Concepts, Rules, and Examples

Current Liabilities

Classification of balance sheets.

Although balance sheets most often will present both assets and liabilities classified into current and noncurrent categories, there is no requirement under international accounting standards, nor indeed under national standards in various countries, that this be done. The salient international standard, IAS 1, notes that "when an enterprise supplies goods or services within a clearly identifiable operating cycle, separate classification of current and noncurrent assets and liabilities on the face of the balance sheet provides useful information by distinguishing the net assets that are continuously circulating as working capital from those used in the enterprise's long-term operations. It also highlights assets that are expected to be realized within the current operating cycle, and liabilities that are due for settlement within the same period."

IAS 1 continues the former IAS 13's optional use of balance sheet classification into current and noncurrent, while clearly supporting such a presentation scheme. In practice, most manufacturing and distributing enterprises do present classified balance sheets, while financial institutions and certain other businesses engaging in long-term projects, such as construction companies, typically do not.

The presentation of a classified balance sheet reveals important information about liquidity, or the debt-paying ability of the enterprise. IAS 1 places substantial weight on this goal, as revealed by the requirement it imposes on entities that choose not to present classified balance sheets. Those enterprises must list assets and liabilities "broadly in order of their liquidity." Furthermore, the standard requires that there must be disclosure of assets expected to be recovered, and liabilities expected to be liquidated, more than twelve months after the date of the balance sheet. This does not necessarily require that these be placed in separate captions in the balance sheet, per se, although that can be done; rather, footnote disclosures can be used to accomplish this objective.

IAS I also makes explicit reference to the requirements imposed by IAS 32 concerning financial assets and liabilities. Since such common balance sheet items as trade and other receivables and payables are within the definition of financial instruments, information about maturity dates is already required under IAS. While most trade payables and accrued liabilities will be due within thirty to ninety days, and thus are understood by all financial statement readers to be current, this requirement would necessitate additional disclosure, either on the face of the balance sheet or in the footnotes thereto, when this assumption is not warranted.

The other purpose of presenting a classified balance sheet is to highlight those assets and obligations that are "continuously circulating" in the phraseology of IAS 1. That is, the goal is to identify specifically resources and commitments that are consumed or settled in the normal course of operating the business. In some types of businesses, such as certain construction enterprises, the normal operating cycle may exceed one year. Thus, some assets or liabilities might fail to be incorporated into a definition based on the first goal of reporting, providing insight into liquidity, but be included in one that meets the second goal.

As a compromise, if a classified balance sheet is indeed being presented, the convention for financial reporting purposes is to consider assets and liabilities current if they will be realized and liquidated within one year or one operating cycle, whichever is longer. Since this may vary in practice from one reporting entity to another, however, it is important for users to read the accounting policies set forth in notes to the financial statements. The classification criterion should be set forth there, particularly if it is other than the rule most commonly employed: one-year threshold.

Nature of current liabilities.

Current liabilities are generally perceived to be those that are due within a brief time span. Convention is to use one year from the balance sheet date as the threshold for categorization as current, although for enterprises that have operating cycles longer than one year (e.g., certain types of construction projects), the longer period is often advocated as a more meaningful demarcation line. IAS 1 states that liabilities are to be considered current when they are expected to he settled in the normal course of the entity's operating cycle or are due to be settled within twelve months from the balance sheet date, whichever is longer. Examples of liabilities which are not expected to be settled in the normal course of the operating cycle but which, if due within twelve months would be deemed current, are current portions of long-term debt and bank overdrafts, dividends declared and payable, and various nontrade payables.

Current liabilities would almost always include not only obligations that are due on demand (typically including bank lines of credit, other demand notes payable, and certain overdue obligations for which forbearance has been granted on a day-to-day basis), but also the currently scheduled payments on longer-term obligations, such as installment notes. Also included in this group would be trade credit and accrued expenses, and deferred revenues and advances from customers for which services are to be provided or product delivered within one year. If certain conditions are met (described below), short-term obligations that are intended to be refinanced may be excluded from current liabilities.

Like all liabilities, current liabilities may be known with certainty as to amount, due date, and payee, or one or more of these elements may be unknown or subject to estimation. Under the principles of accrual accounting, however, the lack of specific information on, say, the amount owed, will not serve to justify a failure to record and report on such obligations. The formerly common term "estimated liabilities" has been superseded per IAS 37 by the term "provisions." Provisions and contingent liabilities are discussed in detail later in this chapter.

Offsetting current assets against related current liabilities.

IAS 1 provides that current liabilities not be reduced by the deduction of a current asset (or vice versa) unless required or permitted by another IAS. In practice, there are few circumstances that would meet this requirement; certain financial institution transactions are the most commonly encountered exceptions.

Types of liabilities.

Current obligations can be divided into those where

1. Both the amount and the payee are known;

2. The payee is known but the amount may have to be estimated;

3. The payee is unknown and the amount may have to be estimated; and

4. The liability has been incurred due to a loss contingency.

These types of liabilities are discussed in the following sections.

Amount and Payee Known

Accounts payable arise primarily from the acquisition of materials and supplies to be used in the production of goods or in conjunction with providing services. Payables that arise from transactions with suppliers in the normal course of business, which customarily are due in no more than one year, may be stated at their face amount rather than at the present value of the required future cash flows.

Notes payable are more formalized obligations that may arise from the acquisition of materials and supplies used in operations or from the use of short-term credit to purchase capital assets. Although international accounting standards do not explicitly address the matter, it is widely agreed that monetary obligations, other than those due currently, should be presented at the present value of the amount owed, thus giving explicit recognition to the time value of money. However, most would agree that this exercise would not be needed to present current obligations fairly. (Of course, if the obligations are interest-bearing at a reasonable rate determined at inception, this is not an issue.)

Dividends payable become a liability of the enterprise when the board of directors declares a cash dividend. Since declared dividends are usually paid within a short period of time after the declaration date, they are classified as current liabilities.

Unearned revenues or advances result from customer prepayments for either performance of services or delivery of product. They may be required by the selling enterprise as a condition of the sale or may be made by the buyer as a means of guaranteeing that the seller will perform the desired service or deliver the product. Unearned revenues and advances should be classified as current liabilities at the balance sheet date if the services are to be performed or the products are to be delivered within one year or the operating cycle, whichever is longer.

Returnable deposits may be received to cover possible future damage to property. Many utility companies require security deposits. A deposit may be required for the use of a reusable container. Refundable deposits are classified as current liabilities if the firm expects to refund them during the current operating cycle or within one year, whichever is longer.

Accrued liabilities have their origin in the end-of-period adjustment process required by accrual accounting. They represent economic obligations, even when the legal or contractual commitment to pay has not yet been triggered, and as such must be given recognition if the matching concept is to be adhered to. Commonly accrued liabilities include wages and salaries payable, interest payable, rent payable, and taxes payable.

Agency liabilities result from the legal obligation of the enterprise to act as the collection agent for employee or customer taxes owed to various federal, state, or local government units. Examples of agency liabilities include sales taxes, income taxes withheld from employee paychecks, and employee social security contributions, where mandated by law. In addition to agency liabilities, an employer may have a current obligation for unemployment taxes. Payroll taxes typically are not legal liabilities until the associated payroll is actually paid, but in keeping with the concept of accrual accounting, if the payroll has been accrued, the associated payroll taxes should be as well.

