Making History: A Look at a Move to IAS 37 from the Longstanding FAS 5 and its Effect on Buy-Sell Transactions

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Introduction
With the impending adoption of International Financial Reporting Standards (IFRS) for U.S.-based companies will come a change to one of the longest standing and pervasive accounting principles in U.S. history. Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies" (SFAS No. 5), has been the guidance governing the recording of contingent losses and liabilities for publicly filing U.S. entities since it was first issued in March 1975. Providing U.S. companies with the option to file under IFRS would mean companies may have to take a different approach when reviewing their contingencies and commitments. An uncertain liability that would not be recorded under U.S. Generally Accepted Accounting Principles (GAAP) may need to be recorded under International Accounting Standard 37, "Provisions, Contingent Liabilities and Contingent Assets" (IAS 37). Similarly, an uncertain liability that would not be disclosed under U.S. GAAP requires disclosure under IFRS. This change will affect many areas of financial reporting, from counsel's disclosures in legal letters provided to auditors, to the calculation of reserves such as the allowance for doubtful accounts, inventory reserves and environmental reserves. In particular, companies entering into buy-sell transactions should carefully consider how this change may affect the accounts that are frequently at issue in post-closing purchase price disputes and whether the purchase price adjustment mechanism prescribed in the agreement should be modified as a result.

Distinct criteria for recognition and disclosure
U.S. GAAP defines a contingency as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss that will ultimately be resolved when one or more future events occur or fail to occur ¹. In order to be reflected in financial statements prepared under U.S. GAAP, SFAS No. 5 requires a potential liability or loss to be both

1. Probable of occurrence
2. Reasonably estimable

IFRS also recognizes that certain liabilities have uncertainties relating to timing, likelihood, and amount. Under IFRS, provisions and contingent liabilities are defined separately. IAS 37 defines a contingent liability as

1. A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity
2. A present obligation that arises from past events but is not recognized because it is not probable or the amount of the obligation cannot be reliably measured ²

IAS 37 defines a provision as a liability of uncertain timing or amount and stipulates that, in order to recognize such a provision:

1. An entity must have a present obligation as a result of a past event
2. It must be more likely than not that an outflow of resource will be required
3. It must be possible to reliably estimate the amount of the obligation ³ 

On the surface, these two accounting principles may appear to be comparable. However, U.S. GAAP and IFRS differ regarding what potential liabilities should be recorded or disclosed in financial statements.
In evaluating those two criteria, the first requirement SFAS No. 5 prescribes is to consider the likelihood of the event that may result in a loss. The spectrum for likelihood of occurrence is comprised of three classifications:

• Remote
• Reasonably possible
• Probable

If management does not consider the likelihood of the loss to be remote (meaning the chance of the future event or events occurring is slight) or probable (meaning the chance of the future event or events occurring is likely), then the likelihood would by default be categorized as reasonably possible. ⁴

IFRS prescribes that a liability be recorded when the contingency is probable and a reliable estimate can be made. However, in contrast to U.S. GAAP, the threshold for accrual of uncertain liabilities or losses prescribed under IFRS is considerably lower. The International Accounting Standards Board (IASB) requires that such losses or liabilities be accrued when their occurrence is more likely than not, which implies a standard of just over 50 percent. Although no benchmark percentage is specified in U.S. GAAP and "probable" is therefore rarely quantified, it is generally considered to be an amount considerably higher than 50 percent ⁵. Studies have cited probable as requiring a likelihood that ranges from 70 to 90 percent ⁶. In addition, certain Financial Accounting Standards Board (FASB) statements acknowledge that "probable" requires a high degree of expectation ⁷.

If it is determined that a contingency is probable under the threshold set by SFAS No. 5, then the second requirement is to consider whether the contingency is reasonably estimable. SFAS No. 5 provides little specific guidance as to what should be considered reasonably estimable.

Comparatively, the IASB appears to be of the view that a probable likelihood and the ability to reasonably estimate go hand-in-hand. IAS 37 states that except in extremely rare cases, an entity will be able to determine a range of possible outcomes and can therefore make an estimate of the obligation that is sufficiently reliable to use in recognizing a provision ⁸. IAS 37 further dictates that in circumstances in which no range of possible outcomes can be determined, a contingent liability exists and should be disclosed.

U.S. GAAP provides for disclosure of contingent liabilities that are reasonably possible, but do not meet the threshold of probable. If a loss is deemed reasonably possible, an entity is required to disclose the nature of the contingency and provide a range of the possible amounts of loss, if the range can be estimated ⁹. SFAS No. 5 currently requires disclosure of loss contingencies that are probable but not reasonably estimable, but additional disclosure requirements may be forthcoming. In June 2008, the Financial Accounting Standards Board (FASB) issued an exposure draft, Proposed Statement, Disclosure of Certain Loss Contingencies—an amendment of FASB Statements No. 5 and 141(R) (issued 6/5/08), contemplating the adequacy of the current disclosure requirements with regard to the likelihood, timing and future cash flows associated with loss contingencies.

