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Chapter13: Current Liabilities and Contingencies

Loss Contingencies

p. 706

Flextronics International Limited's 2009 financial statements indicated potential obligations from pending lawsuits (shown in Graphic 13-7).

GRAPHIC 13-7
Disclosure of Pending Litigation—Flextronics International Limited
Real World Financials

  Note 7: Commitments and Contingencies (in part)

  The Company is subject to legal proceedings, claims, and litigation arising in the ordinary course of business. The Company defends itself vigorously against any such claims. Although the outcome of these matters is currently not determinable, management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on its consolidated financial position, results of operations, or cash flows.

   These “legal proceedings, claims, and litigation” all relate to situations that already have occurred (for example, selling an electronic component with an alleged defect). However, it is not clear that these situations have given rise to liabilities, because Flextronics doesn't know if the situation will result in future payments. Certainly the liabilities may exist on the date of the financial statements, given that very large expenditures could result from some outcomes. But how likely is an unfavorable outcome? Also, precise amounts of Flextronics' potential obligation are not known, but can they be estimated reliably? These are the key questions addressed by accounting standards for loss contingencies.

 

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   A loss contingency existing, uncertain situation involving potential loss depending on whether some future event occurs. is an existing, uncertain situation involving potential loss depending on whether some future event occurs. Whether a contingency is accrued and reported as a liability depends on (a) the likelihood that the confirming event will occur and (b) what can be determined about the amount of loss. Consider an EPA investigation of possible violation of clean air laws, pending at year-end, and for which the outcome will not be known until after the financial statements are issued. The likelihood must be assessed that the company will pay penalties, and if so, what the payment amount will be.

 A loss contingency involves an existing uncertainty as to whether a loss really exists, where the uncertainty will be resolved only when some future event occurs.

   Note that the event that gives rise to the potential liability must occur before the financial statement date. Otherwise, regardless of the likelihood of the eventual outcome, no liability could have existed at the statement date. Remember, one of the essential characteristics of a liability is that it results “from past transactions or events.”

Generally accepted accounting principles require that the likelihood that the future event(s) will confirm the incurrence of the liability be (somewhat arbitrarily) categorized as probable, reasonably possible, or remote:20

Probable

Confirming event is likely to occur.

Reasonably possible

The chance the confirming event will occur is more than remote but less than likely.

Remote

The chance the confirming event will occur is slight.

 
FINANCIAL
Reporting Case

Q4,p.692

Likelihood That a Liability Exists

   Also key to reporting a contingent liability is its dollar amount. The amount of the potential loss is classified as either known, reasonably estimable, or not reasonably estimable.

 

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A liability is accrued if it is both probable that the confirming event will occur and the amount can be at least reasonably estimated. A general depiction of the accrual of a loss contingency is:

Loss (or expense) ......................

x,xxx

  Liability ........................................

x,xxx

 

Accrual of a Loss Contingency—Liability

p. 707

   If one amount within a range of possible loss appears better than other amounts within the range, that amount is accrued. When no amount within the range appears more likely than others, the minimum amount should be recorded and the possible additional loss should be disclosed.21

   As an example of accruing a contingent loss, consider a March 31, 2009, 10Q filed by the Alabama Gas Corporation (Alagasco) (Graphic 13-8). Consistent with GAAP, Alagasco accrued the lower end of a range of possible values and disclosed the potential for other losses above that amount.

GRAPHIC 13-8
Accrual of Loss Contingency—Alabama Gas Corporation
Real World Financials

  7. Commitments and Contingencies (in part)

  In October 2008, Alagasco received a request from the United States Environmental Protection Agency (EPA) . . . in connection with a former manufactured gas plant site located in Huntsville, Alabama. The site, along with the Huntsville gas distribution system, was sold by Alagasco to the City of Huntsville in 1949. . . . Based on the limited information available at this time, Alagasco preliminarily estimates that it may incur costs associated with the site ranging from $2.9 million to $5.9 million. At the present time, the Company cannot conclude that any amount within this range is a better estimate than any other, and accordingly the Company has accrued a contingent liability of $2.9 million. The estimate assumes an action plan for surface soil. If it is determined that a greater scope of work is appropriate, then actual costs will likely exceed the preliminary estimate.

