IAS 37 Redeliberations: Can recognition of a liability influence the outcome of legal
Staff contact: Sarah Broad, +44 20 7246 6465, [email protected]
The recognition principle underlying the ED requires an entity to recognise a
liability when the definition of a liability has been satisfied, unless the liability
cannot be measured reliably. The liability is measured using an expected cash
flow approach, reflecting the amount that the entity would rationally pay to
transfer or settle the liability on the balance sheet date. If a range of possible
outcomes exist, the entity is also required to disclose information indicating the
uncertainties associated with the future cash outflows that will be required to
This paper addresses concerns that applying these principles to a liability, when
the facts and circumstances associated with the liability are the subject of a
lawsuit, may adversely influence the outcome of legal proceedings. For the
purposes of this paper such liabilities are described as “legal claims”.
This paper is divided into four sections:
b. Recent Board discussions [paragraph 5
c. Comment letter analysis [paragraphs 6 – 10
i. Proposed changes to the IAS 37 recognition and disclosure
requirements affecting legal claims [paragraphs 11 – 15
ii. Effect of the proposed changes on discovery and visibility of
financial information relating to legal proceedings [paragraphs 16
iii. Potential options to prevent discovery of work papers [paragraphs
SUMMARY OF RECOMMENDATIONS
The staff does not recommend including an exemption for circumstances when
recognition of a liability would prejudice the entity (prejudicial recognition
exemption) in any final Standard or extending the exemption for disclosure on the
grounds of prejudice to the entity (prejudicial disclosure exemption) to include
paragraph 67 of the ED’s disclosure requirements.
RECENT BOARD DISCUSSIONS
The ED proposes that the start of legal proceedings creates a liability because an
entity is obliged to stand ready to act as the court directs. In June 2006 the
Board reconsidered its position and concluded that the start of legal proceedings,
in itself, does not obligate an entity. Rather, the start of legal proceedings is
another piece of evidence that may be relevant when an entity evaluates whether a
liability exists. The staff notes that respondents’ comment letters were received
prior to June’s Board meeting. Therefore some of the concerns articulated in
those letters and analysed in the next section of this paper should be read in this
1 ED, paragraph 26 and illustrative example 1. 2 Refer to agenda paper 3B presented at the June 2006 Board meeting for further detail.
COMMENT LETTER ANALYSIS
Some respondents are concerned that the conclusion currently in Example 1 of the
ED would require an entity to recognise and disclose information about all legal
claims at the start of legal proceedings. Often this would be earlier than currently
required by IAS 37, especially when the facts and circumstances associated with a
legal claim are uncertain or in dispute.
In many jurisdictions an entity’s financial records relating to a legal claim are
‘discoverable’ as part of the legal process. Therefore some respondents are
concerned that the ED’s proposal could adversely influence an entity’s chance of
successfully defending a claim. This is because recognition of a liability may
reduce the likelihood of pre-trial dismissal or be viewed by a court or a jury as an
Similarly, other respondents are concerned that publishing information about a
legal claim in an entity’s financial statements may reduce an entity’s chance of
negotiating a favourable settlement. This is because the other party to the claim
or a jury may use an entity’s financial records to establish a minimum amount for
damages. Altria Groupnotes ‘… even with valid defences, the amount recorded
on the balance sheet would become the starting amount for damages to be
Respondents located in jurisdictions in which subsidiary financial statements are
placed on the public record are also concerned about the visibility of sensitive
information as a result of recognising or disclosing information about legal
claims. This is due to the lower materiality thresholds typically applied to
subsidiary financial statements compared to consolidated financial statements.
This may mean that information about a legal claim which is not visible at group
level (due to aggregation of information and higher materiality) might be clearly
identifiable in the individual subsidiary financial statements. The General
Counsel 100 Group (a UK representative group) comments ‘… the “valuation”
of claims that are individually immaterial to a large group, may have to be
publicly disclosed in subsidiary accounts, whereas an equivalent business based in
another jurisdictions (eg the US) may not be required to make any disclosure at
all, or be able to aggregate such claims so that individual details can’t be
identified. This could result in a competitive disadvantage for businesses
operating in the UK, compared with those operating overseas.’