The FASB accepted comments on the exposure draft until August 8, 2008, and the FASB is currently in deliberation on the issue.

Defining the threshold
In issuing SFAS No. 5, the FASB intended to heighten the threshold for recording contingent losses and liabilities in financial statements. One of the FASB's objectives was to prevent preparers of financial statements from recording excess or "cookie jar" reserves during profitable years and releasing them in unprofitable years in order to smooth earnings from year to year. IAS 37 provides a benchmark that can be applied more consistently across all industries. However, regardless of the benefits or disadvantages, the application of IAS 37 may result in more liabilities being recorded in financial statements than does the application of SFAS No. 5.

Applying IAS 37 in purchase price adjustment mechanisms
In buy-sell transactions, a base purchase price is often agreed to based on the purchaser's analysis of the target company's financial position as of a certain date. Buy-sell agreements generally contain a provision to adjust the base purchase price to reflect the change in net assets between a balance sheet as of a benchmark date (the benchmark) and a balance sheet as of the closing date (the closing balance sheet). The closing balance sheet is routinely the subject of dispute between the seller and the purchaser.

In post-closing purchase price adjustment disputes, accounts that depend heavily on management estimates are usually the most susceptible to dispute. Accounts such as allowance for doubtful accounts, reserve for excess and obsolete inventory, environmental reserves and legal reserves are generally prepared with a high degree of judgment and subjectivity and therefore are often targets for a buyer looking to decrease the purchase price (or a seller looking to increase it, for that matter). For companies entering into buy-sell agreements, a change from SFAS No. 5 to IAS 37 – lowering the threshold for recording liabilities – may require

1. More liabilities to be recorded
2. Additional grounds to object to liabilities recorded in the financial statements

Managing the shift in standards – language matters
How can companies protect themselves from the unpredictability that can result from changes to accounting standards? Carefully preparing the language used in the purchase price adjustment mechanism is one key strategy.

Make reserves less subjective in agreements
The parties to the agreement should pay particular attention to the language dictating the determination of reserves. One option is to prepare the closing and benchmark balance sheets using a methodology other than the consistent application of U.S. GAAP. For example, the agreement may contain a provision that allows for only certain changes or no changes to the reserves included in the benchmark balance sheet. Generally, the purchase price adjustment mechanism is intended to allow for a change in the purchase price for any change in the value of the business that results from the operation of the business between the date of the benchmark balance sheet and the closing date of the transaction. Specifically, such mechanisms are designed to compensate the seller for cash flowing into the business and compensate the buyer for cash flowing out of the business due to the normal operations in the above-mentioned period, but they make no provision for changes to the purchase price due only to changes in estimates or subjective judgment of the preparer of the statement. If the parties freeze the reserve included in the benchmark balance sheet, or if they limit the changes to the reserve included in the benchmark balance sheet to only those changes that may result from the operation of the business, then the reserves will be less vulnerable to changes based solely on subjective judgments or factors.

Another option may be for the parties to agree beforehand on the reserve account balances to be included in the closing statement, possibly with the help of a third party. A neutral third party that is mutually agreed upon by the parties to the transaction could altogether eliminate the reason for a dispute.

Articulate what should be recorded as a liability
If preparing financial statements under U.S. GAAP, the term “probable” should be specific and well-defined. If preparing financial statements under IFRS, the term "more likely than not" should be articulated. In the event of a dispute, this will help avoid a situation in which the arbitrator is left to create the threshold for recording contingent liabilities. Parties to an agreement need not rely on the definition or criteria in GAAP or IFRS. Rather, they can set forth more specific definitions or criteria in a transaction agreement.

Generally in a dispute, absent specific provisions to the contrary, the most control the parties can exert over how a highly subjective matter is decided is in the selection of an arbitrator. Because the threshold implied by the term "probable" is so highly subjective, it may be best not to leave it to interpretation.

In fact, companies would be wise to try to remove the element of chance from as many facets of buy-sell transactions as possible. Understanding the potential issues that may arise when applying IFRS to financials that will be used in a buy-sell transaction and taking steps to address them can go a long way toward helping both purchasers and sellers achieve their expected outcomes.

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_{1 SFAS No. 5, paragraph 1.
2 IAS 37, paragraph 18.
3 IAS 37, paragraph 14.
4 SFAS No. 5, paragraph 3.
5 IAS 37, paragraph 16.
6 “The IASC-US Comparison Project: A Report on the Similarities and Differences between IASC Standards and US GAAP, 2nd edition.” Published by the FASB, 1999.
7 SFAS No. 143, paragraph 5.
8 IAS 37, paragraph 25.
9 SFAS No. 5, paragraph 10.} 

_{As used in this document, ‘Deloitte’ means Deloitte LLP (and its subsidiaries). Please see  www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.} 

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