2.1 Overview
ASC 450 defines a loss contingency as “[a]n 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.”
Resolution of uncertainty in the context of a loss contingency may confirm the loss,
the impairment of an asset, or the incurrence of a liability. This chapter provides
an overview of the scoping, recognition, measurement, and disclosure requirements
for loss contingencies, along with certain interpretive guidance on accounting for
them.
Contingent liabilities are liabilities for which the possible loss
outcome is unknown or uncertain, such as pending or threatened litigation, actual or
possible claims, or product defects. Uncertainty is inherent in all loss
contingencies. The terms “probable,” “reasonably possible,” and “remote” in ASC
450-20 are used to determine the likelihood of the future event that will confirm a
loss, an impairment of an asset, or the incurrence of a liability. No quantitative
characteristics are provided in the codified definitions; accordingly, entities need
to exercise judgment when applying the terms.
Accrual of a loss contingency is required when (1) it is probable that a loss has
been incurred and (2) the amount can be reasonably estimated. An entity must
determine the probability of the uncertain event and demonstrate its ability to
reasonably estimate the loss from it to accrue a loss contingency. Loss
contingencies that do not meet both of these criteria for recognition may need to be
disclosed in the financial statements.
Typically, under the accounting literature, an entity uses either a
probability-based model or a fair value model when dealing with uncertainty related
to losses. The probability-based recognition guidance in ASC 450-20 differs from
that in other Codification topics under which an entity measures liabilities in
accordance with a fair value objective. To measure a liability at fair value, an
entity must consider events whose occurrence is less than probable. Therefore, a
fair value measurement will result in the recognition of a liability for a
conditional obligation for which the likelihood of future settlement, although more
than zero, is less than probable; a liability would not be recognized in this
situation under the guidance in ASC 450-20 that applies to loss contingencies.
2.1.1 Relationship Between Recognized Loss Contingencies and Reserves
As indicated in ASC 450-20-05-8 and 05-9, when accruing a loss contingency, an
entity does not create or set aside funds to lessen the possible financial
impact of a loss. ASC 450-20-05-8 states, in part:
Confusion
exists between accounting accruals (sometimes referred to as accounting
reserves) and the reserving or setting aside of specific assets to be used
for a particular purpose or contingency. Accounting accruals are simply a
method of allocating costs among accounting periods and have no effect on an
entity’s cash flow. Those accruals in no way protect the assets available to
replace or repair uninsured property that may be lost or damaged, or to
satisfy claims that are not covered by insurance, or, in the case of
insurance entities, to satisfy the claims of insured parties. Accrual, in
and of itself, provides no financial protection that is not available in the
absence of accrual.
In addition, ASC 450-20-05-9 states:
An
entity may choose to maintain or have access to sufficient liquid assets to
replace or repair lost or damaged property or to pay claims in case a loss
occurs. Alternatively, it may transfer the risk to others by purchasing
insurance. The accounting standards set forth in this Subtopic do not affect
the fundamental business economics of that decision. That is a financial
decision, and if an entity’s management decides to do neither, the presence
or absence of an accrued credit balance on the balance sheet will have no
effect on the consequences of that decision. Insurance or reinsurance
reduces or eliminates risks and the inherent earnings fluctuations that
accompany risks. Unlike insurance and reinsurance, the use of accounting
reserves does not reduce or eliminate risk. The use of accounting reserves
is not an alternative to insurance and reinsurance in protecting against
risk. Earnings fluctuations are inherent in risk retention, and they are
reported as they occur.
Further, in a manner consistent with ASC 450-20-50-1, which
requires entities to disclose the nature of recognized accruals, entities should
refrain from using the term “reserves” when referring to the accrual of a loss
contingency.