Obligation – FAQ | IFRS

Obligation

Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. This is normally the case, for example, with amounts payable for goods and services received. However, obligations do not have to be legally binding.

If, for example, an entity decides as a matter of policy to rectify faults in its products even when these become apparent after the warranty period has expired, the costs that are expected to be incurred in respect of goods already sold are liabilities. What are obligations?

Obligations do not include future commitments. What are obligations?

Some liabilities can be measured only by using a substantial degree of estimation. Some entities describe these liabilities as provisions. In some countries, such provisions are not regarded as liabilities because the concept of a liability is defined narrowly so as to include only amounts that can be established without making estimates.

Thus, when a provision involves a present obligation and satisfies the rest of the definition, it is a liability even if the amount has been estimated. Examples include provisions for payments to be made under existing warranties and provisions to cover pension obligations.

Another way of looking at the meaning of obligation as part of IFRS financial reporting in financial statements are the following types of obligations and contingent liabilities that are defined in IAS 37 Provisions, Contingent Liabilities and Contingent Assets:

IFRS reporting line

Definition

Obligating event

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.

Legal obligations

A legal obligation is an obligation that derives from:

  1. a contract (through its explicit or implicit terms);
  2. legislation; or
  3. other operation of law.

Constructive obligations

A constructive obligation is an obligation that derives from an entity’s actions where:

  1. 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
  2. as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

Contingent liability

A contingent liability is:

  1. a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or
  2. a present obligation that arises from past events but is not recognised because:
    1. it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
    2. the amount of the obligation cannot be measured with sufficient reliability.

The Conceptual Framework explains ‘obligation’ along some essential features captured in the following subjects:

1. Duty or responsibility What are obligations?

An obligation is a duty or responsibility that an entity has no practical ability to avoid. An obligation is always owed to another party (or parties). The other party (or parties) could be a person or another entity, a group of people or other entities, or society at large. It is not necessary to know the identity of the party (or parties) to whom the obligation is owed.

An obligating event has occurred that results in an entity having no realistic alternative to settling that obligation. It has become legally enforceable as a consequence of a binding contract (with the transfer of an economic resource from the counterparty to the reporting party) or statutory requirement. This is normally the case, for example, with amounts payable for goods and services received. The counterparty has not been narrowly defined avoiding the risk of not recording certain liabilities (applying the prudence principle).

2. Obligation to transfer an economic resource resulting in a right to receive that economic resource

If one party has an obligation to transfer an economic resource, it follows that another party (or parties) has a right to receive that economic resource. However, a requirement for one party to recognise a liability and measure it at a specified amount does not imply that the other party (or parties) must recognise an asset or measure it at the same amount. For example, particular Standards may contain different recognition criteria or measurement requirements for the liability of one party and the corresponding asset of the other party (or parties) if those different criteria or requirements are a consequence of decisions intended to select the most relevant information that faithfully represents what it purports to represent.

An obligation for one reporting entity is a right for another reporting entity. However, whether the counterparty to a constructive or conditional obligation by the reporting entity has any asset that it controls if the obligation is not legally enforceable, or is conditional on the reporting entity’s own actions.

3. Constructive obligation What are obligations?

Many obligations are established by contract, legislation or similar means and are legally enforceable by the party (or parties) to whom they are owed. Obligations can also arise, however, from an entity’s customary practices, published policies or specific statements if the entity has no practical ability to act in a manner inconsistent with those practices, policies or statements. The obligation that arises in such situations is sometimes referred to as a ‘constructive obligation’.

A constructive obligation is an obligation that derives from an entity’s actions where:

  1. 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
  2. as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

4. Conditional obligations What are obligations?

In some situations, an entity’s duty or responsibility to transfer an economic resource is conditional on a particular future action that the entity itself may take. Such actions could include operating a particular business or operating in a particular market on a specified future date, or exercising particular options within a contract. In such situations, the entity has an obligation if it has no practical ability to avoid taking that action.

The argument is that such a concept gives the most faithful representation (or best report the substance) of the obligations that an entity cannot avoid.

In some cases, a chain of events creates an obligation. For example, an obligation may arise if a minimum threshold is reached in a period (such as a minimum amount of revenue, a minimum number of employees or a minimum amount of assets) and if the reporting entity is still operating on a specified later date. Based on the available evidence it has to be judged which of the events in the chain must have occurred (the condition) for an entity to have a present obligation ‘as a result of past events’.

5. Going concern is no ability to avoid a transfer What are obligations?

A conclusion that it is appropriate to prepare an entity’s financial statements on a going concern basis also implies a conclusion that the entity has no practical ability to avoid a transfer that could be avoided only by liquidating the entity or by ceasing to trade.

Making the transfer is the most beneficial to the entity and therefore the most logical thing to do.

6. Assess ability to avoid a transfer What are obligations?

The factors used to assess whether an entity has the practical ability to avoid transferring an economic resource may depend on the nature of the entity’s duty or responsibility. For example, in some cases, an entity may have no practical ability to avoid a transfer if any action that it could take to avoid the transfer would have economic consequences significantly more adverse than the transfer itself. However, neither an intention to make a transfer, nor a high likelihood of a transfer, is sufficient reason for concluding that the entity has no practical ability to avoid a transfer.

The intention or a high likelihood of not making a transfer is not sufficient to not take into account the liability and the future expected transfer. Only if the nature of the entity or its environment make it plausible that avoiding a transfer maybe successful (i.e de facto not enforceable or enforced) the liability and the future expected transfer might be considered.

7. Uncertainty as to does an obligation exist? What are obligations?

In some cases, it is uncertain whether an obligation exists. For example, if another party is seeking compensation for an entity’s alleged act of wrongdoing, it might be uncertain whether the act occurred, whether the entity committed it or how the law applies. Until that existence uncertainty is resolved—for example, by a court ruling—it is uncertain whether the entity has an obligation to the party seeking compensation and, consequently, whether a liability exists.

In some cases, that uncertainty, possibly combined with a low probability of outflows of economic benefits and an exceptionally wide range of possible outcomes, may mean that the recognition of a liability, necessarily measured at a single amount, would not provide relevant information. Whether or not the liability is recognised, explanatory information about the uncertainties associated with it may need to be provided in the financial statements.

What are obligations?

Leave a comment