Introduction
Commitments are ordinarily required to be disclosed by the companies to provide a complete picture of the companies’ financial position to investors. They do not meet the accounting recognition criteria but are in a sense unavoidable and expected to occur in the future. In this post, the focus is only on commitments arising from purchase of tangible and intangible assets. Generally, information about these commitments is included in intangible and tangible assets notes to the financial statements.
Lack of detailed IFRS guidance regarding tangible and intangible assets commitments
The main issue with reporting of tangible and intangible commitments is a lack of guidance in IFRS. There are generally only two very brief sections that deal with the topic, but only basically mention the requirement to disclose this information:
“The financial statements shall also disclose: (c) the amount of contractual commitments for the acquisition of property, plant and equipment.” IAS 16.74(c)
“An entity shall also disclose: (e) the amount of contractual commitments for the acquisition of intangible assets.” IAS 38.122(e)
Consequently, companies are left to develop their own financial reporting approach.
What are commitments
Commitments are in essence future obligations that will entail cash outflow for tangible and intangible assets. They generally arise from contracts, or binding purchase orders. However, for many businesses they may arise also from other sources, as some activities may not be formalized through contracts and purchase orders. For example, even if lacking such formal contractual basis, the entity should refer to the past practice if some acts do not still result in practice in some kind of expectation to purchase that has ordinarily always been fulfilled in the past. Consequently, every entity needs to analyze its business and its internal processes in order to understand how purchase commitments arise, what is the point of recognition, and create a uniform and consistent accounting policy for the financial reporting purposes.
Example of a possible approach
An example could be that the entity includes in commitments calculation only the contracts and purchase orders that are legally binding and cannot be cancelled without lawsuits or penalties, and does not have any customary business practices that would lead to commitments to purchase.
For such items the entity could then evaluate whether it will fulfil the contract, and include then either the relevant amounts, or if it will not fulfil it, estimate the amount of penalty that would be incurred and if this is insignificant, keep it excluded from the calculation. Furthermore, the entity should carefully review the contracts and purchase orders, and split the amounts that relate purely to actual purchase of tangible and intangible assets from other amounts that may, for example, relate to maintenance expenses, or other operating expenses. The latter part should be excluded from the calculation.
The accountant should have a solid process whereby they can capture the new contracts and purchase orders the company entered into, in order to be able to review them for commitments reporting implications, and aggregate them in the relevant commitments review file. For example, they may periodically request a list of all new contracts from the legal department, and have an appropriate query to extract the lists of relevant purchase orders and confirming with the purchasing team which orders are binding.
Based on the commitments review file, the accountant could then prepare the disclosures which are generally included in the tabular format within the notes to the financial statements. Here they are generally disaggregated into commitments for tangible assets, and commitments for intangible assets, for both, the current and prior periods. Furthermore, a narrative disclosure is included regarding what these commitments generally relate to, and further information regarding timing is included if this is material for the user of the financial statements. Some of this information may need to be coordinated with other teams.
Issue of alignment
Given the lack of IFRS guidance, especially for group companies it is important to clearly communicate an accounting policy on this topic and supplement it by informal communication, to leave no room for interpretation for the local accounting teams. Otherwise, it can easily happen that each local entity will adopt its own slightly different calculation methodology, and the overall approach will be inconsistent within the group.