“Constructive” as per its dictionary meaning it is something which is not obvious or stated explicitly and it perhaps could be derived by inference (presumptions) and the word “Obligation” means a duty or commitment.
Under the current practice there is nothing called constructive obligation, however in some industry it is being done based on some customs/ practices to sustain with some good relations within the market. The current accounting requires to make a provision when an entity has a present obligation as a result of past event and the liability is considered probable and can be reliably estimated which essentially nothing include about constructive obligations.
Para 10 – 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.
Para 10 – 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.
Let’s take some examples to understand –
An entity has published a policy stating that it will clean up some smoke related damages that are normally being caused by such type of industries however the entity specifically mentions in its policy that it will clean up or fix those damages and this has been communicated to the parties concerned. This is one of the examples of constructive obligation. Even these kind of clean of smokes do not require any contractual obligation and it does not happen by any other entity within the same industry however since the entity itself created a policy and communicated to other parties that the entity will take such responsibilities and confirmed to discharge such responsibilities it will be covered under the definition of constructive obligation and hence will be eligible to create a provision.
A decision making authority (either Board or at General meeting) decides to incur some expense e.g. some social benefits which has still not communicated to the parties (not necessary to the same parties) for whom the responsibilities will be discharged will not be constructive obligation. The communication should be made to the parties (not necessary to the same parties) to establish an expectation towards the discharge of these responsibilities then only it will fall under constructive obligation.
Decommissioning liability to be incurred in future in case of Oil and gas industries which are not avoidable based on any future action and hence will be an obligating event (as mentioned in the definition above). Refer the process to account such decommissioning liability in my earlier published article http://taxguru.in/finance/ongc-abandonment-cost-decommissioning-liability-indas-ifrs.html
A specific entity requires fixing smoke filters in order to avoid any legal action. However if an entity change its way of operation then it can possibly avoid such obligation and hence it is not a constructive obligation as being avoidable.
Another example could be Voluntary Retirement Scheme (VRS) which is normally announced at public and media etc and then it goes with approval processes and once an agreement is in place then only a provision is created. However after the applicability of the concept of constructive obligation, an entity will be able to create such VRS (as per our example) provision on the day when it is announced/ communicated to the public at large.
It is to be noted that the communication to the public at large is enough and there is no specific need to identify that other party to whom such obligation needs to be discharged.
One can feel a sense of this new requirement which certainly provide an area to make more provisions based on its constructive nature. Management needs to identify such obligations at the time of transition as well as going forward. Process needs to be updated in order to capture these provisions on time and document the same for audit purposes accordingly.
The other interesting thing to note is, by doing such constructive obligation provision; management will be able to create early provisions and could be in a position to manipulate earnings, and however a proper documentation will be a key for auditor to challenge/ substantiate such provisions.
A reader will appreciate about the main objective of the standard and an approach which one can follow while keeping in mind the basis of origin of such requirements. There could possibly be some specific situations or circumstances where the interpretation of any standard will be different as we should always keep in mind that IND-AS is principle based standards and lot more areas need management judgment in line with the standards relevant interpretation and best practices.
One has to look into all related facts and patterns before concluding this type of assessment based on this concept. Readers are requested not to take this article as any kind of advice (it is not exhaustive in nature) and should evaluate all relevant factors of each individual cases separately.
(Author of this article is an experienced chartered accountant who has specialization on various GAAP conversions assignments covering different industries around different part of the world including acting as IFRS advisor & corporate trainer. He can be reached via email at email@example.com or whatsapp +91-9634706933)