Tag: accounting contingencies

Maybe Yes, Maybe No, It Ain’t Necessarily So

If you wish to dive into an accounting topic akin to scrambled eggs, then accounting contingencies is a fine choice. It’s scattered, can be a bit messy, and cumbersome to bring it all together.

Underlying Uncertainty

In the Master Glossary of the FASB Codification, contingency is defined as “An existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an entity that will ultimately be resolved when one or more future events occur or fail to occur.”

As can be seen, to be accounted for as a contingency under FAS Topic 450, there must be an underlying uncertainty that existed at or before the balance sheet date, which will ultimately be resolved in the future, either by occurring or not occurring.

However, not all uncertainties give rise to a contingency, as defined in FAS Topic 450. It expressly excludes the following uncertainties from consideration under FAS Topic 450:

• Depreciation. Estimates used to allocate the cost of a depreciable asset over the life of the asset are not a FAS Topic 450 type contingency.
• Estimates used in accruals. Amounts owed for services received, even if the amounts must be estimated, are not a FAS Topic 450 type contingency.
• Changes in tax law. Uncertainties related to the possibility of a future change in tax law are not a FAS Topic 450 type contingency.
• Other similar uncertainties. FAS 450-10-55 clarifies that other variations similar to the above are also excluded from FAS Topic 450 consideration.

Loss Contingencies

The guidance on contingencies is situated in the Liability section of the Codification, thus providing a clue that the FASB places greater emphasis on loss contingencies over its fraternal twin of gain contingencies. And, obviously, perhaps, the accounting treatment for a loss contingency is different than that of a gain, with the conservative principle coming front and center.

Definition of Loss Contingency

The Master Glossary defines a loss contingency as “An existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an entity that will ultimately be resolved when one or more future events occur or fail to occur. The term loss is used for convenience to include many charges against income that are commonly referred to as expenses and others that are commonly referred to as losses.”

The loss could result in the impairment of an asset or the incurrence of a liability.

Examples

• Litigation exposure
• Guarantees of indebtedness of others
• Obligations related to product warranties and product defects
• Sales and use tax audits
• Fire losses
• Environmental Remediation

What is Excluded from Contingency Losses under ASC Topic 450?

In general, areas discussed by other sections of the Codification are excluded from contingency loss considerations under ASC Topic 450, such as:

• Measurement of credit losses for instruments within its scope, such as accounts receivable (Topic 326) (Credit losses are discussed at the end of this article.)
• Stock issued to employees (ASC Topic 718)
• Employment-related costs, including deferred compensation contracts (ASC Topics 710, 712, 715)
• Uncertainty in income taxes (ASC Section 740-10-25)
• Accounting and reporting by insurance entities (ASC Topic 944)

How is the Likelihood of Loss Measured

ASC 450-20-25-1 states that “(w)hen a loss contingency exists, the likelihood that the future event or events will confirm the loss or impairment of an asset or the incurrence of a liability can range from probable to remote.”…

“The Contingencies Topic uses the terms probable, reasonably possible, and remote to identify three areas within that range.”

• Probable is defined as the future event or events are likely to occur. (Think in terms of 75% or greater chance of happening.)
• Remote is defined as the chance of the future event or events occurring is slight (think in terms of 10% or less chance of occurring.)
• Reasonably possible is defined as the chance of the future event or events occurring is more than remote but less than likely. In other words, it ranges in that broad area between probable and remote.

What are the Two Considerations for Contingency Loss Recognition

If the underlying loss event happened on or prior to the balance sheet date, ASC 450-20-25 requires two criteria for recognition of a loss contingency:

1. It must be probable that the loss will occur.
2. The amount of the loss must be reasonably estimable using a fair-value objective, which would be the most probable amount at which the contingent liability would be settled.
• Notice that this fair value objective measurement differs from the one in ASC Topic 820, defined as the exit price in a hypothetical orderly transaction between market participants.
• The amount of the loss should be estimated and evaluated independent of any claim for recovery.
• The contingent liability is generally not discounted. But there are exceptions. See ASC 835-30-15-2.

If both of the above criteria are met, and the reasonably estimable loss is a range, the standard requires accrual of the amount that appears to be the better estimate within the range, or accrual of the minimum amount in the range if no amount within the range is a better estimate than any other amount.

In rare cases where the probable loss cannot be reasonably estimated, no loss accrual is made. Of course, disclosure is required describing the contingency and the fact that the company could not reasonably estimate the loss amount.

When is There No Accrual of Loss, but Disclosure Is Required

As described above, if an underlying loss event happened on or prior to the balance sheet date, a loss contingency is recognized in the balance sheet when two criteria are met: 1) It is probable that a loss will occur, and 2) the amount of the loss is reasonably estimable.