Current maturing portion of long-term debt is shown as a current liability if the obligation is to be liquidated by using assets classified as current. However, if the currently maturing debt is to be liquidated by using other than current assets (i.e., by using a sinking fund that is properly classified as an investment), these obligations should be classified as long-term liabilities.

Obligations that, by their terms, are due on demand or will be due on demand within one year (or operating cycle, if longer) from the balance sheet date, even if liquidation is not expected to occur within that period, are classified as current liabilities. Current IAS are not explicit as to how long-term obligations having subjective acceleration provisions, or acceleration based on covenant violations, should be accounted for. However, it is generally acknowledged (and formally required under some national GAAP standards) that the obligation should be classified as a current liability if, as of the balance sheet date, one of the following occurs:

1. The debtor is in violation of the agreement, which makes the obligation callable; or

2. The debtor is in violation of the agreement, and such violation, unless cured within the grace period specified in the agreement, makes the obligation callable.

Note, however, that if circumstances arise that effectively negate the creditor's right to call the obligation, the obligation may be classified as long-term. Examples of such circumstances are

1. The creditor has waived the right to call the obligation caused by the debtor's violation, or it has subsequently lost the right to demand repayment for more than one year (or operating cycle, if longer) from the balance sheet date.

2. The obligation contains a grace period for remedying the violation, and it is probable that the violation will be cured within the grace period.

In either of these situations, the circumstances must be disclosed in the financial statements in which long-term debt classification has been continued notwithstanding the breach condition.

The IASB intends to make certain changes to IAS 1 pertaining to debt classification. These will require that, if a loan covenant making a liability payable on demand if certain conditions related to the borrower's financial position are breached, and such breach exists at the balance sheet date, the liability will have to be classified as current, even if the breach is corrected after the balance sheet date. There would be an exception if, prior to the balance sheet date, the lender has granted a grace period in which to correct the breach and, when the financial statements are authorized for issue, either (1) the borrower has corrected the breach or (2) the grace period has not yet expired. In other words, probable correction of the breach condition would not suffice to warrant continued noncurrent classification under such circumstances.

Short-term obligations expected to be refinanced may be classified as noncurrent liabilities if certain conditions are met. If an enterprise intends to refinance the currently maturing portion of long-term debt or intends to refinance callable obligations by replacing them with either new long-term debt or with equity securities, IAS 1 must be followed. IAS 1 states that an enterprise should reclassify currently maturing portions of long-term debt as long-term, provided that the enterprise intends to refinance the obligation on a long-term basis and its intent is supported by any of the following:

1. Original term greater than twelve months. If the debt was originally scheduled for repayment within one year, a later agreement to extend it cannot, under IAS 1, be reclassified as noncurrent, although once it is extended or refinanced, the new or replacement debt will be classified according to its terms, and not be limited by the terms of the predecessor debt.

2. The enterprise intends to refinance the debt on a long-term basis. This intention must be present as of the balance sheet date in order to be useful in justifying a reclassification of the debt to noncurrent status.

3. The intention to refinance is supported by an agreement to refinance, or to reschedule payments, which is completed before the financial statements are issued. Absent an actual consummation of this agreement before the statements are issued, there can be no assurance that it will be successfully completed, and it would be foolish to permit reclassifying short-term obligations as being long-term under such a scenario. Given that there is often a lag between the date of the financial statements and the issuance thereof, an intention that existed as of the former should be consummated with an actual refinancing by the latter date. In some cases, release of the financial statements will be delayed until the refinancing is put into place, for the very reason that there is a strong desire to report the reclassified debt on the balance sheet.

Logic suggests that if short-term debt is classified as long-term due to the existence of a post-balance-sheet date refinancing or a lender or investor commitment, the replacement debt should not be callable unless there is a violation of a provision of the agreement with which compliance is objectively determinable or measurable. As of the balance sheet date, the reporting enterprise should not be in violation of the terms of the agreement.

Furthermore, the amount of currently maturing debt to be reclassified should not exceed the amount raised by the actual refinancing, nor can it exceed the amount specified in the refinancing agreement. If the amount specified in the refinancing agreement can fluctuate, the maximum amount of debt that would be reclassified is equal to a reasonable estimate of the minimum amount expected to be available on any date from the maturing date of the maturing obligation to the end of the fiscal year. If no estimate can be made of the minimum amount available under the financing agreement, none of the maturing debt should be reclassified as long-term.

Finally, although again not stipulated overtly in IAS 1, a reasonable interpretation would he that if an enterprise uses current assets after the balance sheet date to liquidate a current obligation, and replaces those current assets by issuing either equity securities or long-term debt before the issuance of the balance sheet, the current obligation must still be classified as a current liability in the balance sheet. Without such a provision, it could be argued successfully that many current liabilities in fact are noncurrent, since these are paid off and then reinstated on a regular, sometimes monthly, cycle.

A currently contemplated change to be made to [AS 1 would have it stipulate that a refinancing after the balance sheet date could not be taken into account in classifying liabilities as current or noncurrent. This would seemingly mean that current classification would be required even where the debt was routinely "rolled over" after the balance sheet date.

Long-term debt subject to demand for repayment.

What may be thought of as the polar opposite of short-term debt to be refinanced long-term is the situation in which an enterprise is obligated under a long-term (noncurrent) debt arrangement where the lender has either the right to demand immediate or significantly accelerated repayment, or such acceleration rights vest with the lender upon the occurrence of certain events. For example, long-term (and even many short-term) debt agreements typically contain covenants, which effectively are restrictions on the borrower as to undertaking further borrowings, paying dividends, maintaining specified levels of working capital, and so forth. If the covenants are breached by the borrower, the lender will have the right to call the debt or otherwise accelerate repayment.

In other cases, the lender will have certain "subjective acceleration clauses" inserted into the loan agreement, giving it the right to demand repayment if it perceives that its risk position has deteriorated as a result of changes in the borrower's business operations, liquidity, or other vaguely defined factors. Obviously, this gives the lender great power and subjects the borrower to the real possibility that the nominally long-term debt will, in fact, be short-term.

IAS 1 addresses the matter of breach of loan covenants, but does not address the less common phenomenon of subjective acceleration clauses in loan agreements. As to the former, it provides that continued classification of the debt as noncurrent, when one or more of the stipulated default circumstances has occurred, is contingent upon meeting two conditions: First, the lender has agreed, prior to approval of the financial statements, not to demand payment as a consequence of the breach (this is known as a debt compliance waiver); and second, that it is considered not probable that further breaches will occur within twelve months of the balance sheet date. If one or both of these cannot be met, the debt must be reclassified to current status if a classified balance sheet is presented.

Logic suggests that the existence of subjective acceleration clauses convert nominally long-term debt into currently payable debt. US GAAP, in fact, formally recognizes this reality. The authors therefore suggest that in the presence of such provisions, it would be misleading to categorize debt as noncurrent, regardless of the actual maturity date, since continued forbearance by the lender would be required, and this cannot be controlled by the enterprise reporting the debt. Such debt should be shown as current, with sufficient disclosure to inform the reader that the debt could effectively be "rolled over" until the nominal maturity date, at the sole discretion of the lender.

Payee Known but Amount May Have to Be Estimated

Provisions.

Under IAS 37, Provisions, Contingent Liabilities, and Contingent Assets, those liabilities for which amount or timing of expenditure is uncertain are deemed to be provisions. While this term has been widely used informally (sometimes also being applied to contra asset accounts such as accumulated depreciation or allowance for uncollectible accounts receivable), it now has been given this precise definition (which explicitly excludes contra asset accounts).