One respondent recommends addressing these issues by extending the prejudicial
disclosure exemption in paragraph 71 of the ED to also cover the disclosure
requirements of paragraph 67 (see appendix A). The respondent argues that this
extension would protect an entity from disclosing sensitive information that
might adversely influence the outcome of legal proceedings. But other
respondents disagree and note that the seriously prejudicial exemption will not
offer ‘sufficient protection in the majority of cases’.
Proposed changes to the IAS 37 recognition and disclosure requirements affecting
In many respects the concerns about the public provision of potentially sensitive
information resulting from legal claims are not new. Existing preparers of IFRS
financial statements already provide potentially sensitive information about legal
claims, whether that information is limited to disclosure or not. SEC registrants
preparing financial statements in accordance with US GAAP are also required to
disclose specific details about material legal proceedings.
Similarly, questions about when and how to report information about legal claims
are not new. The Framework
provides guidance on measurement uncertainty, but
4 Comment letter 15 5 American Bar Association, comment letter 59 6 For example, the General Counsel 100 Group, comment letter 11 7 SEC regulation S-K, item 103 requires disclosure of more information than IAS 37.
does not refer to element uncertainty. The current IAS 37 provides limited
guidance on how to address element uncertainty but this guidance was not carried
forward to the ED. The Board has already acknowledged that any final Standard
will need to include some guidance on how to address element uncertainty,
although the extent and form of that guidance remains work in progress.
So what has changed? The staff agrees that the ED’s proposals would have
resulted in earlier recognition of some liabilities. However, the Board’s
conclusion that the start of legal obligations does not, in itself, obligate an entity is
likely to partially alleviate respondents’ concerns about earlier recognition of
liabilities for legal claims. But the Board has tentatively affirmed its proposal to
omit the probability recognition criterion from any final Standard. This is an
Currently, an entity may conclude that it has a present obligation because its past
actions have violated a law or breached a contract. But if it is not probable that an
outflow of resources will be required to settle the obligation, no liability is
recognised. Instead, information about the present obligation is disclosed in the
notes to the financial statements. Anecdotal evidence suggests that some entities
currently delay recognising a liability for a legal claim until it is reasonably
certain that an outflow of resources will be required to settle the claim - ie the
ultimate outcome of legal proceedings is used to identify and recognise a liability,
not the existence of a present obligation. In contrast, following redeliberations,
any final Standard would require recognition of a liability when an entity is
reasonably certain that its past actions have violated a law or breached a contract
8 Refer to agenda paper 10C presented at the May 2006 Board meeting. 9 Refer to agenda paper 3A presented at the June 2006 Board meeting. 10 This anecdotal evidence is supported by the findings included in section E1 of the SEC Report & Recommendations Pursuant to Section 401(c) of the Sarbannes-Oxley Act of 2002 on Arrangements with Off Balance Sheet Implications, Special Purpose Entities and Transparency of Filings by Issues
and by a PwC article in the April edition of CFO Direct Coming Distractions: Eight Looming Risks
. The staff acknowledges that these findings are based on a review of entities preparing financial statements in accordance with US GAAP rather than IFRS and therefore these findings are not a representative sample of IFRS constituents.
– ie when a present obligation exists. Probability of a future outflow no longer
plays a role in determining whether a liability is recognised.
There has also been a small change to the disclosure requirements. Paragraph 92
of IAS 37 includes a prejudicial disclosure exemption. This allows entities to
replace detailed disclosure about legal proceedings with a general description of
the dispute and an explanation of why detailed information has not been
disclosed. The prejudicial disclosure exemption has been carried forward to
paragraph 71 in the ED (for reference the ED’s disclosure requirements are
provided in appendix A to this paper). But, whereas the prejudicial disclosure
exemption in IAS 37 covers all
disclosure requirements, the ED’s prejudicial
disclosure exemption excludes paragraph 67. Therefore, the ED requires
disclosure of the carrying amount of the liability at the period end together with a
description of the nature of the obligation for each class of recognised liablity.
Effect of the proposed changes on discovery and visibility of financial information
relating to legal proceedings
What financial information is ‘discoverable’?