But when is disclosure only required?

If an underlying loss event happened on or before the balance sheet date, but it is only reasonably possible that the loss will occur (i.e., it does not rise to the probable threshold but is more than remote), then the loss is not accrued, but disclosure is required.

The company should disclose the nature of the contingency and provide an estimate of the possible loss or the range of loss or disclose that such an estimate cannot be made.

When is No Recognition of Loss and No Disclosure Required

As described in ASC 450-20, loss recognition and disclosure are not required when a loss is remote, defined as a slight chance of occurrence. A slight chance of a loss occurrence is generally considered to be 10% or less.

Disclosure is still permissible and may sometimes be necessary, depending on the situation. Whether to disclose a potential loss whose occurrence is considered remote is based on the fairness principle; i.e., is it information that a reasonable user of the financial statements would find meaningful?

What About Unasserted Claims

An unasserted claim is one not asserted by the potential claimant. Perhaps the potential claimant is unaware of the matter. Or, maybe the potential claimant is aware of the matter but has not pursued it.

That raises the question of whether a claim or lawsuit will be filed. If it is determined that it is probable a claim or suit will be filed, then the unasserted claim contingency is evaluated the same way as any other contingency under ASC Topic 450.

On the other hand, if it is determined that the likelihood of a suit or claim being asserted is only reasonably possible or remote, then the evaluation under ASC Topic 450 is not necessary for those unasserted claims.

Gain Contingencies

The Master Glossary defines a gain contingency as “(a)n existing condition, situation, or set of circumstances involving uncertainty as to possible gain to an entity that will ultimately be resolved when one or more future events occur or fail to occur.“

Examples of gain contingencies include:

• Legal settlements where the company is the plaintiff and expects to win the case, resulting in a monetary award
• Insurance claims if the company has suffered a loss and expects to receive insurance proceeds exceeding the carrying amount of the damaged assets.

The polar star principle for gain contingencies is found at ASC 450-30-25-1. “A contingency that might result in a gain usually should not be reflected in the financial statements because to do so might be to recognize revenue before its realization.”

ASC 450-30-50-1 further provides that “(a)dequate disclosure shall be made of a contingency that might result in a gain, but care shall be exercised to avoid misleading implications as to the likelihood of realization.“

The accounting principle of conservatism is heard loud and clear when it comes to recognizing a gain related to the resolution of future events. Gain contingencies should not be recognized on the balance sheet before their realization. This realization principle also encompasses a recovery related to a loss contingency, such as an insurance recovery, which is considered a contingency gain.

So, when is realization? It’s when the company has resolved all uncertainties and contingencies related to the receipt of cash. In short, gain contingencies are not recognized on the balance sheet until all contingencies are resolved. It’s rare to see a gain contingency on a company’s balance sheet.

The possible exception to the realization principle stated in the paragraph immediately above relates to the recovery of a contingent loss recognized on the balance sheet. Recovery (such as insurance proceeds) of a contingent loss may be recognized, but only to the extent of the contingent loss, if the recovery’s realization is considered probable and the amount of recovery can be reasonably estimated. However, amounts recovered in excess of the related recognized contingency loss can only be recognized as a gain contingency when all contingencies related to the contingency are resolved. (In other words, the excess gain contingency is usually unrecognized.)

Accounts Receivables and Current Expected Credit Losses

Before ASU No. 2016-13 – Financial Instruments – Credit Losses (codified in ASC Topic 326), the collectability of accounts receivables was evaluated under the ASC 450 contingency model. Accordingly, an allowance for doubtful accounts was not recognized unless it was probable that a loss would be incurred (i.e., a 75% or better chance the receivable would not be collected.)

However, that approach changed on the effective date of ASU No. 2016-13 (beginning with 2023, calendar year-ends.) The Incurred Loss model, which used the probable loss recognition method, was replaced with the CECL (current expected credit loss) model, which uses the expected loss recognition method.

Under the CECL model, losses expected to be incurred will result in loss recognition, even if the loss is remote (remember that remote is as low as 10% or less.) So, the standard has dropped from a probable loss threshold for loss recognition to a remote loss threshold for recognition of the loss. Therefore, a loss must be recognized even if the risk for loss is as low as 10%.

Here is an illustration. Suppose there is a 95% chance that accounts receivable of $1,000,000 will be entirely collected and a 5% chance that none will be collected. A CECL allowance for credit losses of $50,000 should be recognized.

Under the old and now retired incurred loss model previously used to determine the bad debt loss, no loss would have been recognized because it was not probable that a loss would be incurred (75% or greater chance of loss.)

Just a heads-up here. Under the CECL expected loss approach, credit losses will be recognized sooner, and a zero allowance for credit losses is questionable.