Spotlight on provisions and contingencies

The accounting rules have not changed, but the current financial environment and the regulatory focus on management judgement has resulted in heightened attention being placed on the review of provisions and contingent liabilities.

Given the inherent difficulties in estimating potential liabilities, this can be a challenging area for management in many industries, but particularly for the life sciences sector.

Under International Financial Reporting Standards (IFRS) the accounting for provisions and contingent liabilities is addressed by IAS 37 Provisions, contingent liabilities and contingent assets.

Accounting requirements under IFRS

The significance of this accounting area is often underemphasised in annual reports. This may in part be because IAS 37 is perceived as an “old” accounting standard, which is somehow less exciting than areas such as revenue recognition. 

There is also the application of the “recognition criteria” in IAS 37, coupled with measurement difficulties and disclosures, which are largely only found towards the back of the annual report, which also somehow manage to underemphasise the area.

However, given the impact of the judgements, estimates and uncertainties involved, the importance of provisions and contingent liabilities should not be underestimated.

Whilst the general accounting requirements, as summarised below, are generally well understood, it is their application in practice which often brings significant challenges.

Whilst IAS 37 contains specific disclosure requirements, this should not be treated as a checklist; the nature of provisions and contingent liabilities are often entity specific, and facts and circumstances can vary widely. 

Ultimately judgement must be exercised to ensure that sufficient information is disclosed in the financial statements to enable users to understand the nature, timing and amount of a provision or contingent liability.

Provisions in the pharmaceutical sector

In the life sciences sector, the need for provisions can arise for many different reasons. But provisions are most commonly required for:

• product liabilities, anti-trust and patent litigation
• environmental remediation
• other legal proceedings and government investigations
• other provisions restructuring or employee-related

Product liability related claims are a particularly significant issue in the pharmaceutical and healthcare sector. Among other causes, such claims can arise from questions over whether products have been marketed or promoted for use beyond approved indications and whether labels are accurate and defensible. 

Class actions arising from product liabilities remain a real risk for pharmaceutical companies in numerous jurisdictions around the world but particularly in the US. And regulatory action may result in the incurrence of other costs, such as those related to product recalls.

In determining whether a provision is required in respect of product liability claims, there will be many factors to consider. These may include whether there is sufficient history of claims reported and estimates of claims incurred but not yet reported to enable management to make a reliable estimate. 

Companies should have a robust process in place for considering provisions and contingent liabilities of this nature, a process involving the legal function and other parts of the business as necessary.

Contingencies often arise as a result of product liability issues, particularly when matters are at an early stage. For these matters, it is often not practicable for companies to provide information about the potential financial impact of those cases.

However, if the importance of provisions is often overlooked, then the importance of unrecognised contingencies is most certainly too easily overlooked.

With many companies and countries vying to be the first in the marketing of particular products and drugs, there is often the risk of intellectual property (IP) infringement. IP claims typically include challenges to the validity and enforceability of the patents on products or processes as well as assertions regarding potential infringement of patents. By their nature legal action arising from these claims is likely to be significant since a loss in any of these cases could result in loss of patent protection for the product at issue.

Management must exercise significant judgement when assessing the likelihood of a loss being incurred, and in determining whether a reasonable estimate can be made for the loss, or range of loss, for each matter and whether a provision needs to be recorded or a contingent liability disclosed. 

It should also be remembered that the ultimate liability for such matters may vary from the amounts provided in the financial statements. Only when the litigation processes commence may the extent of the claim become apparent, and the outcome will be dependent upon the litigation proceedings, investigations and possible settlement negotiations. This often makes for a protracted process and therefore understanding the likely timing becomes more important.

IAS 37 – Thematic review

The Financial Reporting Council published its thematic review on IAS 37 in October 2021. Expectations and observations from the FRC following this review included:

• Companies rarely explained which method (“expected value” or “most likely outcome”) was used to determine their best estimate.
• The FRC expected companies to provide more information about the anticipated timing of outflows, particularly for longer-term provisions. Discounting should be clearly explained, as the effect of changes in timing or rate can be very significant in this type of provision.
• Companies gave more limited quantitative information about contingent liabilities than expected by the FRC.
• The FRC expected companies to explain material sensitivity to cash flow forecasting.
• Companies with more complex provisions gave more detail to aid the user’s understanding.
• Where management had been unable to estimate the amount of probable or possible economic outflow, better disclosures explained why and provided “order of magnitude” information.

The FRC also provided their views on the characteristics of good disclosure and expectations regarding disclosure. These characteristics included:

• A succinct background that can be read on a standalone basis.
• An update on the position from prior periods (where relevant) and how this affected the provisions recognised or contingent liabilities disclosed.
• Where applicable, explanation of the extent to which external specialists were used in determining the expected outflow and whether specific models or guidance had been applied in the provision’s calculation.
• A range of possible outcomes or sensitivity information for changes in key assumptions.
• “Indications of uncertainty” in timing and/or amount that help users understand the potential financial effect (which may arise beyond the next financial year) of additional or reduced costs and/or earlier or later timing of outflows.
• Management commentary on significant year-end balances and unrecognised exposures, and on significant movements recognised during the period (whether additions, new provisions, utilisations or reversals).

Summary

Accounting for provisions and contingent liabilities is particularly challenging in the life sciences sector. Given the challenges and level of judgement involved, it is an area that will continue to attract attention.

Whilst the underlying accounting and disclosure requirements for provisions and contingent liabilities have not changed in some years, there is nevertheless evolving best practice. Companies will need to invest time in their corporate reporting to maintain and build trust in important areas such as provisions and contingencies.