   It is important to note that some loss contingencies don't involve liabilities at all. Some contingencies, when resolved, cause a noncash asset to be impaired, so accruing the contingency means reducing the related asset rather than recording a liability:

Loss (or expense) ........................................

x,xxx

  Asset (or valuation account) .........................

x,xxx

 Accrual of a Loss Contingency—Asset Impairment

   The most common loss contingency of this type is an uncollectible receivable. You have recorded these before without knowing you were accruing a loss contingency (Debit: bad debt expense; Credit: allowance for uncollectible accounts).

   If one or both criteria for accrual are not met, but there is at least a reasonable possibility that a loss will occur, a disclosure note should describe the contingency. It also should provide an estimate of the potential loss or range of loss, if possible. If an estimate cannot be made, a statement to that effect is needed.

 A loss contingency is disclosed in notes to the financial statements if there is at least a reasonable possibility that the loss will occur.

   As an example of only disclosing a contingent loss, consider a disclosure note accompanying recent financial statements issued by Varian Medical Systems, Inc., which designs and manufactures cancer therapy systems. VMS felt that the loss contingency from an investment was only reasonably possible, and accordingly did not accrue a liability but provided the information noted in Graphic 13-9.

GRAPHIC 13-9
Disclosure of Loss Contingency—VMS, Inc.
Real World Financials

  Note 9 (in part)

  . . . we agreed to invest $5 million in a consortium to participate in the acquisition of a minority interest in dpiX LLC (“dpiX”), which supplies us with amorphous silicon thin-film transistor arrays. Based on information provided by dpiX, management currently believes it is reasonably possible that we will recognize a loss of up to $5 million on this investment.

   Graphic 13-10 highlights the appropriate accounting treatment for each possible combination of (a) the likelihood of an obligation's being confirmed and (b) the determinability of its dollar amount.

p. 708

GRAPHIC 13-10
Accounting Treatment of Loss Contingencies

 

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*Except for certain guarantees and other specified off-balance-sheet risk situations discussed in chapter 14.

Product Warranties and Guarantees

MANUFACTURER'S ORIGINAL WARRANTY. Satisfaction guaranteed! Your money back if not satisfied! If anything goes wrong in the first five years or 100,000 miles … ! Three-year guarantee! These and similar promises accompany most consumer goods. The reason—to boost sales. It follows, then, that any costs of making good on such guarantees should be recorded as expenses in the same accounting period the products are sold (matching principle). Also, it is in the period of sale that the company becomes obligated to eventually make good on a guarantee, so it makes sense that it recognizes a liability in the period of sale. The challenge is that much of the cost of satisfying a guarantee usually occurs later, sometimes years later. This is a loss contingency. There may be a future sacrifice of economic benefits (cost of satisfying the guarantee) due to an existing circumstance (the guaranteed products have been sold) that depends on an uncertain future event (customer claim).

 Most consumer products are accompanied by a guarantee.

   As you might expect, meeting the accrual criteria is more likely for some types of loss contingencies than for others. For instance, the outcome of pending litigation is particularly difficult to predict. On the other hand, the criteria for accrual almost always are met for product warranties (or product guarantees). While we usually can't predict the liability associated with an individual sale, reasonably accurate estimates of the total liability for a period usually are possible, because prior experience makes it possible to predict how many warrantees or guarantees (on average) will need to be satisfied. So the contingent liability for warranties and guarantees usually is accrued in the reporting period in which the product under warranty is sold. This is demonstrated in Illustration 13-6.

 The contingent liability for product warranties almost always is accrued.

   Estimates of warranty costs cannot be expected to be precise. However, if the estimating method is monitored and revised when necessary, overestimates and underestimates should cancel each other over time. The estimated liability may be classified as current or as part current and part long-term, depending on when costs are expected to be incurred.

ILLUSTRATION 13-6

Product Warranty

The costs of satisfying guarantees should be recorded as expenses in the same accounting period the products are sold.

  Caldor Health, a supplier of in-home health care products, introduced a new therapeutic chair carrying a two-year warranty against defects. Estimates based on industry experience indicate warranty costs of 3% of sales during the first 12 months following the sale and 4% the next 12 months, totaling 7% that should be accrued in the year of sale. During December 2011, its first month of availability, Caldor had $2 million of chair sales.