IAS 37 provides a comprehensive definition of the term "provision." It mandates, in a clear-cut manner, that a provision should be recognized only if

• The enterprise has a present obligation (legal or constructive) as a result of a past event;

• It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and

• A reliable estimate can be made of the amount of the obligation.

In addition, the standard offers in-depth guidance on the topic of provisions. Each of the key words in the definition of the term "provision" is explained in detail by the standard. Explanations and clarifications offered by the standard for above keywords are summarized below.

• Present obligation. The standard opines that in almost all cases it will be clear that a past event has given rise to a present obligation. However, in exceptional cases, for example: in case of a lawsuit when it is not clear whether a present obligation has arisen, an enterprise should determine whether a present obligation exists at the balance sheet date by taking into account all available evidence including, for example, opinion of an expert (legal counsel).

• Past event. Not all past events lead to a present obligation. Only an "obligating event" which, according to the standard, is an event that leaves the enterprise with no realistic option but to settle the obligation, leads to a present obligation. Thus, past events that are obligating events alone need to be provided for (i.e., recognized as provisions). For example, past events, like unlawful environmental damage by an enterprise, would be considered obligating events that would then necessitate the recognition of a provision for costs like cleanup costs or penalties and fines. Similarly, recognition of a provision for (future) decommissioning costs (e.g., of an oil installation or a nuclear power station), to the extent that the enterprise is obliged to rectify damage already caused, is essential. In contrast, however, when it is deemed possible that an enterprise can avoid future expenditure by its future action, no provision is to be recognized for the anticipated future expenditure.

  The concept of a past event will be better understood through the following case study.

  • Vexcel Enterprises Inc. owns and operates a factory that is located in an industrial area that offers many strategic advantages but also has strict rules of compliance (established by the local municipality) that all establishments operating therein must follow. To ensure strict compliance with these rules all factories are inspected semiannually. During the initial visit by the municipal inspector, which coincided with the closing of the accounts for Vexcel's fiscal third quarter, September 30, 2003, the inspector noted certain serious violations and served a notice on the company. This notice gave Vexcel Enterprises two options. It was allowed a six-month window, until March 31, 2004, during which it could comply fully with the regulations and thus avoid any penalties. Alternatively, it could shut down its factory before this six-month period elapsed, in which case, on grounds of hardship, no penalties would be levied, providing the windup proceedings were completed by the end of this grace period.

  • If it decided to comply with this order of the municipality, Vexcel Enterprises would need to undertake extensive repairs to its existing factory building; this would require an outlay of $2 million towards repairs and maintenance over the next six months. Full compliance with the regulations within six months of the order is necessary to avoid the payment of penalties. Furthermore, if noncompliance beyond the six months is construed as a continuing default, punitive damages might also be levied upon the entity.

  • At December 31, 2003, its fiscal year-end, Vexcel Enterprises is debating whether or not to recognize the cost of the future renovation to the factory building as a provision in its balance sheet. Since Vexcel Enterprises can still avoid the future expenditure by its future actions (e.g., by relocating its factory to another industrial area or by disposing of these operations before the end of the six-month period), it should not recognize at year-end a provision for repairs and maintenance. This anticipated (i.e., future) expenditure for repairs and maintenance (amounting to $2 million) cannot be recognized as a provision under IAS 37, since it can be avoided by a future action of the enterprise.

• Probable outflow of resources embodying economic benefits. For a provision to qualify for recognition it is essential that it is not only a present obligation of the reporting enterprise, but also it should be probable that an outflow of resources embodying benefits to settle the obligation will in fact result. For the purposes of this standard, a unique definition of the term "probable" has been propounded: by way of a footnote to IAS 37, Paragraph 23, this definition is made applicable only to this standard. The footnote states that this interpretation of the term "probable," which for the purposes of IAS 37 has been defined to mean "more likely than not," does not necessarily apply to other IAS. Put differently, this means, that the probability of the event occurring should be greater than the probability of its nonoccurrence. In contrast, where it is not probable that a present obligation exists, an enterprise need only disclose (as opposed to recognizing a provision) a contingent liability, unless the possibility is remote.

• Reliable estimate of the obligation. The standard recognizes that except in extremely rare cases, an enterprise will usually be able to make an estimate of the obligation that is sufficiently reliable to use in recognizing a provision. Such an estimate would normally be derived from a range of possible outcomes.

Other salient features of provisions explained by the standard include the following:

1. For all estimated liabilities that are included within the definition of provisions, the amount to be recorded and presented on the balance sheet should be the best estimate as of the balance sheet date of the amount of expenditure that will be required to settle the obligation. This is often referred to as the "expected value" of the obligation, which is operationally defined as the amount the enterprise would pay, currently, to either settle the actual obligation or provide consideration to a third party to assume it. For estimated liabilities comprised of large numbers of relatively small, similar items, weighting by probability of occurrence can be used to compute the aggregate expected value; this is often used to compute accrued warranty reserves, for example. For those estimated liabilities consisting of only a few (or a single) discrete obligations, the most likely outcome may be used to measure the liability when there is a range of outcomes having roughly similar probabilities; but if possible outcomes include amounts much greater (and lesser) than the most likely, it may be necessary to accrue a larger amount if there is a significant chance that the larger obligation will have to be settled, even if that is not the most likely outcome as such.

   The concept of "expected value" can be best explained through a numeric illustration.

   • Good Samaritan Inc. manufactures and sells pinball machines under warranty. Customers are entitled to refunds if they return defective machines with valid proof of purchase. Good Samaritan Inc. estimates that if all machines sold and still in warranty had major defects, total replacement costs would equal $1,000,000; if all those machines suffered from minor defects, the total repair costs would be $500,000. Good Samaritan's past experience, however, suggests that only 10% of the machines sold will have major defects, and that another 30% will have minor defects. Based on this information, the expected value of the product warranty costs to be accrued at year-end would be computed as follows:

     Expected value of the cost of refunds:

     Resulting from major defects:	$1,000,000 x 0.10	=	$100,000
     Resulting from minor defects:	$ 500,000 x 0.30	=	150,000
     No defects:	$ 0 x 0.60	=	--
     	Total	=	$250,000

2. The "risks and uncertainties" surrounding events and circumstances should be taken into account in arriving at the best estimate of a provision. However, as pointed out by the standard, uncertainty should not justify the creation of excessive provisions or a deliberate overstatement of liabilities.

3. The standard also addresses the use of present values or discounting (i.e., recording the estimated liability at present value, after taking into account the time value of money). While the entire subject of present value measurement in accounting has been widely debated, and in practice there is a notable lack of consistency (with some standards requiring it, others prohibiting it, and many others remaining silent on the issue), IAS 37 has stood fast on the subject of present value measurement, despite some opposition voiced in response to the exposure draft and a plea for more guidance. The standard requires the use of discounting when the effect would be material. Thus, provisions estimated to be due farther into the future will have more need to be discounted than those due currently.

   IAS 37 clarifies that the discount rate applied should be consistent with the estimation of cash flows (i.e., if cash flows are projected in nominal terms) that is, in the amount expected to be paid out, reflecting whatever price inflation occurs between the balance sheet date and the date of ultimate settlement of the estimated obligation, then a nominal discount rate should be used. If cash flows are projected in real terms, net of any price inflation, then a real interest rate should be applied. In either case, past experience must be used to ascertain likely timing of future cash flows, since discounting cannot otherwise be performed.

