Inside the IFRS Framework: Differentiating Impairment Losses from Provisions
Ricardo Julio Rodil | November 2, 2015 |
Ever since the adoption of International Financial Reporting Standards (IFRS), preparers of financial statements here in Brazil, and dare I speculate in other countries that have adopted IFRS, have been misused the word provision. Many continue to use the word in the same way they did before IFRS: that is, used in the context of doubtful debts, obsolete and slow-moving inventories and losses on investments for example. Whenever I venture to discuss this issue, I am usually accused of being too zealous or a perfectionist, in my strenuous efforts to apply IFRS. In this article, I will aim to stress the conceptual difference between impairment losses and provisions—and hopefully convince you that there is a significant difference that is worth acknowledging. And, thus there is method in my apparent madness.
The Concept of Impairment Losses before and after IFRS
The onset of IFRS challenged us, as accountants, to embrace the concept of impairment as something that applies to all assets—all perhaps with the exception of cash. Impairment is now a concept intimately and definitively attached to almost every asset measured at cost or depreciated/amortized cost. Before IFRS, this concept was limited almost exclusively to trade accounts receivable and obsolete or slow-moving inventories. The terms allowance for doubtful accounts and provision for obsolete inventories have been in our vocabularies for decades—at least those of us trained in the days before IFRS was born.
Still talking about the past—before IFRS—preparers of financial statements usually understood and applied those concepts by looking in the rearview mirror only. Take accounts receivable, for example: if a debtor had several amounts outstanding, the concept of doubtful was only applied to those amounts overdue. The fact that the same customer, likely facing financial difficulties, might very well be doubtful in connection with amounts owed at a date in the future was completely ignored. Similarly, inventory was the object of same rationale.
Impairment Assets versus Provisions
The concept of impairment of assets, clearly introduced in IFRS and, specifically in IAS 36, refers to the amount by which the carrying amount of an asset (or a cash-generating unit or group of assets) exceeds its recoverable amount. This concept reflects business reality. An asset or group of assets will only be retained when capable of generating enough cash to pay for itself and, preferably, produce some profit. If the asset were unable to pay for itself, then its carrying amount would have to be reduced to reflect the loss of capability to produce cash and profit. As a consequence, the business owner has to reflect this “business value” in the financial statements of its entity. The result is the recognition of a loss. Period. There is no provision and, as such, no liability to be stated in the balance sheet. Rather the asset(s) should be shown at a lower amount—the lower of the two, cost or market value. End of story.
IAS 37 defines provisions as “liabilities of uncertain timing or amount.” It goes on to clarify that, in certain jurisdictions, the term provision is used in the context of items such as depreciation, impairment of assets, and doubtful debts. It also clarifies that these items represent “adjustments to the carrying value of assets.” That is, these items are not provisions in the IFRS lexicon and so should not be labelled as such when applying IFRS. Once we accept that a provision is in fact a liability, it’s worth seeing how IAS 37 defines liabilities and its components:
IAS 37, paragraph 11 to be precise, defines three kinds of liabilities:
- Accounts payable, which are those liabilities derived from the purchase of goods or services, which have been received by the entity and invoiced by the supplier. In connection with these accounts, there is a transparent condition of amount and maturity.
- Accruals, which are liabilities arisen from the purchase of goods or services that have been received or supplied but have not been paid, invoiced, or formally agreed with the supplier, what includes amounts due to employees (for example, amounts relating to accrued vacation pay and its related salary taxes).
- Provisions have been defined above. The main difference between provisions and accruals is the degree of uncertainty regarding the calculation of the liability and/or the actual maturity.
A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
An obligating event is an event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation.
A legal obligation is an obligation that derives from:
(a) a contract (through its explicit or implicit terms);
(b) legislation; or
(c) other operation of law.
A constructive obligation is an obligation that derives from an entity’s actions where:
(a) by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and
(b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.
In Brazil, and I suspect other South American countries that have adopted IFRS, the distinction between accruals and provisions is small, and most of this kind of liability would be classified as provisions.
Losses, in relation to assets that have to be recognized at a value below their carrying amount, must be accounted for as losses, not as provisions. The fact that, for control purposes, the credit may be recorded in a separate account does not change the nature of the entry. The debit has to be applied to income, and the asset shown at its net recoverable amount. This does not make it a provision as no liability is present—no creditor would be eligible to receive any amount of resources embodying economic benefit that flows from the entity. In writing this article, I have sought to clarify the difference between impairment losses and provisions. This distinction, and the appropriate treatment of these items, is crucial to the accuracy of financial reporting under IFRS.