The objective of discovery is to ensure that all parties go to trial with as much
knowledge as possible and that neither party should be able to keep secrets from
the other. Discovery can take many forms. Legal dictionaries define electronic
discovery as “review and production of evidentiary material for litigation stored
in electronic format. This may include e-mail, word processing, spreadsheets,
databases and presentations”. The staff understands that an entity’s published
financial statements and its supporting work papers (electronic or otherwise) used
to prepare the information contained therein are both discoverable as part of the
legal process in many jurisdictions. Both sources of discoverable information will
11 Source: www.dictionary.law.com 12 Source: www.legal-definitions.com
Discovery & visibility of information in an entity’s financial statements
The staff thinks that the effect of the changes proposed in the ED on the amount
of information about legal proceedings included in an entity’s financial statements
First, the staff thinks that respondents’ concerns about information included in an
entity’s financial statements can be limited to recognition and disclosure of single
legal claims. The staff agrees that this situation is most likely to arise in small
entities or subsidiary entities preparing individual financial statements, but may
affect larger entities too. This is because small and subsidiary entities are more
likely to have one material legal claim which is clearly identifiable in the balance
sheet and in the notes to the financial statements.
In contrast, larger companies and consolidated groups are more likely to have a
number of similar legal claims which may be aggregated into one class for
financial reporting purposes. Thus, information about a single claim is not visible
in either the balance sheet or the ‘provisions’ note accompanying the financial
statements. For example, an entity recognising total ‘provisions’ of $1,000,000 in
its balance sheet might disclose in the notes to the financial statements that
$700,000 of the total provision recognised relates to product liability legal claims,
$50,000 relates to other legal claims and $250,000 relates to the entity’s asset
Secondly, the staff questions whether the exclusion of paragraph 67 from the
ED’s prejudicial disclosure exemption will significantly increase the amount of
information available about single legal claims in an entity’s financial statements.
Paragraph 67 of the ED requires disclosure of the carrying amount of the liability
at the period end together with a description of the nature of the obligation for
of recognised liabilities. Consider the example of an entity which
recognises total ‘provisions’ of $100,000 in its balance sheet relating to a single
legal claim. The staff thinks that the requirements of paragraph 67 may be met by
simply stating that the total balance relates to legal proceedings. Paragraph 67
does not require an entity to disclose the fact that the total figure relates to one
single claim. Nor does paragraph 67 require disclosure of the nature of each
Appendix B includes an extract from the GlaxoSmithKline 31 December 2005
Annual Report. This extract illustrates how an entity can recognise and disclose
information about legal claims without providing users with specific information
about each single claim. This example is taken from the consolidated financial
statements of a large entity but could also be applied by a smaller or subsidiary
Lastly, the staff questions the ability of the plaintiff to use the information
provided in an entity’s financial statements to influence ongoing legal
proceedings, even if a single legal claim is the only material liability. An ability
to use the financial statements to influence the outcome of legal proceedings
assumes that the plaintiff knows that it is the only party which has made a claim
against the entity. Careful wording in the notes to the financial statements could
ensure that this fact would not be readily ascertainable from the financial
statements as a standalone document. Rather the plaintiff will only be able to
identify this fact by gaining access to an entity’s internal work papers supporting
the information included in the financial statements.
Discovery & visibility of information in an entity’s supporting work papers
The staff thinks that respondents’ concerns about discovery of an entity’s
supporting work papers can be limited to recognised single legal claims.
As noted above, the ED’s proposal to omit the probability recognition criterion
means that previously unrecognised legal claims will now be recognised,
necessitating the preparation of additional supporting work papers (ie for the
purposes of measurement). The ED does not change the status quo for legal
claims which are already recognised in accordance with IAS 37. Recognition
may occur before out of court settlement negotiations or court proceedings have
been concluded. Logically, one would expect that work papers relating to
recognised claims are already discoverable (although in this instance,
respondents’ comments may highlight an existing issue about the discovery of
work papers for liabilities currently recognised under IAS 37 and therefore should
not be dismissed without consideration).