4. Future events that may affect the amount required to settle an obligation should he reflected in the provision amount where there is sufficient objective evidence that such future events will in fact occur. For example, if an enterprise believes that the cost of cleaning up a site at the end of its life will be reduced by future changes in technology, the amount recognized as a provision for cleanup costs should reflect a reasonable estimate of cost reduction resulting from any anticipated technological changes.

5. Gains from expected disposal of assets should not be taken into account in arriving at the amount of the provision (even if the expected disposal is closely linked to the event giving rise to the provision).

6. Reimbursements by other parties should be taken into account when computing the provision, only if it is virtually certain that the reimbursement will be received. The reimbursement should be treated as a separate asset on the balance sheet. However, in the income statement, the provision may be presented net of the amount recognized as a reimbursement.

7. Changes in provision should be reviewed at each balance sheet date and adjusted to reflect the current best estimate. If upon review it appears that it is no longer probable that an outflow of resources embodying economics will be required to settle the obligation, then the provision should be reversed.

8. Use of provision is to be restricted to the purpose for which it was recognized originally. If an expenditure is set against a provision that was originally recognized for another purpose, that would camouflage the impact of the two different events.

9. Provision for future operating losses should not be recognized. This is explicitly prescribed by the standard since future operating losses do not meet the definition of a liability (as defined in the standard) and the general recognition criteria laid down in the standard.

10. Present obligations under onerous contracts should be recognized and measured as a provision. The standard introduces the concept of onerous contracts that it defines as contracts under which unavoidable costs of meeting the obligations exceed the economic benefits expected under the contracts. Executory contracts that are not onerous do not fall within the purview of this standard. In other words, such contracts (executory contracts which are not onerous) need not be recognized as a provision.

    The standard mandates that unavoidable costs under a contract represent the "least net costs of exiting from the contract." Such unavoidable costs should be measured at the lower of

    • The cost of fulfilling the contract; or

    • Any compensation or penalties arising from failure to fulfill the contract.

11. Provision for restructuring costs is recognized only when the general recognition criteria for provisions are met. A constructive obligation to restructure arises only when an enterprise has a detailed formal plan for the restructuring which identifies at least: the business or the part of the business concerned, principal locations affected, approximate number of employees that would need to be compensated for termination resulting from the restructuring (along with their function and location), expenditure that would be required to carry out the restructuring, and information as to when the plan is to be implemented.

    Further, the recognition criteria also requires that the enterprise should have raised a valid expectation in those affected by the restructuring that it will, in fact, carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it. Thus, until both the conditions mentioned above are satisfied, a restructuring provision cannot be made based upon the concept of constructive obligation.

    Only direct expenditure arising from restructuring should be provided for. Such direct expenditure should be both necessarily incurred for the restructuring and should not be associated with the ongoing activities of the enterprises. Thus, a provision for restructuring would not include costs like: cost of retraining or relocating the enterprise's current staff members or costs of marketing or investments in new systems and distribution networks (such expenditures are categorically disallowed by the standard as they are considered to be expenses relating to the future conduct of the business of the enterprise and thus are not liabilities relating to the restructuring program). Also, identifiable future operating losses up to the date of a restructuring are not to be included in the provision for a restructuring (unless they relate to an onerous contract). Furthermore, in keeping with the general measurement principles relating to provisions outlined in the standard, the specific guidance in IAS 37 relating to restructuring prohibits taking into account any gains on expected disposal of assets in measuring a restructuring provision, even if the sale of the assets is envisaged as part of the restructuring.

    A management decision or a board resolution to restructure (an enterprise) taken before the balance sheet date does not automatically give rise to a constructive obligation at the balance sheet date unless the enterprise has, before the balance sheet date: either started to implement the restructuring plan, or announced the main features of the restructuring plan to those affected by it in a sufficiently specific manner such that a valid expectation is raised in them (that the enterprise will in fact carry out the restructuring).

    Examples of events that may fall under the definition of restructuring are

    • A fundamental reorganization of an enterprise that has a material effect on the nature and focus of the enterprise's operations;

    • Drastic changes in the management structure, for example, making all functional units autonomous;

    • Changing the focus of the business to a more strategic location or place by relocating the headquarters from one country or region to another; and

    • The sale or termination of a line of business (if certain other conditions are satisfied, then a restructuring could be considered a discontinuing operation under IAS 35).

12. Disclosures mandated by the standard for provisions are the following:

    • For each class of provision, the carrying amount at the beginning and the end of the period, additional provisions made in the period, amounts used during the period, unused amounts reversed during the period, and increase during the period in the discounted amount arising from the passage of time and the effect of change in discount rate (comparative information is not required).

    • For each class of provision, a brief description of the nature of the obligation and the expected timing of any resulting outflows of economic benefits, an indication of the uncertainties regarding the amount or timing of those outflows (including, where necessary in order to provide adequate information, disclosure of major assumptions made concerning future events), and the amount of any expected reimbursement stating the amount of the asset that has been recognized for that expected reimbursement.

    • In extremely rare circumstances, if the above disclosures as envisaged by the standard are expected to seriously prejudice the position of the enterprise in a dispute with third parties on the subject matter of the provision, then the standard takes a lenient view and allows the enterprise to disclose the general nature of the dispute together with the fact that, and reason why, the information has not been disclosed.

For the purposes of making the above disclosures, it may be essential to group or aggregate provisions. The standard also offers guidance on how to determine which provisions may be aggregated to form a class. As per the standard, in determining which provisions may be aggregated to report as a class, the nature of the items should be sufficiently similar for them to be aggregated together and reported as a class. For example, while it may be appropriate to aggregate into a single class all provisions relating to warranties of different products, it may not be appropriate to group and present, as a single class, amounts relating to normal warranties and amounts that are subject to legal proceedings.

Example footnote illustrating disclosures required under IAS 37 with respect to provisions

Provisions

At December 31, 2003, provisions consist of the following:

	Opening balance	Additions	Provision utilized	Unutilized provision reversed	Closing balance
Provision for environmental costs	1,000,000	900,000	(800,000)	(100,000)	1,000,000
Provision for staff bonus	2,000,000	1,000,000	(900,000)	--	2,100,000
Provision for restructuring costs	1,000,000	500,000	(100,000)	(200,000)	1,200,000
Provision for decommissioning costs	5,000,000	500,000	(2,000,000)	--	3,500,000
	9,000,000	2,900,000	(3,800,000)	(300,000)	7,800,000

Provision for environmental costs. Statutory decontamination costs relating to old chemical manufacturing sites are determined based on periodic assessments undertaken by environmental specialists employed by the company and verified by independent experts.

Provision for staff bonus. Provisions for staff bonus represents contractual amounts due to the company's middle management, based on one month's basic salary, as per current employment contracts.

Provision for restructuring costs. Restructuring provisions arise from a fundamental reorganization of the company's operations and management structure.

Provision for decommissioning costs. Provision is made for estimated decommissioning costs relating to oilfields operated by the company based on engineering estimates and independent experts' reports.

The following section of the chapter provides examples of provisions that would need to be recognized, based on the rules laid down by the standard. It also discusses common provisions and the accounting treatment that is often applied to these particular items.

Dry-docking costs.

