IAS 37 rule on legal costs set to cause confusion

They’re the sort of liabilities companies loath and accountants dread. They’re not taught at school and, to the uninitiated, can prompt a baffled look and a scratch of the head.

IAS 37, an accounting rule which governs how listed companies write-up a range of difficult-to-define liabilities, has been earmarked for replacement for at least five years.

Within the walls of the International Accounting Standard Board’s (IASB) a proposed replacement is being fine-tuned, but it’s not without its detractors.

The ultimate aim is to increase transparency, but in the process, there are fears it could prejudice major court cases and force lawyers to play actuary.

Most contentiously the proposals would set down rules on how big business accounts for major court cases in their financial statements.

The IASB has been fiddling with a possible replacement for years, aimed at increasing the quantitive data in financial statements on the potential costs involved in losing or settling court cases.

The new rule would particularly affect the litigation-prone pharmaceutical and tobacco industries – with billions on the line at any given time – but is wide enough in scope to impact all big business in some way, eventually.

Debate has centered on how businesses represent court cases in their liability column. According to current rules, companies must ask themselves two questions before putting pen to paper: firstly, have I done anything wrong, and, secondly, is it more likely than not that I will have to pay anything?

The IASB propose to remove the first question, and provide more clarity around the second.

Managers, under the rules, would have to weigh up all possible court outcomes – victory, settlement, dismissal or outright loss, among others.
A value would be assigned to each outcome and the final liability would become a weighted average of the potential outcomes.

Lawyers fear it would not accurately reflect the reality of court cases, where litigants are often faced with two realistic outcomes – win or loss.
“You know it is never going to be a definite number, it is either going to be very large or nothing,” said Ken Wild, senior technical partner at Deloitte.

Deloitte is yet to arrive at a formal position on a revised rule, and Wild said there was still debate on the proposals.

“If you just have two outcomes – £100bn or zero – it is pretty finger-in-the-air-type exercise to work out what the probability is.”

There’s also concern the accounting treatment may prejudice the legal proceedings, potentially revealing how much companies are willing to pay to walk away from a court case. Kathryn Cearns, consultant accountant with lawyers Herbert Smith, believes, in some circumstances, the rule may inadvertently force companies to reveal what could be prejudicial information.

“The best thing for companies to do, with these levels of uncertainty, is to give out as much information as they can without prejudicing their position… We are going to have to look at the wording quite closely,” she said.

Within the IASB, proponents of the new approach say the liability will be an aggregate figure, and will not show potential liability of individual cases.
Cearns said this does not occur in all cases. “If I had total liabilities of £10m last year, and I have to provide for a £100m claim against me this year, it’s not going to be difficult to find out,” she said.

The number the IASB is ultimately trying to arrive at is how much less an investor would rationally pay for a business because of a court case or other similar uncertain liability.

Wild, prefers an approach which offers management more room to explain their views on the matter. The proposed IASB approach, he argues, has a danger of encouraging “spurious accuracy”. “You ask twenty leading barristers and counsels a question and you will get twenty different answers. No number is rich in meaning – a number is only a number... You lose the arguments behind it when y ou publish.”

Further reading:

IASB's guide to liabilities and amendments to IAS 37