The staff does not think that respondents’ concerns about discovery apply to a
expected cash flow calculation for a portfolio of legal claims. This is because it is
likely that a portfolio of similar obligations will be assessed, measured and
reported on a total basis. As a result, an entity’s assessment and measurement of
each individual claim is not readily apparent in the supporting work papers. (As
an aside, the staff notes that portfolios of legal claims are rare because most
material legal disputes are unique and class actions are not permitted in several
Based on the analysis above the staff thinks that respondents’ concerns about the
discovery and visibility of financial information relating to legal proceedings can
be narrowed down to recognised, single legal claims. These claims may be
visible in an entity’s financial statements. But the staff thinks that careful
wording combined with the prejudicial disclosure exemption means that the
information included in the financial statements alone will not be sufficient to
influence the outcome of legal proceedings. Therefore, it is discovery of work
papers supporting a single legal claim recognised in the financial statements that
13 IAS 37 already requires an entity to recognise a liability for a single legal claim when a present obligation exists and an outflow of economic benefits is probable.
Potential options to prevent discovery of work papers
The staff thinks that a prejudicial recognition
exemption would be the only way to
prevent discovery of financial information relating to a single legal claim. This is
because a prejudicial recognition exemption would mean that an entity need not
prepare an expected cash flow calculation, hence there would be no work paper to
This, in our view, is not a viable option. A recognition exemption would decrease
the amount of useful information made available compared to the current IAS 37
and favours preparers over users of financial statements. Moreover, the staff is
not aware that discovery of information relating to liabilities recognised in
accordance with the current IAS 37 has adversely influenced the outcome in a
sufficient number of lawsuits to warrant an exemption to the recognition
Secondly, the staff also notes that respondents’ concerns may be partly alleviated
by the Board’s conclusion in June 2006 that the start of legal proceedings, in
itself, does not obligate the entity. This is because this conclusion is likely to
reduce the number of additional legal liabilities which would be recognised earlier
Thirdly, the staff observes that discovery is a legal process. Extending discovery
to include information which is not publicly available (such as an entity’s internal
work papers) and the use of that information in legal proceedings is a legal issue,
not a financial reporting issue. The IASB’s role is to establish the extent and
nature of information to be included in publicly available financial statements.
The IASB does not have the ability to influence legal proceedings.
14 That is to say, the limited number of respondents who comment on this issue indicates this is not a pervasive issue and the staff is not aware of any requests for a recognition exemption presented to IFRIC or other interpretive bodies. 15 Although note the staff recommendation in agenda paper 4A which would require an entity to disclose information about possible obligations.
Consequently, staff does not recommend including a prejudicial recognition
APPENDIX A: The ED’s disclosure requirements
For each class of recognised non-financial liability, an entity shall disclose the
carrying amount of the liability at the period-end together with a description
of the nature of the obligation.
For any class of recognised non-financial liability with estimation uncertainty,
an entity shall also disclose:
(a) a reconciliation of the carrying amounts at the beginning and end of the
(i) liabilities incurred;
(ii) liabilities derecognised;
changes in the discounted amount resulting from the passage
of time and the effect of any change in the discount rate; and
other adjustments to the amount of the liability (eg revisions in
estimated cash flows that will be required to settle it).
(b) the expected timing of any resulting outflows of economic benefits.
(c) an indication of the uncertainties about the amount or timing of those
outflows. If necessary to provide adequate information, an entity shall
disclose the major assumptions made about future events, as described
in paragraph 41.
(d) the amount of any right to reimbursement, stating the amount of any
asset that has been recognised for that right.
If a non-financial liability is not recognised because it cannot be measured
reliably, an entity shall disclose that fact together with:
(a) a description of the nature of the obligation;
(b) an explanation of why it cannot be measured reliably;
(c) an indication of the uncertainties relating to the amount or timing of any
outflow of economic benefits; and
(d) the existence of any right to reimbursement.
In determining which non-financial liabilities may be aggregated to form a class, an entity considers whether the nature of the items is sufficiently similar for a single statement about them to fulfil the requirements of paragraphs 67-69. Thus, it may be appropriate to treat as a single class of non-financial liabilities amounts relating to warranties of different products, but it would not be appropriate to treat as a single class amounts relating to normal warranties and amounts subject to legal proceedings.
