I’ve listed almost all types of current liabilities on my previous post [All Types of Items shown as Current Liabilities]. Contingencies are part of current liabilities, but since it is a broad and controversy topic, I decide to emphasize contingencies discussion separately in this post. I am going to talk about it from the past concepts, standards and researches up to the most recent update standard by the Accounting Standard Codification [ASC] by the US GAAP. Although it is coincidently, some of regular readers of Accounting Financial & Tax.com are requiring this topic, this topic should enrich most of accountant knowledge in contingencies standard.
Contingencies in SFAS No. 5 [Since 1975]
The definition adopted by the US Financing Accounting Standards Board (FASB) in its standard “Accounting for Contingencies“, Statement of Financial Accounting Standard No. 5 (SFAS No. 5) (1975), is:
a contingency is defined as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain . . . or loss . . . to an enterprise that will eventually be resolved when one or more future events occur or fail to occur”.
Examples of contingencies are:
- allowances for uncollectible accounts;
- estimated liabilities for warranties;
- estimated losses on lawsuits; and
- estimated losses related to pollution caused by company operations referred as to “Environment Redemption”.
According to SFAS No. 5, only contingencies in which the possible future event may indicate an asset is impaired or a liability has been incurred on the balance sheet date are candidates for accrual or disclosure. For example, the risk of losses from future injuries suffered by those who interact with a company are not included in contingencies if the injuries have not yet occurred. (On the other hand, if a product is defective and customers who have used the product may take some action, a contingency exists despite the fact that no claims have been asserted.) Another example is that recording a liability for catastrophes that may occur in the future is not appropriate because the event has not occurred.
An estimated loss from a loss contingency should be charged to income if the information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements, and the amount can be reasonably estimated.
The FASB notes that a reasonable estimate can be established even if only a range of amounts can be estimated. In such a case the minimum amount or the better estimate in the range should be accrued and the full range disclosed in notes. An illustration of this would be a situation in which a company has lost a lawsuit but the amount of the damages remains unresolved. However, a company may be reluctant to accrue an amount because reporting of possible claims could result in changing the probability that such claims will be asserted (see Thornton, 1983, p. 82).
The FASB provided three terms to describe contingencies:
- probable i.e., likely to occur;
- reasonably possible a chance that is more than remote but less than probable; and
- remote a slight chance of occurrence.
If a loss contingency is both probable and reasonably estimable, it should be charged against income. If a loss is probable but cannot be estimated or if the loss is reasonably likely (whether measurable or not), it should be disclosed in a note. If the probability of loss is remote, it need not be reported at all.
Unfortunately, the term probable, in particular, has been interpreted in different ways by practicing accountants. In a survey of accountants average values and ranges for the three terms were: probable, average 70 percent, range 4080 percent; reasonably possible, 60 percent, range 4080 percent; remote: 10 percent, range 025 percent (Boritz, 1990 p. 24). These verbal expressions apparently mean different things to different people and invite inconsistency in practice.
Contingencies on IAS 10 [Since 1980]
The International Accounting Standard (IAS) No. 10, “Contingencies and Events Occurring after the Balance Sheet Date“, effective January 1, 1980, follows SFAS No. 5 closely. One difference between the two standards is that if a range of amounts is available, at least the minimum should be accrued according to the IAS standard. Recommended disclosures include the nature of the contingency, the uncertain factors that may affect the future outcome, and an estimate of the financial effect, or a statement that such an estimate cannot be made.
Contingencies in Real Business
In practice, however, management seems to have a conservative view of the required reporting. An interesting example of contingencies is found in the Manville Corporation situation. For a number of years the company faced increasing claims in asbestos-health suits, with 9,300 suits brought by 12,800 plaintiffs at the end of 1981. Disposition costs increased rapidly as well. No liability was accrued at the end of 1981, despite an ability to calculate at least a minimum liability on claims outstanding. The company went into bankruptcy proceedings in 1982 because of the claims, but still did not record a liability. Disclosures were extensive in the 1982 report, but no liability was recorded because “the eventual disposition of the Claims cannot be predicted at this time” (p. 10). This was a consistent position maintained by the company for several years until the company emerged from bankruptcy in 1988 and recorded a $1.28 billion charge in that year.
Auditor Involvement in Contingencies
Auditor involvement with contingencies is considered in the USA by Statement on Auditing Standards (SAS) No. 58 (April, 1988), “Reports on Audited Financial Statements“. The section that deals with uncertainties indicates that an explanatory paragraph in the audit report may be required unless the auditor is satisfied that the likelihood of a loss is remote.