In some countries it is required by law, for the purposes of obtaining a certificate of seaworthiness, that ships must periodically (e.g., every three to five years) undergo extensive repairs and maintenance costs that are customarily referred to as "dry-docking costs." Depending on the type of vessel and its remaining useful life, such costs could be significant in amount. Before IAS 37 came into effect, some argued that dry-docking costs should be periodically accrued (in anticipation) and amortized over a period of time such that the amount is spread over the period commencing from the date of accrual to the date of payment. Using this approach, if every three years a vessel has to be dry-docked at a cost of $5 million, then such costs could be recognized as a provision at the beginning of each triennial period and amortized over the following three years.

Under the requirements set forth by IAS 37, provisions for future dry-docking expenditures cannot be accrued, since these future costs are not contractual in nature and can be avoided (e.g., by disposing of the vessel prior to its next overhaul). In general, such costs are to be expensed when incurred. However, consistent with IAS 16 and SIC 23, if a separate component of the asset cost was recognized at inception (e.g., at acquisition of the vessel) and depreciated over its (shorter) useful life, then the cost associated with the subsequent dry-docking can likewise be capitalized as a separate asset component and depreciated over the interval until the next expected dry-docking. While the presumption is that this asset component would be included in the property and equipment accounts, in practice, some enterprises record major inspection or overhaul costs as a deferred charge (a noncurrent prepaid expense account) and amortize them over the expected period of benefit, which has the same impact on total assets and periodic results of operations.

Unlawful environmental damage.

Cleanup costs and penalties resulting from unlawful environmental damage (e.g., an oil spill by a tanker ship which contaminates the water near the sea port) would need to be provided for in those countries which have laws requiring cleanup, since it would lead to an outflow of resources embodying economic benefits in settlement regardless of the future actions of the enterprise.

In case the enterprise which has caused the environmental damage operates in a country that has not yet enacted legislation requiring cleanup, in some cases a provision may still be required based on the principle of constructive obligation (as opposed to a legal obligation). This may be possible if the enterprise has a widely publicized environmental policy in which it undertakes to clean up all contamination that it causes and the enterprise has a clean track record of honoring its published environmental policy. The reason a provision would be needed under the second situation is because the recognition criteria have been met, that is, there is a present obligation resulting from a past obligating event (the oil spill) and the conduct of the enterprise has created a valid expectation on the part of those affected by it that the enterprise will clean up the contamination (a constructive obligation) and the outflow of resources embodying economic benefits is probable.

Provision for restructuring costs.

An enterprise which publicly announces, before the balance sheet date, its plans to shut down a division in accordance with a board decision and a detailed formal plan, would need to recognize a provision for the best estimate of the costs of closing down the division. In this case the recognition criteria are met as follows: a present obligation has resulted from a past obligating event (public announcement of the decision to the public at large) which gives rise to a constructive obligation from that date, since it creates a valid expectation that the division will be shut down and an outflow of resources embodying economic benefits in settlement is probable.

However, in this case, if the enterprise had not publicly announced its plans to shut down the division before the balance sheet date, or did not start implementing its plan before the balance sheet date, no provision would need to be made since the board decision alone would not give rise to a constructive obligation at the balance sheet date (since no valid expectation has in fact been raised in those affected by the restructuring that the enterprise will start to implement that plan).

Onerous contract.

An enterprise relocates its offices to a more prestigious office complex because the old office building that it was occupying (and has been there for the last twenty years), does not suit the new corporate image it wants to project. However, the lease of the old office premises cannot be canceled at the present time since it continues for the next five years. This is a case of an onerous contract wherein the unavoidable costs of meeting the obligations under the contract exceed the economic benefits under it. A provision is thus required to he made for the best estimate of unavoidable lease payments.

Decommissioning costs.

An oil company installed an oil refinery on leased land. The installation was completed before the balance sheet date. On expiration of the lease contract, after a period of seven years, the refinery would be relocated to another strategic location that would ensure uninterrupted supply of crude oil. The decommissioning costs of the oil refinery would need to be recognized at the balance sheet date. A provision should be recognized for the present value of the estimated decommissioning costs to take place after seven years.

Taxes payable include federal or national, state or provincial, and local income taxes. Due to frequent changes in the tax laws, the amount of income taxes payable may have to be estimated. That portion deemed currently payable must be classified as a current liability. The remaining amount is classified as a long-term liability. Although estimated future taxes are broadly includable under the category "provisions," specific rules in IAS 12 prohibit discounting these amounts to present values.

Property taxes payable represent the unpaid portion of an entity's obligation to a state or other taxing authority that arises from ownership of real property. Often these taxes are levied in arrears, based on periodic reassessments of value and on governmental budgetary needs. Accordingly, the most acceptable method of accounting for property taxes is a monthly accrual of property tax expense during the fiscal period of the taxing authority for which the taxes are levied. The fiscal period of the taxing authority is the fiscal period that includes the assessment or lien date.

A liability for property taxes payable arises when the fiscal year of the taxing authority and the fiscal year of the entity do not coincide or when the assessment or lien date and the actual payment date do not fall within the same fiscal year. For example, XYZ Corporation is a calendar-year corporation that owns real estate in a state that operates on a June 30 fiscal year. In this state, property taxes are assessed and become a lien against property on July 1, although they are not payable until April 1 and August 1 of the next calendar year. XYZ Corporation would accrue an expense and a liability on a monthly basis beginning on July 1. At year-end (December 31), the firm would have an expense for six months' property tax on their income statement and a current liability for the same amount.

Bonus payments may require estimation since the amount of the bonus payment may be affected by the amount of income taxes currently payable.

Compensated absences refer to paid vacation, paid holidays, and paid sick leave. IAS 19 addresses this issue and requires that an employer should accrue a liability for employee's compensation of future absences if the employee's right to receive compensation for future absence is attributable to employee services already rendered, the right vests or accumulates, ultimate payment of the compensation is probable, and the amount of the payment can be reasonably estimated.

If an employer is required to compensate an employee for unused vacation, holidays, or sick days, even if employment is terminated, the employee's right to this compensation is said to vest. Accrual of a liability for nonvesting rights depends on whether the unused rights expire at the end of the year in which earned or accumulated and are carried forward to succeeding years. If the rights expire, a liability for future absences should not be accrued at year-end because the benefits to be paid in subsequent years would not be attributable to employee services rendered in prior years. If unused rights accumulate and increase the benefits otherwise available in subsequent years, a liability should be accrued at year-end to the extent that it is probable that employees will be paid in subsequent years for the increased benefits attributable to the accumulated rights, and the amount can reasonably be estimated.

Pay for employee leaves of absence that represent time off for past services should be considered compensation subject to accrual. Pay for employee leaves of absence that will provide future benefits and that are not attributable to past services rendered would not be subject to accrual. Although in theory such accruals should be based on expected future rates of pay, as a practical matter these are often computed on current pay rates that may not materially differ and have the advantage of being known. Also, if the payments are to be made some time in the future, discounting of the accrual amounts would seemingly be appropriate, but again this may not often be done for practical considerations.

Similar arguments can be made to support the accrual of an obligation for post-employment benefits other than pensions if employees' rights accumulate or vest, payment is probable, and the amount can be reasonably estimated. If these benefits do not vest or accumulate, these would be deemed to be contingent liabilities. Contingent liabilities are discussed in IAS 37 and are considered later in this chapter.

Short sale obligations.