During December

Cash (and accounts receivable) ........................................

2,000,000

  Sales revenue ........................................

2,000,000

December 31, 2011 (adjusting entry)

Warranty expense ([3% + 4%] × $2,000,000) ........................................

140,000

  Estimated warranty liability ........................................

140,000

     When customer claims are made and costs are incurred to satisfy those claims, the liability is reduced (let's say $61,000 in 2012):

Estimated warranty liability ........................................

61,000

  Cash, wages payable, parts and supplies, etc ........................................

61,000

p. 709

EXPECTED CASH FLOW APPROACH. In Chapter 6, you learned of a framework for using future cash flows as the basis for measuring assets and liabilities, introduced by the FASB in 2000 with Statement of Financial Accounting Concepts No. 7, “Using Cash Flow Information and Present Value in Accounting Measurements.”22 The approach described in the Concept Statement offers a way to take into account any uncertainty concerning the amounts and timing of the cash flows. Although future cash flows in many instances are contractual and certain, the amounts and timing of cash flows are less certain in other situations, such as warranty obligations.

 SFAC No. 7 provides a framework for using future cash flows in accounting measurements.

   As demonstrated in Illustration 13-6, the traditional way of measuring a warranty obligation is to report the “best estimate” of future cash flows, ignoring the time value of money on the basis of immateriality. However, when the warranty obligation spans more than one year and we can associate probabilities with possible cash flow outcomes, the approach described by SFAC No. 7 offers a more plausible estimate of the warranty obligation. This “expected cash flow approach” incorporates specific probabilities of cash flows into the analysis. In Chapter 6, we discussed the expected cash flow approach to determining present value. Illustration 13-7 provides an example.

ILLUSTRATION 13-7

Product Warranty

Probabilities are associated with possible cash outcomes.

The probability-weighted cash outcomes provide the expected cash flows.

The present value of the expected cash flows is the estimated liability.

 Caldor Health, a supplier of in-home health care products, introduced a new therapeutic chair carrying a two-year warranty against defects. During December of 2011, its first month of availability, Caldor had $2 million of chair sales. Industry experience indicates the following probability distribution for the potential warranty costs:

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An arrangement with a service firm requires that costs for the two-year warranty period be settled at the end of 2012 and 2013. The risk-free rate of interest is 5%. Applying the expected cash flow approach, at the end of the 2011 fiscal year, Caldor would record a warranty liability (and expense) of $131,564, calculated as follows:

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December 31, 2011 (adjusting entry)

Warranty expense ........................................

131,564

  Estimated warranty liability (calculated above) ........................................

131,564

*Present value of $1, n = 1, i = 5% (from Table 2)

Present value of $1, n = 2, i = 5% (from Table 2)

p. 710

EXTENDED WARRANTY CONTRACTS. It's difficult these days to buy a CD player, a digital camera, a car, or almost any durable consumer product without being asked to buy an extended warranty agreement. An extended warranty provides warranty protection beyond the manufacturer's original warranty. Because an extended warranty is priced and sold separately from the warranteed product, it essentially constitutes a separate sales transaction. So, rather than only worrying about how to recognize the contingent liability associated with an extended warranty, we face another accounting question: “When should the revenue from the sale of an extended warranty be recognized?”

   By the accrual concept, revenue is recognized when earned, not necessarily when cash is received. Because the earning process for an extended warranty continues over the entire warranty period, revenue should be recognized over the same period. However, cash typically is received up front, when the extended warranty is sold. So, revenue from separately priced extended warranty contracts is deferred as a liability at the time of sale and recognized on a straight-line basis over the contract period. Notice that this is similar to an advance payment for products or services that, as we discussed earlier, creates an “unearned revenue” liability to supply the products or services. We demonstrate accounting for extended warranties in Illustration 13-8.

ILLUSTRATION 13-8

Extended Warranty

Revenue from the extended warranty is recognized during the three years of the contract period.