In extremely rare cases, disclosure of some or all of the information required
by paragraphs 68 and 69 can be expected to prejudice seriously the position of
the entity in a dispute with other parties on the subject matter of the non-
financial liability. In such cases, an entity need not disclose the information,
but shall disclose the general nature of the dispute, together with the fact that,
and reason why, the information has not been disclosed.
APPENDIX B: Extracts from the GlaxoSmithKline 31 December 2005 Annual
(the first page only of note 41 has been reproduced in this appendix)
27 Other provisions
The Group has recognised costs in previous years in respect of plans for manufacturing and other restructuring initiated in 1998, 1999 and in 2001 following the merger of Glaxo Wellcome and SmithKline Beecham and the acquisition of Block Drug. These plans are largely completed. Costs recognised as a provision, principally in respect of identiﬁed severances at sites where it has been announced that manufacturing activities will cease and site closure and cleaning costs are expected to be incurred mainly within the next three years. Costs of asset write-downs have been recognised as impairments of property, plant and equipment.
The Group has recognised costs in previous years in respect of plans for the integration of the Glaxo Wellcome and SmithKline Beecham businesses. Implementation of the integration following the merger is substantially complete. Costs recognised as a provision in respect of identiﬁed severances are expected to be incurred in 2006 and in respect of the programme to encourage staff to convert Glaxo Wellcome or SmithKline Beecham share options into GlaxoSmithKline share options when employees exercise these options up to 2010. The discount on this latter provision increased by £4 million in 2005 (2004 – £4 million), and was calculated using risk-free rates of return.
GlaxoSmithKline is involved in a number of legal and other disputes, including notiﬁcation of possible claims. Provisions for legal and other disputes include amounts relating to US anti-trust, product liability, contract terminations, self-insurance, environmental clean-up and property rental. The company’s Directors, having taken legal advice, have established provisions after taking into account insurance and other agreements and having regard to the relevant facts and circumstances of each matter and in accordance with accounting requirements. These provisions were discounted by £71 million in 2005 (2004 – £11 million) using risk-free rates of return. The effect of the change in the discount rate in 2005 is to increase the discount at 31st December by £20 million. A number of products have a history of claims made and settlements which makes it possible to use an IBNR (incurred but not reported) actuarial technique to determine a reasonable estimate of the Group’s exposure for unasserted claims in relation to those products. Apart from the IBNR provision, no provisions have been made for unasserted claims. The ultimate liability for
such matters may vary from the amounts provided and is dependent upon the outcome of litigation proceedings, investigations and possible settlement negotiations.
It is in the nature of the Group’s business that a number of these matters, including those provided using the IBNR actuarial technique, may be the subject of negotiation and litigation over several years. The largest individual amounts provided are expected to be settled within three years.
At 31st December 2005, it is expected that £115 million (2004 – £236 million) of the provision made for legal and other disputes will be reimbursed. This amount is included within non-current assets.
For a discussion of legal issues, refer to Note 41 ‘Legal proceedings’.
41 Legal proceedings [extract only reproduced in this appendix]
The Group is involved in significant legal and administrative proceedings, principally product liability, intellectual property, tax, antitrust and governmental investigations and related private litigation. The Group makes provision for these proceedings on a regular basis as summarised in Notes 2 and 27. The Group may make additional significant provisions for such legal proceedings as required in the event of further developments in these matters, consistent with generally accepted accounting principles. Litigation, particularly in the USA, is inherently unpredictable and excessive awards that may not be justified by the evidence may occur. The Group could in the future incur judgments or enter into settlements of claims that could result in payments that exceed its current provisions by an amount that would have a material adverse effect on the Group’s financial condition, results of operations and/or cash flows.
Intellectual property claims include challenges to the validity of the Group’s patents on various products or processes and assertions of non-infringement of those patents. A loss in any of these cases could result in loss of patent protection for the product at issue. The consequences of any such loss could be a significant decrease in sales of that product and could materially affect future results of operations for the Group.