When an individual or enterprise sells securities that are not owned, this is referred to as a "short sale," and is usually accomplished by means of securities borrowed from a brokerage firm. In such cases, the borrowed securities are not recorded as an asset by the borrower. The IASC's IAS 39 Implementation Guidance Committee has noted that a short seller accounts for the obligation to deliver securities that it has sold as a "liability held for trading." Therefore, if an enterprise sells an unrecorded financial asset that is subject to a securities borrowing agreement, the enterprise recognizes the proceeds from the sale as an asset, and the obligation to return the asset as a liability held for trading. Liabilities held for trading, just like held for trading securities that are assets of the entity, must be measured at fair value. Changes in fair value will be reflected currently in earnings.

Payee Unknown and the Amount May Have to Be Estimated

The following are further examples of estimated liabilities, which also will fall within the definition of provisions under IAS 37. Accordingly, discounting should be applied to projected future cash flows to determine the amounts to be reported on the balance sheet if the effect of discounting is material, and if timing can be estimated with sufficient accuracy to accomplish this process.

Premiums are usually offered by an enterprise to increase product sales. They may require the purchaser to return a specified number of box tops, wrappers, or other proofs of purchase. They may or may not require the payment of a cash amount. If the premium offer terminates at the end of the current period but has not been accounted for completely if it extends into the next accounting period, a current liability for the estimated number of redemptions expected in the future period will have to be recorded. If the premium offer extends for more than one accounting period, the estimated liability must be divided into a current portion and a long-term portion.

Product warranties providing for repair or replacement of defective products may be sold separately or may be included in the sale price of the product. If the warranty extends into the next accounting period, a current liability for the estimated amount of warranty expense expected in the next period must be recorded. If the warranty spans more than the next period, the estimated liability must be partitioned into a current and long-term portion.

Contingent Liabilities

IAS 37 defines a contingent liability as an obligation that is either

• A possible obligation arising from past events, the outcome of which will be confirmed only on the occurrence or nonoccurrence of one or more uncertain future events which are not wholly within the control of the reporting enterprise; or

• A present obligation arising from past events, which is not recognized either because it is not probable that an outflow of resources will be required to settle an obligation or the amount of the obligation cannot be measured with sufficient reliability.

An enterprise should not recognize a contingent liability. Instead, it should disclose it in the notes to the financial statements (unless the possibility of an outflow of resources embodying economic benefits is remote, in which case even disclosure is not necessary).

Contingent liabilities may develop in a way not initially anticipated. Thus, it is imperative that they are assessed continually to determine whether an outflow of resources embodying economic benefits has become probable. If the outflow of future economic benefits becomes probable, then a provision is required to be recognized in the financial statements of the period in which the change in such a probability occurs (except in extremely rare cases, when no reliable estimate can be made of the amount needed to be recognized as a provision).

Contingent liabilities must be distinguished from estimated liabilities, although both involve an uncertainty that will be resolved by future events. However, an estimate exists because of uncertainty about the amount of an event requiring an acknowledged accounting recognition. The event is known and the effect is known, but the amount itself is uncertain. For example, depreciation is an estimate, but not a contingency, because the actual fact of physical depreciation is acknowledged, although the amount is obtained by an assumed accounting method.

In a contingency, whether there will be an impairment of an asset or the occurrence of a liability is the uncertainty that will be resolved in the future. The amount is also usually uncertain, although that is not an essential characteristic. Collectibility of receivables is a contingency because both the amount of loss and the identification of which customer will not pay in the future is unknown. Similar logic would hold for obligations related to product warranties. Both the amount and the customer are currently unknown.

Assessing the likelihood of contingent events.

It is tempting to express quantitatively the likelihood of the occurrence of contingent events (e.g., an 80% probability), but this exaggerates the precision possible in the estimation process. For this reason, accounting standards have not been written to require quantification of the likelihood of contingent outcomes. Rather, qualitative descriptions, ranging along the continuum from remote to probable, have historically been prescribed.

IAS 37 sets the threshold for accrual at "more likely than not," which most experts have defined as being very slightly over a 50% likelihood. Thus, if there is even a hint that the obligation is more likely to exist than to not exist, it will need to be formally recognized if an amount can be reasonably estimated for it. The impact will be both to make it much less ambiguous when a contingency should be recorded, and to force recognition of far more of these obligations at earlier dates than they are being given recognition at present.

When a loss is probable and no estimate is possible, these facts should be disclosed in the current period. The accrual of the loss should be made in the period in which the amount of the loss can be estimated. This accrual of a loss in future periods is a change in estimate. It is not a prior period adjustment.

Remote contingent losses.

With the exception of certain remote contingencies for which disclosures have traditionally been given, contingent losses that are deemed remote in terms of likelihood of occurrence are not accrued or disclosed in the financial statements. For example, every business risks loss by fire, explosion, government expropriation, or guarantees made in the ordinary course of business. These are all contingencies because of the uncertainty surrounding whether the future event confirming the loss will or will not take place. The risk of asset expropriation exists, but this has become less common an occurrence in recent decades and, in any event, would be limited to less developed or politically unstable nations. Unless there is specific information about the expectation of such occurrences, which would thus raise the item to the possible category in any event, thereby making it subject to disclosure, these are not normally discussed in the financial statements.

Litigation.

The most difficult area of contingencies is litigation. In some developed nations there is a great deal of commercial and other litigation, some of which exposes reporting entities to risks of material losses. Accountants must generally rely on attorneys' assessments concerning the likelihood of such events. Unless the attorney indicates that the risk of loss is remote or slight, or that the impact of any loss that does occur would be immaterial to the company, the accountant will require that the entity add explanatory material to the financial statements regarding the contingency. In cases where judgments have been entered against the entity, or where the attorney gives a range of expected losses or other amounts, certain accruals of loss contingencies for at least the minimum point of the range must be made. Similarly, if the reporting entity has made an offer in settlement of unresolved litigation, that offer would normally be deemed the lower end of the range of possible loss and, thus, subject for accrual. In most cases, however, an estimate of the contingency is unknown and the contingency is reflected only in footnotes.

Example of illustrative footnotes—contingent liabilities

1. A former plant manager of the establishment has filed a claim related to injuries sustained by him during an accident in the factory. The former employee is claiming approximately $3.5 million as damages for permanent disability, alleging that the establishment had violated a safety regulation. At December 31, 2003, no provision has been made for this claim, as management intends to vigorously defend these allegations and believes the payment of any penalty is not probable.

2. Based on allegations made by a competitor, the company is currently the subject of a government investigation relating to antitrust matters. If the company is ultimately accused of violations of the country's antitrust laws, fines could be assessed. Penalties would include sharing of previously earned profits with a competitor on all contracts entered into from inception. The competitor has indicated to the governmental agency investigating the company that the company has made excessive profits ranging from $50 million to $75 million by resorting to restrictive trade practices that are prohibited by the law of the country. No provision for any penalties or other damages has been made at year-end since the company's legal counsel is confident that these allegations will not be sustained in a court of law.

The IASB is presently pursuing several technical projects, one of which, dealing with business combinations, would revise the definition of contingent liability to converge with the US GAAP definition, though this is not expected to have any impact on the recognition or measurement of contingent liabilities. If adopted, this would define a contingent liability as "a present obligation that arises from past events that may require a future cash outflow (or other sacrifice of economic benefits) based on the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the enterprise."

Contingent Assets

Per IAS 37, a contingent asset is a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events that are not wholly within the control of the reporting enterprise.

