Marking-to-market IAS 37 provisions using options: an empirical demonstration

Purpose - International Accounting Standards Rule 37 (IAS 37) for Contingent Liabilities and Assets were designed to make analysis of exposures facing a corporate entity easier to understand, but the rules may be insufficiently prescriptive making provisions inadequate predictors of potential outlays. The purpose of this research is to redress this problem. We apply financial option theory to objectively mark-to-market the appropriateness of provisions replacing subjective inputs with market derived calculations. Design/methodology/approach - This study applies financial option theory to determine whether provisions are appropriate according to market data. This research supports inferences regarding the probability of a provision being used while evidencing scope for earnings management. Findings - In addition to showing how IAS 37 provisions may be calibrated against market data, from the large sample of UK-listed companies, the proposition that over-provisioning is common and related to share price volatility, is supported, supporting the view that IAS 37 rules may facilitate earnings management. Practical implications - The financial and reporting community have struggled in interpreting the appropriateness of IAS 37 provisions. Are they too large or too small? What is the probability they will be used? Using option theory and market data, various subjective judgements may now be validated. This research should have tangible value to analysts, auditors, investors and other stakeholders concerned in the accurate valuation of potential liabilities. Originality/value - Replacing subjective judgement and insufficiently prescriptive guidance, this study shows that financial option theory and share price data may be used to objectively calibrate the size of IAS 37 provisions.