear,” CBSN News Business, Feb. 25, 2010.
http://www.cbsnews.com/stories/2010/02/25/business/main6241698.shtml?tag=mncol;lst;2
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