Contingent assets usually arise from unplanned or unexpected events that give rise to the possibility of an inflow of economic benefits to the enterprise. An example of a contingent asset is a claim against an insurance company that the enterprise is pursuing legally.

Contingent assets should not be recognized; instead, they should be disclosed if the inflow of the economic benefits is probable. As with contingent liabilities, contingent assets need to be continually assessed to ensure that developments are properly reflected in the financial statements. For instance, if it becomes virtually certain that the inflow of economic benefits will arise, the asset and the related income should be recognized in the financial statements of the period in which the change occurs. If, however, the inflow of economic benefits has become probable (instead of virtually certain), then it should be disclosed as a contingent asset.

Example of illustrative footnotes—gain contingency/contingent asset

1. During the current year, the court of first instance found that a multinational company (MNC) had infringed on certain patents and trademarks owned by the company. The court awarded $100 million in damages for these alleged violations by the MNC. In accordance with the court order, the MNC will also be required to pay interest on the award amount and legal costs as well. Should the MNC appeal to an appellate court, the verdict of the court of first instance and the amount of the damages could be reversed or reduced. Therefore, at December 31, 2003, the company has not recognized the award amount in the accompanying financial statements since it is not virtually certain of the verdict of the appellate court.

2. In June 2003, the company settled its longtime copyright infringement and trade secrets lawsuit with a competitor. Under the terms of the settlement, the competitor paid the company $2.5 million, which was received in full and final settlement in October 2003, and the parties have dismissed all remaining litigation. For the year ended December 31, 2003, the Company recognized the amount received in settlement as "other income," which is included in the accompanying financial statements.

The IASB's project dealing with business combinations would revise the definition of contingent asset to converge with the US GAAP definition, though this is not expected to have any impact on the recognition or measurement of contingent assets. If adopted, this would define a contingent asset as "a present right that arises from past events that may result in future cash inflow (or other economic benefits) based on the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the enterprise."

Disclosures Prescribed by IAS 37 for Contingent Liabilities and Contingent Assets

An enterprise should disclose, for each class of contingent liability at the balance sheet date, a brief description of the nature of the contingent liability and, where practicable, an estimate of its financial effect measured in the same manner as provisions, an indication of the uncertainties relating to the amount or timing of any outflow, and the possibility of any reimbursement.

In aggregating contingent liabilities to form a class, it is essential to consider whether the nature of the items is sufficiently similar to each other such that they could be presented as a single class.

In the case of contingent assets where an inflow of economic benefits is probable, an enterprise should disclose a brief description of the nature of the contingent assets at the balance sheet date and, where practicable, an estimate of their financial effect, measured using the same principles as provisions.

Where any of the above information is not disclosed because it is not practical to do so, that fact should be disclosed. In extremely rare circumstances, if the above disclosures as envisaged by the standard are expected to seriously prejudice the position of the enterprise in a dispute with third parties on the subject matter of the contingencies, then the standard takes a lenient view and allows the enterprise to disclose the general nature of the dispute, together with the fact that, and reason why, the information has not been disclosed.

Transitional Provisions

The effect of adopting IAS 37 was to have been reported as an adjustment to the opening balance of retained earnings. It is interesting to note that IAS 37 did not give the option of the allowed alternative treatment that was permitted by IAS 8. To that extent it was a departure from the accounting treatment prescribed under IAS.

Reporting Events Occurring After the Balance Sheet Date

Authorization date.

The determination of the authorization date (i.e., the date when the financial statements could be considered legally authorized for issuance) is critical to the concept of events after the balance sheet date. It serves as the cutoff point after the balance sheet date, up to which the post-balance-sheet events are to be examined in order to ascertain whether such events qualify for the treatment prescribed by the revised standard IAS 10. This standard explains the concept through the use of illustrations.

The general principles that need to be considered in determining the authorization date of the financial statements are set out below.

• When an enterprise is required to submit its financial statements to its shareholders for approval after they have already been issued, the authorization date in this case would mean the date of original issuance and not the date when these are approved by the shareholders; and

• When an enterprise is required to issue its financial statements to a supervisory board made up wholly of nonexecutives, authorization date would mean the date on which management authorizes them for issue to the supervisory board.

Consider the following examples:

1. The preparation of the financial statements of Xanadu Corp. for the accounting period ended December 31, 2003, was completed by the management on January 15, 2004. The draft financial statements were considered at the meeting of the board of directors held on January 18, 2004, on which date the Board approved them and authorized them for issuance. The annual general meeting (AGM) was held on February 10, 2004, after allowing the requisite notice period mandated by the corporate statute. At the AGM the shareholders approved the financial statements. The approved financial statements were filed by the corporation with the Company Law Board (the statutory body of the country that regulates corporations) on February 21, 2004.

   Given these facts, the date of authorization of the financial statements of Xanadu Corp. for the year ended December 31, 2003, is January 18, 2004, the date when the board approved them and authorized them for issue (and not the date they were approved in the AGM by the shareholders). Thus, all post-balance-sheet events between December 31, 2003, and January 18, 2004, need to be considered by Xanadu Corp. for the purposes of evaluating whether or not they are to be accounted or reported under IAS 10.

2. Suppose in the above cited case the management of Xanadu Corp. was required to issue the financial statements to a supervisory board (consisting solely of nonexecutives including representatives of a trade union). The management of Xanadu Corp. had issued the draft financial statements to the supervisory board on January 16, 2004. The supervisory board approved them on January 17, 2004, and the shareholders approved them in the AGM held on February 10, 2004. The approved financial statements were filed with the Company Law Board on February 21, 2004.

   In this case the date of authorization of financial statements would be January 16, 2004, the date the draft financial statements were issued to the supervisory board. Thus, all post-balance-sheet events between December 31, 2003, and January 16, 2004, need to be considered by Xanadu Corp. for the purposes of evaluating whether or not they are to be accounted or reported under IAS 10.

Adjusting and nonadjusting events (after the balance sheet date).

Two kinds of events after the balance sheet date are delineated by the standard. These are, respectively, "adjusting events after the balance sheet date" and "nonadjusting events after the balance sheet date." Adjusting events are those post-balance-sheet events that provide evidence of conditions that actually existed at the balance sheet date, albeit they were not known at the time. Financial statements should be adjusted to reflect adjusting events after the balance sheet date.

Examples of adjusting events, given by the standard, are the following:

1. Resolution after the balance sheet date of a court case that confirms a present obligation requiring either an adjustment to an existing provision or recognition of a provision instead of mere disclosure of a contingent liability;

2. Receipt of information after the balance sheet date indicating that an asset was impaired or that a previous impairment loss needs to be adjusted. For instance, the bankruptcy of a customer subsequent to the balance sheet date usually confirms the existence of loss at the balance sheet date, and the disposal of inventories after the balance sheet date provides evidence (not always conclusive, however) about their net realizable value at the balance sheet date;

3. The determination after the balance sheet date of the cost of assets purchased, or the proceeds from assets disposed of, before the balance sheet date;

4. The determination subsequent to the balance sheet date of the amount of profit sharing or bonus payments, where there was a present legal or constructive obligation at the balance sheet date to make the payments as a result of events before that date; and

5. The discovery of frauds or errors, after the balance sheet date, that show that the financial statements were incorrect at year-end before the adjustment.

Commonly encountered situations of adjusting events are illustrated below.

