Present obligation and obligating event

Learning objectives

• Determine whether a present obligation exists at the end of the reporting period by applying the 'more likely than not' threshold to all available evidence, including the opinion of experts and events after the reporting period.L2, L3
• Analyse whether an obligation exists independently of the entity's future actions (cleaning up past damage as opposed to future upgrading to comply with standards).L2, L3
• Assess whether a decision or statement by the entity has created a constructive obligation (sufficiently specific communication, valid expectation on the part of third parties).L3, L4
• Explain when new legislation creates an obligation (virtually certain to be enacted as drafted) and when damage becomes an obligating event.L2, L3
• Justify why no provision is recognised for costs that need to be incurred to operate in the future.L2, L3, L4

Normative references

• IAS 37 §15In rare cases where it is not clear whether there is a present obligation, a past event is deemed to give rise to a present obligation if, taking account of all available evidence, it is more likely than not that a present obligation exists at the end of the reporting period.
• IAS 37 §16In almost all cases it will be clear whether a present obligation exists; where there is doubt (a lawsuit, for example), the entity assesses it on the basis of all available evidence, including the opinion of experts and any additional evidence provided by events after the reporting period. If a present obligation is more likely than not, a provision is recognised (criteria met); if it is more likely that none exists, a contingent liability is disclosed, unless the possibility of an outflow of resources is remote.
• IAS 37 §17A past event that leads to a present obligation is an obligating event: the entity has no realistic alternative to settling the obligation, either because settlement can be enforced by law or, in the case of a constructive obligation, because the event creates valid expectations in other parties that it will discharge the obligation.
• IAS 37 §18Financial statements deal with the financial position of an entity at the end of its reporting period and not its possible position in the future: no provision is recognised for costs that need to be incurred to operate in the future. Only liabilities that exist at the end of the reporting period are recognised.
• IAS 37 §19Only obligations arising from past events that exist independently of the entity's future actions (i.e. the future conduct of its business) are provided for: penalties or clean-up costs for unlawful environmental damage, decommissioning costs of an oil installation or a nuclear power station to the extent that the entity is obliged to rectify damage already caused. By contrast, expenditure that the entity intends or needs to incur to operate in a particular way in the future (fitting smoke filters, for example) can be avoided by its future actions: no provision.
• IAS 37An obligation always involves another party, whose identity may be unknown (the public at large). A management or board decision does not give rise to a constructive obligation at the end of the reporting period unless it has been communicated before that date to those affected in a sufficiently specific manner to raise a valid expectation in them that the entity will discharge its responsibilities.
• IAS 37An event that does not give rise to an obligation immediately may do so at a later date, because of changes in the law or because an act by the entity (a sufficiently specific public statement) gives rise to a constructive obligation. Thus, environmental damage becomes an obligating event when a new law requires it to be rectified or when the entity publicly accepts responsibility for rectification.
• IAS 37Where details of a proposed new law have yet to be finalised, an obligation arises only when the legislation is virtually certain to be enacted as drafted; such an obligation is then treated as a legal obligation.

Original summaries of the paragraphs (reference register), never a quotation of the standard.

20 questions

• When it is not clear whether there is a present obligation, a past event is deemed to give rise to a present obligation if, taking account of all available evidence, it is more likely than not that one exists at the reporting date.L2
• To assess whether a lawsuit creates a present obligation at the reporting date, which evidence does the entity take into account?L2
• A supplier is claiming penalties from Fontrel for breach of a supply contract. At the reporting date, Fontrel disputes the claim; its lawyers nevertheless consider it more likely than not that the court will find a wrongful breach, and the penalties can be reliably estimated. Payment would then be probable. What does Fontrel conclude?L3
• Local residents are suing Gavrelle, which they accuse of causing cracks in their houses during works. The appointed experts conclude that it is more likely than not that the cracks come from natural ground movement; a risk of an adverse ruling remains, without being remote. What does Gavrelle conclude at the reporting date?L3
• Fines incurred for illegal pollution already caused may give rise to a provision, because the obligation exists independently of the entity's future actions.L2
• A new regulation requires Brisaco to fit its paint shop with a soundproofing system by 20X7 if it wants to keep operating it. At the 20X5 reporting date, nothing has been installed. Should Brisaco recognise a provision for the cost of the installation?L2
• Celtane is reviewing five expenditures at its reporting date. Which correspond to a present obligation that may give rise to a provision?L2
• Durmanel may recognise a provision this year for the costs it will have to incur next year to keep operating its plant.L2
• On 18 December 20X5, Ferlac's board decides to provide free replacement of a series of water heaters, beyond the warranty. The customers concerned are informed only by a letter dated 12 January 20X6. Is there a constructive obligation at 31 December 20X5?L3
• Galvane's accountant recognised a provision of 210,000 for a buy-back programme for defective products, supported only by the minutes of the executive committee of 28 December approving the programme. No announcement has been made to customers or distributors. What is the error?L3
• An obligation exists under IAS 37 only if the entity knows the precise identity of the party to which it is bound.L3
• Between 20X1 and 20X4, Haldric stored waste on its land, which the law then allowed. In November 20X5, a law is enacted requiring operators to clean up land contaminated in this way. When does Haldric's clean-up obligation arise?L3
• Isarne operates a quarry in a country where no law requires sites to be restored. In September 20X5, its chairman publicly announces, with figures and a timetable, that Isarne will restore the areas already worked; the local press and elected officials report it. What is the position at 31 December 20X5?L3
• A bill under discussion would require manufacturers to collect their old appliances; its detailed content has not yet been finalised. From when does a legal obligation arise for Junivel?L2
• Korrane recognised a provision of 380,000 for a recycling levy provided for in a bill still being debated in Parliament; several amendments changing the tax base are under discussion and the vote is uncertain. What is the error?L3
• For a past event to be an obligating event, which condition must it meet?L2
• Laudric, which operates car washes, has for six years published on its website an "environmental charter" undertaking to treat the polluted sludge of its former stations, which it has always done. At 31 December 20X5, three stations closed during the year contain sludge; in addition, management is considering installing new retention tanks in 20X6 in the stations still open, with no legal obligation. Write a memo analysing the obligations to be provided for, distinguishing the rules of the standard, the case data and judgement.L4
• Mirelan, which runs a leisure park, is being sued by visitors injured when a footbridge collapsed in August 20X5. At 31 December, its lawyers are divided; an expert report delivered on 25 January 20X6, before the financial statements are authorised, establishes that the collapse resulted from a maintenance failure attributable to Mirelan. Write a memo concluding on whether a present obligation exists at 31 December and on its treatment, stating the evidence used and the element of judgement.L4
• Nordak operates cold-storage warehouses. A regulation requires the refrigeration units using a now-banned fluid to be replaced by the end of 20X7, failing which the warehouses can no longer be operated; the replacement is estimated at 900,000. Nordak could also sell or close the warehouses before that date. At 31 December 20X5, what should be concluded?L4
• On 20 January 20X6, before the financial statements are authorised, a court orders Obervane to compensate a former partner for a breach committed in 20X5. The accountant keeps at 31 December 20X5 the mere contingent liability identified in November, on the grounds that "the judgment is after the reporting date". Where is the error?L3