 Brand Name Appliances sells major appliances that carry a one-year manufacturer's warranty. Customers are offered the opportunity at the time of purchase to also buy a three-year extended warranty for an additional charge. On January 3, 2011, Brand Name sold a $60 extended warranty, covering years 2012, 2013, and 2014.

January 3, 2011

December 31, 2012, 2013, 2014 (adjusting entries)

Cash (or accounts receivable) ........................................

60

  Unearned revenue—extended warranties ........................................

60

Unearned revenue—extended warranties ........................................

20

  Revenue—extended warranties ($60 ÷ 3) ........................................

20

   The costs incurred to satisfy customer claims under the extended warranties also will be recorded during the same three-year period, achieving a proper matching of revenues and expenses. If sufficient historical evidence indicates that the costs of satisfying customer claims will be incurred on other than a straight-line basis, revenue should be recognized by the same pattern (proportional to the costs).23

Premiums

Cash rebates have become commonplace. Cash register receipts, bar codes, rebate coupons, or other proofs of purchase often can be mailed to the manufacturer for cash rebates. Sometimes promotional offers promise premiums other than cash (like toys, dishes, and utensils) to buyers of certain products. Of course the purpose of these premium offers is to stimulate sales. So it follows that the estimated amount of the cash rebates or the cost of noncash premiums estimated to be given out represents both an expense and an estimated liability in the reporting period the product is sold. Like a manufacturer's warranty, this loss contingency almost always meets accrual criteria. As with warranties, even though it is difficult to predict whether a particular buyer will redeem a premium, it is much easier to predict the total number of premiums that will be redeemed based on experience with customer redemptions in similar circumstances. Premiums are illustrated in Illustration 13-9.

p. 711

  
ADDITIONAL CONSIDERATION

Accounting for contingencies is controversial. Many accountants dislike the idea of only recognizing a liability for a contingent loss when it is probable, and then reporting the liability at the best estimate of the future expenditure. The obvious alternative is fair value, which does not incorporate probability into determining whether to recognize a loss but rather considers probability when measuring the amount of loss. Recent changes in GAAP have adopted fair value approaches for some types of events that are contingent losses (or appear to be close relatives). Consider the following examples:

Illustration 13-7 uses a discounted expected cash flow approach to measure the contingent liability associated with an extended warranty. That approach approximates fair value.

Recall from Chapter 10 that asset retirement obligations are recorded at fair value when an asset is acquired. The offsetting liability is similar to a contingent liability because it is an uncertain future amount arising from the past purchase of the asset but is recorded at fair value.

Sometimes a company provides a guarantee that may require it to make payment to the guaranteed party based on some future event. For example, a company might guarantee the debt of an affiliated company, thus making it easier for that affiliate to obtain financing. Recent GAAP views this sort of guarantee as having two parts: (1) a certain “stand ready obligation” to meet the terms of the guarantee, and (2) the uncertain contingent obligation to make future payments depending on future events (for example, the affiliate defaulting on their debt). The “stand ready obligation” is recorded initially at fair value, while the contingent obligation is handled as an ordinary contingent loss.24

  

ILLUSTRATION 13-9

Premiums

The costs of promotional offers should be recorded as expenses in the same accounting period the products are sold.

  CMX Corporation offered $2 cash rebates on a particular model of hand-held hair dryers. To receive the rebate, customers must mail in a rebate coupon enclosed in the package plus the cash register receipt. Previous experience indicates that 30% of coupons will be redeemed. One million hair dryers were sold in 2011 and total payments to customers were $225,000.

Promotional expense (30% × $2 × 1,000,000) ......................

600,000

  Estimated premium liability ...................................................

        600,000

To record the estimated liability for premiums.

Estimated premium liability ...................................................

225,000

  Cash ..............................................................................

        225,000

To record payments to customers for coupons.

   The remaining liability of $375,000 is reported in the 2011 balance sheet and is reduced as future rebates are paid. The liability should be classified as current or long term depending on when future rebates are expected to be paid.

   Of course, if premiums actually are included in packages of products sold, no contingent liability is created. For example, the costs of toys in Cracker Jack boxes and cereal boxes, and phone cards and compact discs in drink cartons are simply expenses of the period the product is sold, for which the amount is readily determinable.