• During the year 2003 Taj Corp. was sued by a competitor for $10 million for infringement of a trademark. Based on the advice of the company's legal counsel, Taj accrued the sum of $5 million as a provision in its financial statements for the year ended December 31, 2003. Subsequent to the balance sheet date, on February 15, 2004, the Supreme Court decided in favor of the party alleging infringement of the trademark and ordered the defendant to pay the aggrieved party a sum of $7 million. The financial statements were prepared by the company's management on January 31, 2004, and approved by the Board on February 20, 2004. Taj Corp. should adjust the provision by $2 million to reflect the award decreed by the Supreme Court (assumed to be the final appellate authority on the matter in this example) to be paid by Taj Corp. to its competitor. Had the judgment of the Supreme Court been delivered on February 25, 2004, or later, this post-balance-sheet event would have occurred after the cutoff point (i.e., the date the financial statements were authorized for original issuance). If so, adjustment of financial statements would not have been required.

• Penn Corp. carries its inventory at the lower of cost and net realizable value. At December 31, 2003, the cost of inventory, determined under the first-in, first-out (FIFO) method, as reported in its financial statements for the year then ended, was $5 million. Due to severe recession and other negative economic trends in the market, the inventory could not be sold during the entire month of January 2004. On February 10, 2004, Penn Corp. entered into an agreement to sell the entire inventory to a competitor for $4 million. Presuming the financial statements were authorized for issuance on February 15, 2004, the company should recognize this loss of $1 million in the financial statements for the year ended December 31, 2003.

In contrast with the foregoing, nonadjusting events are those post-balance-sheet events that are indicative of conditions that arose after the balance sheet date. Financial statements should not be adjusted to reflect nonadjusting events after the balance sheet date. An example of a nonadjusting event is a decline in the market value of investments between the balance sheet date and the date when the financial statements are authorized for issue. Since the fall in the market value of investments after the balance sheet date is not indicative of their market value at the balance sheet date (instead it reflects circumstances that arose subsequent to the balance sheet date) the fall in market value need not, and should not, be recognized in the financial statements at the balance sheet date.

Not all nonadjusting events are significant enough to require disclosure, however. The revised standard gives examples of nonadjusting events that would impair the ability of the users of financial statements to make proper evaluations or decisions if not disclosed. Where nonadjusting events after the balance sheet date are of such significance, disclosure should be made for each such significant category of nonadjusting event, of the nature of the event and an estimate of its financial effect or a statement that such an estimate cannot be made. Examples given by the standard of such significant nonadjusting post-balance-sheet events are the following:

1. A major business combination or disposing of a major subsidiary;

2. Announcing a plan to discontinue an operation;

3. Major purchases and disposals of assets or expropriation of major assets by government;

4. The destruction of a major production plant by fire;

5. Announcing or commencing the implementation of a major restructuring;

6. Abnormally large changes in asset prices or foreign exchange rates;

7. Significant changes in tax rates and enacted tax laws;

8. Entering into significant commitments or contingent liabilities; and

9. Major litigation arising from events occurring after the balance sheet date.

Dividends proposed or declared after the balance sheet date.

Dividends on equity shares proposed or declared after the balance sheet date should not be recognized as a liability at the balance sheet date. This is a significant change from the requirements under the predecessor version of the standard, IAS 10. The earlier standard on this subject had permitted, as an allowed alternative to mere disclosure, formal balance sheet recognition of a proposed dividend as a liability. Under the revised standard, if dividends are proposed or declared subsequent to the balance sheet date, but before the financial statements are authorized for issue, these may not be recognized as a liability. Only disclosure is permitted in such circumstances. IAS 1 permits an enterprise to make this disclosure either in the notes to the financial statements or on the face of the balance sheet as a separate component of equity; IAS 10 reiterates this disclosure guidance.

Going concern considerations.

Deterioration in an entity's financial position after the balance sheet date could cast substantial doubts about an enterprise's ability to continue as a going concern. IAS 10 requires that an enterprise should not prepare its financial statements on a going concern basis if management determines after the balance sheet date either that it intends to liquidate the enterprise or cease trading, or that it has no realistic alternative but to do so. IAS 10 notes that disclosures prescribed by IAS 1 under such circumstances should also be complied with.

Disclosure requirements.

The following disclosures are mandated by IAS 10:

1. The date when the financial statements were authorized for issue and who gave that authorization. If the enterprise's owners have the power to amend the financial statements after issuance, this fact should be disclosed;

2. If information is received after the balance sheet date about conditions that existed at the balance sheet date, disclosures that relate to those conditions should be updated in the light of the new information; and

3. Where nonadjusting events after the balance sheet date are of such significance that nondisclosure would affect the ability of the users of financial statements to make proper evaluations and decisions, disclosure should be made for each such significant category of nonadjusting event, of the nature of the event and an estimate of its financial effect or a statement that such an estimate cannot be made.

Accounting for Financial Liabilities

IAS 39 has established new requirements for accounting for financial liabilities that are held for trading and those that are derivatives. These will now be accounted for at fair value. Other financial liabilities will continue to be reported at amortized historical cost, pending a possible later endorsement of the notion of employing fair value to account for all financial assets and liabilities.

Initial measurement of financial liabilities.

IAS 39 stipulates that all financial liabilities are to be initially measured at cost, which (assuming they are each incurred in an arm's-length transaction) would equal fair value. Any related transaction costs are included in this initial measurement. In rare instances when the fair value of the consideration received is not reliably determinable, resort is to be made to a computation of the present value of all future cash flows related to the liability. In such a case, the discount rate to apply would be the prevailing rate on similar instruments issued by a party having a similar credit rating.

Remeasurement of financial liabilities.

While the adoption of a pure fair value reporting model for financial instruments was contemplated and may yet come to fruition in the IASB's ultimate project on financial instruments, all major national standard setters and the IASB have concluded that at the present time such would not be a practical solution. IAS 39 provides that, subsequent to initial recognition, an enterprise should measure all financial liabilities, other than liabilities held for trading purposes and derivative contracts that are liabilities, at amortized cost. Where the initial recorded amount is not the contractual maturity value of the liability (e.g., as when transaction costs are added to the issuance price, or when there was a premium or discount upon issuance) periodic amortization should be recorded, using the constant effective yield method.

An exception to the general rule applies when the financial liability is held for trading or is a derivative. An example of the former would be a "short" position in a security, the market value of which will be reported as a liability on the balance sheet. By definition, a short position is held for trading, since it represents a gamble that the price of the underlying security that has been sold will fall in the near term. Derivatives could be any of a wide range of instruments, such as swaps, forwards, futures and options; these will be liabilities if the reporting entity will be obligated to perform (e.g., if it has sold a "naked" option, giving the counterparty the right to purchase a security, at a fixed price, which the reporting entity in fact does not own). All financial liabilities that are held for trading or are derivatives, with two exceptions, are to be reported at fair value.

The first exception to this general rule applies in the case of a derivative liability that is linked to and that must be settled by delivery of an unquoted equity instrument, the fair value of which cannot be reliably measured. Those derivatives are to be measured at cost rather than fair value.

Secondly, financial liabilities that have been designated as hedged items are to be accounted for under the special hedge accounting rules of IAS 39. These are explained in Chapter 5 and illustrated in Chapter 10.

The various issues that may arise in connection with obtaining fair value information are also set forth in Chapter 5 and will not be repeated here.

Gains or losses occurring upon remeasurement of financial liabilities held for trading are included in results of operations in the period in which the fair value change occurs.