‘Reserves’: things we don’t know how to account for?

The word ‘reserve’ has sometimes been used to describe two items on opposite sides of the balance sheet. The first item is oil or gas reserves, which are assets. The second item is insurance ‘reserves’, which are liabilities. Coincidentally, accounting standard setters have found both items hard to deal with.

I think the label ‘reserve’ can be appropriate for some assets, but not for liabilities, for reasons I give  below.

‘Reserve’ as a label for assets

The label ‘reserve’ makes intuitive sense for oil and gas deposits. Dictionaries define a reserve as a supply of something (for example, a commodity, fuel or money) that is available for use if needed.

It might sometimes be helpful for the word ‘reserve’ to be included in the label for assets or other kinds, not just for oil and gas deposits.

‘Reserve’ as a label for liabilities

On the other hand, using the label ‘reserve’ for a liability causes confusion because it:

  • doesn’t distinguish liabilities from reserves that are a component of equity.
  • implies wrongly that a ‘reserve’ is an amount that management has ‘set aside’ and plans to pay, rather than an amount that the company must pay because the company already has a liability.
  • perpetuates a mistaken idea that the only purpose of recognising (or not recognising) a liability is to manage the level of a company’s dividend distributions.
  • encourages the misleading idea that a company’s management can choose freely what amount to use in measuring liabilities. Management must measure liabilities at amounts that report their magnitude.
  • risks confusion with assets that are legitimately labelled as reserves.

Because of the confusion it causes, I believe the label ‘reserve’ is not appropriate for liabilities.

In the past, reductions in the carrying amount of assets (for example impairment or even depreciation) were sometimes labelled as ‘reserves’. That labelling is just as inappropriate as it is for liabilities.

Exemption from the hierarchy in IAS 8

Apart from sometimes being labelled as reserves, oil and gas reserves and insurance liabilities have another thing in common. They are 2 of only 3 items for which the IASB exempts (or once exempted) companies from a requirement that companies must consider a hierarchy in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.

The IAS 8 hierarchy specifies the sources companies must consider in developing accounting policies when no Standard applies to a particular transaction or other event, or when a Standard allows a choice of accounting policy.

Why the IASB created the exemptions

The IASB created the 3 exemptions around the time when many companies were switching to IFRS Accounting Standards. The exemptions were needed because the IASB had plans to work on difficult long-term projects developing lasting solutions. Those solutions would not yet be available when those companies switched to the IASB’s Standards.

The exemptions avoided forcing those companies to change their accounting polices twice in quick succession, with the second round of changes possibly even undoing some or all of the first round.

Where the IASB created the exemptions

The exemptions were:

  • in IFRS 4 Insurance Contracts. The exemption (and the need for it) disappeared when the successor Standard IFRS 17 Insurance Contracts came into force.
  • in IFRS 14 Regulatory Deferral Accounts. This exemption (and the need for it) should disappear when the IASB finishes its project on rate-regulated activities.
  • in IFRS 6 Exploration for and Evaluation of Mineral Resources. In 2023, the IASB decided that it will propose a minor wording change clarifying that the IASB no longer considers the exemption temporary.

Leaving the IFRS 6 exemption in place

In my view, the forthcoming proposal for IFRS 6 is not just a minor wording change. The substantive proposal is that the IASB will not remove a highly unusual exemption. The IASB only made that exemption because it planned to do more standard-setting work.

Leaving the IFRS 6 exemption in place permanently might well be the right outcome, but the proposal to do that needs full public scrutiny. The proposal may not be prominent enough if the IASB buries it as a proposed minor wording change among other proposed Annual Improvements .

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