Litigation Claims

Pending litigation similar to that disclosed by Flextronics in Graphic 13-7 on page 706 is not unusual. In fact, the majority of medium and large corporations annually report loss contingencies due to litigation. By far the most common disclosure is nonspecific regarding the actual litigation but uses wording similar to this contingency disclosure from Pfizer's 2008 annual report (Graphic 13-11).

p. 712

  
ADDITIONAL CONSIDERATION

Cents-off coupons are a popular marketing tool. Coupons clipped from newspapers, from mail offers, or included in packages are redeemable for cash discounts at the time promoted items are purchased. Issuing the coupons creates a contingent liability to be recorded in the period the coupons are issued. However, because the hoped-for sales don't materialize until later, a question arises as to when the related expense should be recognized. Logically, since the purpose of coupon offers is to stimulate sales, the expense properly should be deferred as an asset until the coupons are redeemed (when the future sales occur).

Illustration

On December 18, 2011, Craft Foods distributed coupons in newspaper inserts offering 50 cents off the purchase price of one of its cereal brands when coupons are presented to retailers. Retailers are reimbursed by Craft for the face amount of coupons plus 10% for handling. Previous experience indicates that 20% of coupons will be redeemed. Coupons issued had a total face amount of $1,000,000 and total payments to retailers in 2011 were $50,000. Retailers were paid $170,000 in 2012.

Promotional expense (redeemed in 2011) ..................................

50,000

  Cash ........................................................................................

50,000

To record payments to retailers for coupons in 2011.

Deferred promotional expense (an asset) .....................................

170,000

 Estimated coupon liability ([20% × $1,000,000 × 1.10] − $50,000)..................

170,000

To record the estimated liability for coupons at end of 2011.

Estimated coupon liability ...........................................................

170,000

  Cash .......................................................................................

170,000

Promotional expense (redeemed in 2012) .................................

170,000

  Deferred promotional expense ................................................

170,000

To record payments to retailers for coupons in 2012.

   This situation, though prevalent, is not addressed by promulgated accounting standards. In practice, most firms either (a) recognize the entire expense with the liability in the period the coupons are issued, like we record premiums, or (b) recognize no liability in the period the coupons are issued, recording the expense when reimbursements are made. One reason is that the same coupons are reissued periodically, making it difficult to associate specific reimbursements with specific offers. Another reason is that the time lag between the time a merchant receives a coupon from customers and the time it's presented to the manufacturer for reimbursement prevents appropriate apportionment of the expense.

GRAPHIC 13-11
Disclosure of Litigation Contingencies—Pfizer.
Real World Financials

 

Note 19: Legal Proceedings and Contingencies (in part) Legal Proceedings

We and certain of our subsidiaries are involved in various patent, product liability, consumer, commercial, securities, environmental and tax litigations and claims, government investigations, and other legal proceedings that arise from time to time in the ordinary course of our business. Litigation is inherently unpredictable, and excessive verdicts do occur. Although we believe we have substantial defenses in these matters, we could in the future incur judgments or enter into settlements of claims that could have a material adverse effect on our results of operations in any particular period.

   In practice, accrual of a loss from pending or ongoing litigation is rare. Can you guess why? Suppose you are chief financial officer of Feinz Foods. Feinz is the defendant in a $44 million class action suit. The company's legal counsel informally advises you that the chance the company will win the lawsuit is quite doubtful. Counsel feels the company might lose $30 million. Now suppose you decide to accrue a $30 million loss in your financial statements. Later, in the courtroom, your disclosure that Feinz management feels it is probable that the company will lose $30 million would be welcome ammunition for the opposing legal counsel. Understanding this, most companies rely on the knowledge that in today's legal environment the outcome of litigation is highly uncertain, making likelihood predictions difficult. Companies may accrue estimated lawyer fees and other legal costs, but usually do not record a loss until after the ultimate settlement has been reached or negotiations for settlement are substantially completed. Instead, disclosure notes typically describe the specifics of the litigation along with whether management feels an adverse outcome would materially affect the financial position of the company. As you can see in Graphic 13-12, the Las Vegas Sands Corporation, in a recent quarterly report, disclosed but did not accrue damages from a lawsuit it lost, even after the award was affirmed by trial court, because the company was appealing the verdict.

