Time to recognise constructive obligation

ACCOUNTANCY

The purpose of accounting is to present the economic and financial reality of an enterprise. While there is no formal definition of "true and fair view" in the accounting literature, the term is generally taken to encompass a number of criteria.

Financial statements are said to provide a true and fair view if they are neutral and free from bias and material errors. In order to provide a true and fair view, the management and the board of directors must make an assessment of the "economic reality" and report that information. This brings subjectivity and provides a scope for earnings management.

Recently promulgated accounting rules rely much more than before on the management's perspective for the accounting of assets and liabilities, thereby increasing the possibility of earnings management. The accounting rules for the recognition of constructive obligations and provisions give an interesting example.

A liability is an obligation present at the balance sheet date. The true test of liability is that the enterprise has no practical way to avoid settling the obligation. The legal position is important, but it is not the overriding consideration in deciding whether an obligation is present at the balance sheet date.

An enterprise recognises an obligation only when it is probable (more likely) that it will result in outflow of economic benefits (e.g. cash and cash equivalents) and the enterprise is able to estimate the amount with reasonable accuracy.

Usually an obligation arises as a consequence of a binding contract or from a statutory requirement. An obligation may also arise from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner.

Such obligations are termed "constructive obligations." Constructive obligations arise when an enterprise has given others to believe that it has undertaken an obligation and will settle the same. A constructive obligation gets translated into a contractual obligation.

For example, a constructive obligation arises from a restructuring scheme when the scheme is communicated to those who will be affected by it and when the implementation time is so close that the enterprise has no option but to implement.

The constructive obligation gets translated into a contractual obligation when the enterprise enters into binding contracts in the process of implementation of the scheme.

Similarly, a constructive obligation arises when the chairman of the board of directors announces the board's decision to take up certain social responsibilities voluntarily and the announcement gets huge publicity in the media and it is communicated to the appropriate authority.

At this stage, the company cannot withdraw the commitment without hurting its reputation. Therefore, practically, it cannot avoid the obligation. The constructive obligation gets translated into contractual obligations when the enterprise enters into binding contracts in the process of implementing the board's decision.

In many situations, a liability is recognised much before the firm enters into a binding contract. Let us take the example of a voluntary retirement scheme. Usually, a VRS implementation goes through six stages: "on principal" approval by the board of directors; formulation of the draft scheme; approval of the draft scheme by the board of directors; discussion of the draft with the employees' union and finalisation of the scheme; communication of the scheme to target employees; receipt of applications (offers) from employees; and acceptance of the applications resulting in a binding contract.

At which stage should a provision for VRS be recognised in the balance sheet? If we recognise the concept of constructive obligations, a provision should be recognised when the scheme is communicated to the employees. If we do not recognise the concept of constructive obligation, a liability should be recognised only when the enterprise has entered into binding contracts with employees.

Often it is argued that it is difficult to reliably estimate the cash flow resulting from the VRS until the applications from employees are received and accepted by the management. This is not tenable, because the CEO's proposal before the board of directors already presents an estimate of the number of employees who will offer early retirement.

Timeliness in dissemination of information adds value to the information and reduces the information gap between the users of financial statements and the management. Therefore, it is desirable to recognise the concept of constructive obligation.

On the negative side, the practice of recognising constructive obligations provides significant opportunity for earnings management by overstating liabilities. The determination of the point in time when the constructive obligation should be recognised and estimation of the amount of the liability involves judgement.

In fact the scope for earnings management is much higher in case of recognition of provisions. A provision is a liability of uncertain timing and amount. For example, the liability resulting from product warranty is surrounded by uncertainties. It is difficult to ascertain, at the balance sheet date, the parties who will report defects in the products sold and the amount of economic benefits that will flow out of the enterprise.

Similarly, the estimation of Asset Retirement Obligation (e.g. obligation to dismantle and remove the asset and restore the site) is surrounded by uncertainties.

Usually, the life of tangible fixed assets (e.g. an oil rig) is quite long, and ARO is settled much after the provision is made. Therefore, the estimation should take into account the expected state of technological and other environment at the time of settlement of the ARO.

Moreover, the outflow of economic benefits to settle the obligation resulting from product warranty or ARO depends on the strategy of the enterprise. The cost to settle the obligation using internal resources might be different from the cost that will be incurred if the company appoints an external agency to settle those obligations. Similarly, the cost will be different if an enterprise takes an insurance cover against the product warranty.

An enterprise discloses an obligation as contingent liability if it estimates that it is less likely that an outflow of economic benefits will result from the obligation. An obligation, which is more likely to result in outflow of economic benefits is also presented as contingent liability if the enterprise cannot estimate the amount with adequate reliability.

The difference between provision and contingent liability is thin. Whether the company should provide for an obligation or whether it will just be disclosed in footnotes depends on the management's judgement regarding the probability of the obligation resulting in an outflow of economic benefits.

Although the Indian GAAP does not recognise the concept of constructive obligation, IFRS and US GAAP do. Indian GAAP for accounting for provisions and contingent liabilities are substantially same as those stipulated in IFRS and US GAAP, except that the Indian GAAP does not allow discounting while the IFRS and US GAAP require measurement of the provision at present value if the effect of the time value of money is material. US GAAP requires ARO to be recognised at fair value.

We too should recognise the concept of constructive obligation. It is not appropriate to reject a well established accounting concept only because it provides scope for earnings management. Earnings management is a worldwide problem and the only way to tackle it is to strengthen the institutional mechanisms.

(The writer is a professor of finance control at IIM-C)