Redefining liabilities

By Tim Beauchamp
Illustration: Jason Schnieder

PSAB redefines public sector liabilities and issues new guidance for recognizing liabilities

Legislation plays a vital role in all government operations and can include laws for approving various programs through establishing spending limits and providing governments with the authority to spend. It can play a role in determining if a government, which includes the legislature and council, has a liability.

A provincial government’s legislation, for example, can create liabilities for a local government related to such things as environmental protection. A government can pass legislation that places liabilities on itself, for example, the introduction of a transfer program where the recipients of the transfer have already met eligibility requirements such as age, income or other requirements. In other circumstances, a government may have legislation in place but it is merely a framework or authorization for making future decisions rather than a reaction to a specific event, such as general rules governing the funding of natural disasters.

From 1981 until the release of the new definition of liability, a government’s legislation was the focus of the Public Sector Accounting Board’s (PSAB) definition of liability. That definition noted that liabilities are financial obligations arising from past transactions or events as the result of contracts, agreements and legislation in force at the accounting date.

That meant until legislation was in force, a government could not recognize a liability. This definition was relatively easy to understand and provided a very “bright line” for recognizing a liability. However, because liability recognition depended on a two-part test, i.e., a past transaction or event and legislation being in force, governments had the ability to choose when legislation would pass affecting the timing of recognition.

Alternatively, some governments were recognizing liabilities provided the related legislation was passed in the stub period (i.e., the period between the date of the financial statements and the date the statements were completed). This reflected that a liability could exist at the accounting date without legislation being in force and that the future passing of legislation just confirmed the liability. Nevertheless, legislation was still triggering the recognition of liabilities.

PSAB needed to determine whether legislation and an obligating transaction or event resulted in a liability or whether the obligating transaction or event on its own resulted in a liability.

Redefining liabilities in the public sector
The PSAB set out to review its definition of a liability cognizant of the difficulties with the current definition and recognizing the importance of legislation in the public sector. The issue was determining what role, if any, legislation played in the recognition of a liability. For the public sector, this implied broadening the definition to include liabilities that may have existed at the accounting date regardless of when legislation was passed.

The private and public sector definitions in Australia, New Zealand, the UK and the US revealed that liabilities were not always based on contracts, agreements or legislation being in force at the accounting date. These definitions included contracts, agreements and legislation (where applicable) in force at the accounting date but also those liabilities created from the assessment of facts and circumstances that exist at the accounting date.

In essence, these definitions focus on whether the government has lost control over its ability to avoid the future sacrifice of economic benefits. These definitions en- visage that other types of liabilities such as constructive obligations should be recognized provided they otherwise meet the definition of a liability. From this perspective, legislation was not considered a fundamental characteristic of a liability.

PSAB agreed with this approach and re-defined its definition, removed the requirement that legislation be in place and included other types of liabilities that could arise from, for example, constructive obligations. In turn it exposed its proposal and, for the most part, the government community agreed that the existing definition was too narrow to capture all of a government’s liabilities and that focusing on whether legislation was passed was not necessarily the right point for liability recognition in all cases.

The new definition defines liabilities as a government’s present obligations to others, arising from past transactions or events, the settlement of which is expected to result in the future sacrifice of economic benefits. It goes on to say liabilities have three essential characteristics: they embody a duty or responsibility to others, leaving the government little discretion to avoid settlement of the obligation; the duty or responsibility entails a future of economic benefits; and the transaction or event obligating the government has already occurred.

This new definition does not prevent the recognition of liabilities simply because the legislation has not yet been approved. For the purposes of the public sector, these situations will likely be rare, but for the purposes of a general definition of liability, it must be broad enough to encompass any such situation that might arise.

This definition and three characteristics are now included in Financial Statement Concepts Section PS 1000 for the senior governments and in Objectives of Financial Statements, Section PS 1700 for local governments.

Providing guidance to recognize liabilities
In support of the new definition, PSAB also undertook to include a new Handbook section — Liabilities, Section PS 3200 — that provides guidance for applying the definition of liabilities. In essence the new section describes each of the fundamental characteristics of a liability (i.e., little or no discretion to avoid a liability, the future sacrifice of economic benefit and the obligating past transaction or event).

Discretion is the ability to make choices, judgments and decisions. Having little or no discretion means that a government has given up its freedom to make further choices and decisions related to the obligation. The government’s obligation does not depend on its future actions, such as passing legislation or future transactions or events. Nevertheless, there can be situations where a government, for discretionary grants, may continue to have discretion until legislation is passed.

Determining when a government has little or no discretion is particularly difficult for assessing liabilities that arise from constructive and equitable obligations. PSAB recognized the need for guidance and the new section sets out two criteria: a government must acknowledge and indicate that it will act on its decision and take responsibility for the obligation, and the government has sufficiently communicated its decision to the affected parties. When taken together, a government has little or no discretion to avoid the liability. It would be at this point that a liability would be recognized.

Evidence that a government has and will act on its decision includes past practices, established policies, approved plans, and legislation at various stages of its ap-proval. Evidence that a government has sufficiently communicated its decision in-clude an announcement of the amount involved, identification of the individuals or organizations affected by the decision and an announcement of the time frame for implementing the decision.

The second fundamental characteristic is that the obligation entails settlement to others by a future transfer or use of assets, provision of goods and services, or other form of economic settlement. It is not necessary for the government to know the specific identity of the party or parties involved as the obligation to a future sacrifice of economic benefits may be to the public at large.

Finally, for some transactions and events, determining the obligating transaction or event is fairly straightforward. For example, the point of exchange is usually when the obligating transaction or event occurs. However, there can be transactions or events, such as non-exchange transactions, where the recognition point is not so clear. For example, the obligating transaction or event may be based on the actions of others, such as meeting eligibility criteria.

The new guidance also notes that legislation with a retroactive application date cannot create a past transaction or event.

The additional guidance includes disclosure requirements for liabilities that cannot be recognized because a reasonable estimate of the amount involved can-not be made. Disclosures would include information about the nature of the liability and the reason why an estimate cannot be made of the amount involved.

The new definition and Handbook section moves the definition and recognition of liabilities away from contracts, agreements and legislation being in force at the accounting date to assessing when a government has little or no discretion to avoid the future sacrifice of economic benefits. The new definition may not be as easy to apply and may introduce a level of professional judgment, but it does get at the heart of what a liability is.

It will serve as the foundation for all future Handbook sections that address liabilities. It acknowledges that while legislation can play a role in determining liabilities, it is not a fundamental to the definition of liabilities. Further, the additional guidance in Section PS 3200 should provide preparers and auditors of financial statements with assistance for applying the definition to their situations and should serve to increase consistency in its interpretation and application in the public sector.