p. 713

GRAPHIC 13-12
Disclosure of a Lawsuit—Las Vegas Sands Corporation
Real World Financials

 

8: Commitments and Contingencies Litigation Relating to Macao Operations (in part)

…. , On June 30, 2008, a judgment was entered in this matter in the amount of $58.6 million (including pre-judgment interest)… . The Company intends to continue to vigorously pursue available appeals up to the Nevada Supreme Court. The Company believes that it has valid bases in law and fact to overturn or appeal the verdict. As a result, the Company believes that the likelihood that the amount of the judgment will be affirmed is not probable, and, accordingly, that the amount of any loss cannot be reasonably estimated at this time. Because the Company believes that this potential loss is not probable or estimable, it has not recorded any reserves or contingencies related to this legal matter. In the event that the Company's assumptions used to evaluate this matter as neither probable nor estimable change in future periods, it may be required to record a liability for an adverse outcome.

Subsequent Events

It's important to remember that several weeks usually pass between the end of a company's fiscal year and the date the financial statements for that year actually are issued or available to be issued.25 Events occurring during this period can be used to clarify the nature of financial statement elements at the report date. This situation can be represented by the following time line:

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   For instance, if information becomes available that sheds light on a legal claim that existed when the fiscal year ended, that information should be used in determining the probability of a loss contingency materializing and in estimating the amount of the loss. The settlement of a lawsuit after the December 31 report date of ADESA, Inc., apparently influenced its accrual of a loss contingency (Graphic 13-13).

 When the cause of a loss contingency occurs before the year-end, a clarifying event financial statements are issued can be to determine how the contingency is reported.

GRAPHIC 13-13
Accrual of Litigation Contingencies—ADESA, Inc.
Real World Financials

 

Note 21 Commitments and Contingencies (in part)

In January 2007, the settlement agreement was finalized and the federal district court formally dismissed the litigation. The Company recorded provisions totaling approximately $0.6 million in the third quarter of 2006. . . .

p. 714

   For a loss contingency to be accrued, the cause of the lawsuit must have occurred before the accounting period ended. It’s not necessary that the lawsuit actually was filed during that reporting period.

   Sometimes, the cause of a loss contingency occurs after the end of the year but before the financial statements are issued:

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 If an event giving rise to a contingency occurs after the year-end, a liability should not be accrued.

   When a contingency comes into existence after the company's fiscal year-end, a liability cannot be accrued because it didn't exist at the end of the year. However, if the failure to disclose the possible loss would cause the financial statements to be misleading, the situation should be described in a disclosure note, including the effect of the possible loss on key accounting numbers affected.26

   In fact, any event occurring after the fiscal year-end but before the financial statements are issued that has a material effect on the company's financial position must be disclosed in a subsequent events disclosure note. Examples are an issuance of debt or equity securities, a business combination, and discontinued operations.

   A disclosure note of Pfizer from its 2008 annual report is shown in Graphic 13-14 and describes an event that occurred in the first quarter of 2009.

GRAPHIC 13-14
Subsequent Events—Pfizer
Real World Financials

 

21. Subsequent events (in part)

On January 26, 2009, we announced that we have entered into a definitive merger agreement under which we will acquire Wyeth in a cash-and-stock transaction valued on that date at $50.19 per share, or a total of $68 billion. We plan to finance this acquisition with a combination of cash (about $22.5 billion), debt financing (about $22.5 billion) and the issuance of common stock (about $23.0 billion, based on the price of our common stock on January 23, 2009, the last trading day prior to our announcement on January 26). We have received a commitment from a syndicate of banks for the debt financing related to this transaction.