Legal expenses incurred and provisions related to legal claims are charged to selling, general and administration costs. Provisions are made, after taking appropriate legal advice, when a reasonable estimate can be made of the likely outcome of the dispute. In 2004 the Group established an actuarially determined provision for product liability claims incurred but not yet reported as described in Note 27. At 31st December 2005 the Group’s aggregate provision for legal and other disputes (not including tax matters described under ‘Taxation’ in Note 12 ) was over £1.1 billion. The ultimate liability for legal claims may vary from the amounts provided and is dependent upon the outcome of litigation proceedings, investigations and possible settlement negotiations.
The most significant of those matters are described below.
Intellectual property Advair
In September 2004, the Group applied to the US Patent and Trademark Office (USPTO) for re-issue of its combination patent for Advair
, an inhaled combination of salmeterol and fluticasone propionate, which expires in September 2010. This followed an internal review which concluded that the language in the patent may not accurately describe all of the circumstances of the invention and may not claim the invention as precisely as it could. The objective of seeking re-issuance is to strengthen the protection afforded by the patent. In January 2006, the USPTO issued a final office action rejecting that application. The Group will seek reconsideration of the rejection, and a response to the USPTO is expected in the first half of the year. While the application for re-issue remains pending, the patent remains in force and is listed in the register of pharmaceutical patents maintained by the US Food and Drug Administration (FDA) (the Orange Book). The Group holds other US patents relating to Advair
which are not affected by the re-issue application, including the compound patent related to the active ingredient salmeterol which
affords protection through August 2008 (after giving effect to an expected grant of paediatric exclusivity by the FDA) and various patents relating to the Diskus
device which expire over a period from 2011 to 2016.
Avandia and Avandamet
In August 2003, the Group filed an action in the US District Court for the District of New Jersey against Teva Pharmaceuticals USA Inc. for infringement of the Group’s patent relating to the maleate salt form of rosiglitazone, the active ingredient in Avandia
, which expires in 2015. In September 2003, the Group filed a comparable action in the same court against Dr Reddy’s Laboratories, alleging infringement of the same patent. Those actions were filed in response to Abbreviated New Drug Application (ANDA) filings with the FDA by Dr Reddy’s Laboratories and Teva with certifications that the Group’s maleate salt patent is invalid. FDA approval of those ANDAs is stayed until the earlier of November 2006 or resolution of the respective patent infringement actions.
Teva subsequently filed an additional certification challenging the validity of the Group’s basic compound patent for rosiglitazone, and in January 2004 the Group commenced an action against Teva in the same court for infringement of that patent. The basic compound patent currently expires in 2012 after giving effect to patent term restoration and paediatric exclusivity.
In January 2005, the Group filed an action in the US District Court for the District of New Jersey against Teva for infringement of the same two patents – the basic compound and maleate salt patents for rosiglitazone. Teva had filed an ANDA with the FDA for a generic version of Avandamet
with a certification that those patents are invalid or not infringed. FDA approval of that ANDA is stayed until the earlier of June 2007 or resolution of the patent infringement action. Since Avandamet
is protected by the same patents as Avandia
, any earlier holding of invalidity in the Avandia
cases would be dispositive for Avandamet
In December 2003, the Group commenced an action in the US District Court for the Southern District of New York against Dr Reddy’s Laboratories, alleging infringement of one of the two primary compound patents for sumatriptan, the active ingredient in Imitrex
. The patent at issue affords protection through February 2009 after giving effect to a grant of paediatric exclusivity by the FDA. The defendant had filed an ANDA with the FDA for sumatriptan oral tablets with a certification of invalidity of that compound patent but did not certify invalidity or non-infringement of the other compound patent that expires in June 2007 after giving effect to paediatric exclusivity.
In March 2004, the Group commenced an infringement action against Cobalt Pharmaceuticals which was transferred to the US District Court for the Southern District of New York. The defendant had filed an ANDA for sumatripan oral tablets with a certification of invalidity or non-infringement of the same compound patent at issue in the Dr Reddy’s case. Final pre-trial conference in the consolidated Dr Reddy’s and Cobalt case is scheduled for May 2006.
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