Contingencies and Lawsuits
Disclosure of contingencies may lower stock prices and could lead to lawsuits. However, in general disclosure of contingencies should help to avoid lawsuits because it leads investors to form realistic expectations. When a contingent liability results in an actual loss, the largest effect on stock price should be in those cases where disclosure was insufficient or there was no disclosure.
Some companies worry that disclosing an amount will tip their hand in any lawsuit that is under way. However, the general nature of most disclosures suggests that this is not too serious a concern.
Contingencies Most Recent Standard by GAAP Codification [ASC]
ASC 450 defines a contingency as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss. The uncertainty will ultimately be resolved when one or more future events occur or fail to occur. ASC 450 defines the different levels of probability as to whether or not future events will confirm the existence of a loss as follows:
- Probable—The future event or events are likely to occur.
- Reasonably possible—The chance of the future event or events occurring is more than remote but less than likely.
- Remote—The chance of the future event or events occurring is slight.
Professional judgment is required to classify the likelihood of the future events occurring. All relevant information that can be acquired concerning the uncertain set of circumstances needs to be obtained and used to determine the classification.
ASC 450 states that a loss must be accrued if both of the following conditions are met:
- It is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements.
- The amount of loss can be reasonably estimated.
Loss contingencies are recognized only if there is an impairment of an asset or the incurrence of a liability as of the balance sheet date. Examples of possible loss contingencies include:
- Collectibility of receivables
- Warranty liabilities and product defects
- Loss due to fire, explosion, or other hazards
- Expropriation of assets
- Litigation, claims, and assessments
- Incurred but not reported (IBNR) claims if the entity insures its risk of loss with a claims-made policy
- Exposures under multiple-year retrospectively rated insurance contacts
- Catastrophic losses by insurance and reinsurance entities
- The contingent obligations under guarantees
- Obligations under standby letters of credit
- Repurchase agreements
- Withdrawal from a multiemployer plan
- Consideration for a failed registration statement
Disclosures of Loss Contingencies
Events that give rise to loss contingencies that occur after the balance sheet date (i.e., bankruptcy or expropriation) but before issuance of the financial statements may require disclosure so that statement users are not misled. “Note disclosures” OR “pro forma financial statements” may be prepared as supplemental information to show the effect of the loss.
It is not necessary that a single amount be identified. A range of amounts is sufficient to indicate that some amount of loss has been incurred and should be accrued.
The amount accrued is the amount within the range that appears to be the best estimate. If there is no best estimate, the minimum amount in the range should be accrued since it is probable that the loss will be at least this amount (ASC 450-20). The maximum amount of loss should be disclosed.
If future events indicate that the minimum loss originally accrued is inadequate, an additional loss should be accrued in the period when this fact becomes known. This accrual is a change in estimate, not a prior period adjustment.
When a loss is probable and no estimate is possible, these facts should be disclosed in the current period. The accrual of the loss should be made in the earliest period in which the amount of the loss can be estimated. Accrual of that loss in future periods is a change in estimate. It is not a prior period adjustment.
If the occurrence of the loss is reasonably possible, the facts and circumstances of the possible loss and an estimate of the amount, if determinable, should be disclosed.
If the occurrence of the loss is remote, no accrual or disclosure is usually required.
When a public company cannot estimate the reasonably likely impact of a contingent liability, but a range of amounts are determinable, the SEC requires disclosure of those amounts. Disclosure of contingencies for public companies should also include quantification of the related accruals and adjustments, costs of legal defense, and reasonably likely exposure to additional loss, as well as the assumptions that management has made about those amounts, and the extent to which the resulting estimates of loss are sensitive to changes in those assumptions.
ASC 450 does not generally apply when determining which contingent assets or liabilities are to be recognized as of the date of an acquisition. Instead, under provisions of ASC 805, the acquirer recognizes at their acquisition date fair values the assets acquired and liabilities assumed that arise from contract related contingencies.
For non-contractual contingencies, the acquirer shall assess as of the acquisition date whether it is more likely than not that a contingency shall result in an asset or liability; if so, the acquirer recognizes the acquisition-date asset or liability at its fair value. A non-contractual contingency that does not meet the more-likely-than-not criterion is to be treated as previously described under ASC 450.
If the acquirer later obtains new information about the expected outcome of an acquisition-related contingency, it should then measure each liability at the higher of its acquisition-date fair value or the amount that would be recognized under ASC 450. Each acquisition-related contingent asset should be reported at the lower of its acquisition-date fair value or the best estimate of its future settlement amount.