  
ADDITIONAL CONSIDERATION

Contingent liabilities that a company acquires when it purchases another company are treated differently from those that arise during the normal course of business. GAAP for business combinations requires that accounting for an acquired contingency depends on whether the contingency is contractual (arising from a contract, such as a warranty agreement) or non-contractual (arising in some other way, such as litigation). Non-contractual contingencies are ignored if they are not viewed as “more likely than not.” All other contingencies (whether contractual or non-contractual) are recognized at fair value as of the acquisition date. In the future, the contingent liability is shown in the balance sheet at the higher of acquisition-date fair value or the amount that would be recognized under FASB ASC 450—Contingencies (previously SFAS No. 5) if the contingent liability arose in the normal course of business. Any quarter-by-quarter changes are reported as gains or losses in the income statement.27

  


p. 715

Unasserted Claims and Assessments

Even if a claim has yet to be made when the financial statements are issued, a contingency may warrant accrual or disclosure. However, an unfiled lawsuit or an unasserted claim or assessment need not be disclosed unless it is probable that the suit, claim, or assessment will occur. If it is probable, then the likelihood of an unfavorable outcome and the feasibility of estimating a dollar amount should be considered in deciding whether and how to report the possible loss.

   For example, suppose a trucking company frequently transports hazardous waste materials and is subject to environmental laws and regulations. Management has identified several sites at which it is or may be liable for remediation. For those sites for which no penalties have been asserted, management must assess the likelihood that a claim will be made, and if so, whether the company actually will be held liable. If management feels an assessment is probable, an estimated loss and contingent liability would be accrued only if an unfavorable outcome is probable and the amount can be reasonably estimated. However, a disclosure note alone would be appropriate if an unfavorable settlement is only reasonably possible or if the settlement is probable but cannot be reasonably estimated. No action is needed if chances of that outcome occurring are remote. Notice that when the claim or assessment is unasserted as yet, a two-step process is involved in deciding how it should be reported:

 It must be probable that an unasserted claim or assessment or an unfiled lawsuit will occur before considering whether and how to report the possible loss.

1.

 

Is a claim or assessment probable? (If the answer to this question is no, no disclosure is needed; skip step 2.)

2.

 

Only if a claim or assessment is probable should we evaluate (a) the likelihood of an unfavorable outcome and (b) whether the dollar amount can be estimated.

   If the conclusion of step 1 is that the claim or assessment is not probable, no further action is required. If the conclusion of step 1 is that the claim or assessment is probable, the decision as to whether or not a liability is accrued or disclosed is precisely the same as when the claim or assessment already has been asserted.

   As described in a March 31, 2009, disclosure note (see Graphic 13-15), Union Pacific felt that some unasserted claims met the criteria for accrual under this two-step decision process.

GRAPHIC 13-15
Unasserted Claims—Union Pacific Corporation
Real World Financials

 

15. Commitments and Contingencies (in part)

Asserted and Unasserted Claims—Various claims and lawsuits are pending against us and certain of our subsidiaries. We cannot fully determine the effect of all asserted and unasserted claims on our consolidated results of operations, financial condition, or liquidity; however, to the extent possible, where asserted and unasserted claims are considered probable and where such claims can be reasonably estimated, we have recorded a liability.

   Notice that the treatment of contingent liabilities is consistent with the accepted definition of liabilities as (a) probable, future sacrifices of economic benefits (b) that arise from present obligations to other entities and (c) that result from past transactions or events.28 The inherent uncertainty involved with contingent liabilities means additional care is required to determine whether future sacrifices of economic benefits are probable and whether the amount of the sacrifices can be quantified.

p. 716

INTERNATIONAL FINANCIAL REPORTING STANDARDS

 

Contingencies. Accounting for contingencies is part of a broader international standard, IAS No. 37, “Provisions, Contingent Liabilities and Contingent Assets.” Overall, accounting for contingent losses currently is quite similar between IFRS and U.S. GAAP. A loss contingency is accrued under U.S. GAAP if it's both probable and can be reasonably estimated. IFRS is similar, but defines “probable” as “more likely than not,” which is a lower threshold than typically associated with “probable” in U.S. GAAP. Also, IFRS refers to these accrued liabilities as “provisions,” and refers to possible obligations that are not accrued as “contingent liabilities,” while the term “contingent liabilities” is used for all of these obligations in U.S. GAAP. And, if there is a range of equally likely outcomes associated with a contingency, IFRS requires using the midpoint of the range, while U.S. GAAP requires use of the low end of the range.

   Another difference in accounting relates to whether to report a long-term contingency at its expected future value or its present value. IFRS requires reporting present values of estimated cash flows when the effect of time value of money is material. U.S. GAAP allows using present values under some circumstances when the timing of cash flows is fixed or reliably determinable.29

   Here's a portion of a footnote from the 2009 financial statements of Vodafone, which reports under IFRS:

      

Note 2: Signifcant Accounting Policies (in part)

Provisions are recognised when the Group has a present obligation (legal or constructive) as a result of a past event, it is probable that the Group will be required to settle that obligation and a reliable estimate can be made of the amount of the obligation. Provisions are measured at the directors' best estimate of the expenditure required to settle the obligation at the balance sheet date and are discounted to present value where the effect is material.

      
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IFRS ILLUSTRATION

 

Real World Financials

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WHERE WE'RE HEADED
 

The controversy over accounting for contingencies and mixture of approaches is likely to continue. The FASB recently removed from their agenda a project to reconsider the recognition and measurement of contingent losses, but may revisit the issue in the future. In the meantime, the FASB has a project ongoing that is intended to enhance footnote disclosures of contingent losses. The IASB has a project ongoing that is likely to move closer to fair-value recognition of contingencies. In particular, it is likely that the IASB will eliminate the requirement that an amount be “probable” to be recognized, such that amounts that now are currently only disclosed in the footnotes will be accrued and included as expenses and liabilities. Probability of loss will still matter, but only will be factored into measuring the expected value of the liability.30

 

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20Because FASB ASC 740–10–25: Income Taxes–Overall–Recognition (previously “Accounting for Uncertainty in Income Taxes,” FASB Interpretation No. 48 (Norwalk, Conn.: FASB, 2006)) provides guidance on accounting for uncertainty in income taxes, FASB ASC 450–10: Contingencies–Loss Contingencies (previously SFAS No. 5) no longer applies to income taxes. GAAP regarding uncertainty in income taxes changes the threshold for recognition of tax positions from the most probable amount to the amount that has a “more likely than not” chance of being sustained upon examination. We discuss accounting for uncertainty in income taxes in .

21FASB ASC 450–20–30: Contingencies–Loss Contingencies–Initial Measurement (previously “Reasonable Estimation of the Amount of the Loss,” FASB Interpretation No. 14 (Stamford, Conn.: FASB, 1976)).

22“Using Cash Flow Information and Present Value in Accounting Measurements,” Statement of Financial Accounting Concepts No. 7 (Norwalk, Conn.: FASB, 2000). Recall that Concept Statements do not directly prescribe GAAP, but instead provide structure and direction to financial accounting.

23FASB ASC 605–20–25: Revenue Recognition–Services–Recognition (previously “Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts,” FASB Technical Bulletin 90-1, 1990.)

24FASB ASC 460–10–25: Guarantees–Overall–Recognition (previously “Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” FASB Interpretation No. 45 (Stamford, Conn.: FASB, 2002)).

25Financial statements are viewed as issued if they have been widely distributed to financial statement users in a format consistent with GAAP. Some entities (for example, private companies) do not widely distribute their financial statements to users. For those entities, the key date for subsequent events is not the date of issuance but rather the date upon which the financial statements are available to be issued, which occurs when the financial statements are complete, in a format consistent with GAAP, and have obtained the necessary approvals for issuance. Entities must disclose the date through which subsequent events have been evaluated (FASB ASC 855: Subsequent Events (previously “Subsequent Events,” Statement of Financial Accounting Standards No. 165 (Stamford, Conn.: FASB, 2009)).

26FASB ASC 450–20–50v9: Contingencies—Loss Contingencies—Disclosure (previously “Accounting for Contingencies,” Statement of Financial Accounting Standards No. 5 (Stamford, Conn.: FASB, 1975), par. 11).

27FASB ASC 805-20-25: Business Combinations—Identifiable Assets and Liabilities, and Any Noncontrolling Interest—Recognition (previously “Business Combinations,” Statement of Financial Accounting Standards No. 141R (Stamford, Conn.: FASB, 1975)).

28“Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, 1985).

29FASB ASC 410–30–35–12: Asset Retirements and Environmental Obligations–Environmental Obligations–Subsequent Measurement.

30Exposure Draft of Proposed Amendments to IAS 37 Provisions, Contingent Liabilities and Contingent Assets and IAS 19 Employee Benefits, IASB, June 2005.

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