Unasserted Claims or Assessments
It is not necessary to disclose loss contingencies for an unasserted claim or assessment where there has been no manifestation of an awareness of possible claim or assessment by a potential claimant unless it is deemed probable that a claim will be asserted and a reasonable possibility of an unfavorable outcome exists. Under the provisions of ASC 450, general or unspecified business risks are not loss contingencies and, therefore, no accrual is necessary. Appropriations of retained earnings may be used for these risks as long as no charge to income is made to establish the appropriation. Disclosure of these business risks may be required under ASC 275.
Estimate vs. contingency
Distinguishing between an estimate and a contingency can be difficult because both involve an uncertainty that will be resolved by future events. However, an estimate exists because of uncertainty about the amount of a loss resulting from an event requiring an acknowledged accounting recognition. The event has occurred and the effect is known, but the amount itself is uncertain. For example, depreciation is an estimate, but not a contingency because the actual fact of physical depreciation is acknowledged, although the amount is obtained by an assumed accounting method.
In a contingency, the amount is also usually uncertain, although that is not an essential characteristic. Instead, the uncertainty lies in whether the event has occurred (or will) and what the effect, if any, on the enterprise would be. Collectibility of receivables is a contingency because it is uncertain whether a customer will not pay at a future date, although it is probable that some customers will not pay. Similar logic would hold for obligations related to product warranties. That is, it is uncertain whether a product will fail, but it is probable that some will fail within the warranty period.
Other contingencies are rarely recognized until specific events confirming their existence occur. Every business risks loss by fire, explosion, government expropriation or casualties in the ordinary course of business. To the extent those losses are not (or cannot be) insured, the risks are contingencies. Because those events are often random in their occurrence, uncertainty surrounds whether the future event confirming the loss will or will not take place. The passage of time usually resolves the uncertainty. Until the event confirming the loss occurs (or is probable of occurrence) and the amount of the loss can be reasonably estimated, the potential loss is not recognized in financial statements.
The most difficult area of contingencies is “litigation“. Accountants must rely on attorneys’ assessments concerning the likelihood of such events. Unless the attorney indicates that the risk of loss is remote or slight, or that the loss if it occurs would be immaterial to the company, disclosure in financial statements is necessary and an accrual may also be necessary.
In practice, attorneys are loathe to state that the risk of loss is remote, as that term is defined by ASC 450, although the likelihood of obtaining a definitive response to lawyer’s letters under SAS 12 is improved if the auditors explicitly cite a materiality threshold. In cases where judgments have been entered against the reporting entity, or where the attorney gives a range of expected losses or other amounts and indicates that an unfavorable outcome is probable, accruals of loss contingencies for at least the minimum point of the range must be made. In most cases, however, an estimate of the contingency is unknown and the contingency is reflected only in footnotes.
Accruals for contingencies, including those arising in connection with litigation, are limited under GAAP to expected losses resulting from events occurring prior to the balance sheet date. One unresolved issue is whether expected legal costs to be incurred in connection with a loss contingency (that is being accrued) should be accrued as well. Apparently, GAAP would permit such an accrual, but practice is varied. With respect to SEC registrants, the SEC Staff expects the decision to do so to be disclosed in the financial statements and applied consistently (ASC 450-20-S99).
Past Researches on Contingencies
The most extensive study on contingencies is the monograph by Daniel Thornton (1983) dealing with the conceptual issues in financial reporting of contingencies and uncertainties. The market effect of disclosure of contingencies was studied by Banks & Kinney (1982). They found that there is a negative relationship between stock price performance and initial disclosure of contingencies.
Deakin (1989), reporting on the Pennzoil-Texaco case, found no accrual until actual payment was agreed upon by the parties. In December 1985 Texaco lost a court case with a $10.5 billion jury award. The footnote disclosure for 1985 included no accrual because the amount could not be determined. After state appeals had been lost in 1986, the annual report still did not accrue any loss (now at 9.1 billion plus interest). The judgment was upheld in 1987 and Texaco filed for bankruptcy. This led to final settlement of the suit for $3 billion in early 1988. Texaco accrued the full amount of the loss in its 1987 statements. The other party, Pennzoil, did not record the contingent gain until 1988. Deakin criticized the delay in Texaco’s accrual of a loss.
Raghunandan (1993) examined the predictive ability of auditor loss contingency report modifications in terms of a later material loss. He found that modifying paragraphs in the audit opinion had predictive ability in connection with later material losses. He concluded that auditors appear to have information beyond that generally available and that they attempt to protect themselves with a qualifying paragraph if a loss is likely.