2.2 Scope
ASC 450-20
15-2 The
following transactions are excluded from the scope of this
Subtopic because they are addressed elsewhere in the
Codification:
- Stock issued to employees, which is discussed in Topic 718.
- Employment-related costs, including deferred compensation contracts, which are discussed in Topics 710, 712, and 715. However, certain postemployment benefits are included in the scope of this Subtopic through application of paragraphs 712-10-25-4 through 25-5.
- Uncertainty in income taxes, which is discussed in Section 740-10-25.
- Accounting and reporting by insurance entities, which is discussed in Topic 944.
- Measurement of credit losses for instruments within the scope of Topic 326 on measurement of credit losses.
All loss contingencies should be evaluated under ASC 450-20 unless
they are within the scope of other authoritative literature. The table below
contains a nonexhaustive list of examples of contingencies or uncertainties that are
within the scope of other authoritative literature.
The sections below address certain scope-related topics.
2.2.1 Firmly Committed Executory Contracts
Although the ASC master glossary does not define “executory contract,” an entity
may find the following considerations useful in assessing the meaning of this
term:
- Although never finalized and ultimately removed from the EITF’s agenda, EITF Issue 03-17 refers to an executory contract as “a contract that remains wholly unperformed or for which there remains something to be done by either or both parties of the contract.”
- IAS 37 refers to an executory contract as a contract “under which neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent.”
The ASC master glossary defines a firm purchase commitment as “an agreement with
an unrelated party, binding on both parties and usually legally enforceable,”
that is both (1) specific in “all significant terms, including the price and
timing of the transaction,” and (2) “includes a disincentive for nonperformance
that is sufficiently large to make performance probable.” Disincentives for
nonperformance may be, for example, in the form of (1) a fixed payment
requirement for each period under the agreement regardless of whether the
purchaser takes delivery or (2) the inability of a purchaser to change the
contractual delivery and payment terms with a supplier without a penalty payment
for nonperformance.
At the inception of a firmly committed executory contract, both parties to the
contract expect to receive benefits from the contract that are equal to or
greater than the costs to be incurred under the contract. However, during the
term of the contract, the fair value of the remaining contractual rights may
unexpectedly decline below the remaining costs to be incurred, resulting in a
firmly committed executory “loss contract.”
When determining whether to recognize a contingent liability for
such a loss contract, entities should first consider the applicability of any
industry- and transaction-specific guidance. Firmly committed executory
contracts addressed under U.S. GAAP include the following:
- A firm purchase commitment for goods or inventory under ASC 330.
- Construction or production-type contracts within the scope of ASC 605-35 (see Deloitte’s Roadmap Revenue Recognition for a discussion of onerous performance obligations).
- Certain executory contracts subject to ASC 420 related to exit or disposal activities.
- An insurance contract with a premium deficiency subject to ASC 944-60.
- Certain derivative contracts within the scope of ASC 815.
The EITF discussed loss recognition for all other firmly
committed executory contracts (i.e., contracts not otherwise within the scope of
authoritative literature that provides recognition and measurement guidance on
losses in accordance with firmly committed executory arrangements) from the
perspective of the (1) buyer and (2) seller. However, the EITF was unable to
reach a consensus on these issues because of their broad scope and recommended
that the FASB add a project on executory contracts to its agenda. Currently,
there is no authoritative accounting guidance, other than that referred to
above, that would support the recognition of a contingent liability when the
fair value of remaining contractual rights under a firmly committed executory
contract declines below the remaining costs to be incurred.
While the EITF did not provide authoritative guidance on the
recognition of a liability for a loss contract, on the basis of comments by the
SEC staff, it is generally inappropriate to accrue for a loss related to a
firmly committed executory contract unless there is specific authoritative
literature to the contrary. However, regardless of whether an entity has
recognized a liability related to a firmly committed executory contract, the
entity should consider the need for disclosure of the arrangement in the
financial statements to prevent the financial statements from being misleading.
In addition, SEC registrants should consider whether commitments related to
executory contracts should be included in their SEC Regulation S-K disclosures
(e.g., within MD&A). See Section 2.8.4 for a discussion of the disclosure requirements
for firmly committed executory contracts.
2.2.2 Application of ASC 450 to Employee Benefit Arrangements
Compensation to executives and employees in addition to base salary
or wages can take many forms, including (1) share-based payment arrangements; (2)
deferred compensation or bonus plans; and (3) postemployment benefit, postretirement
benefit, and special termination or early retirement plans. The specific accounting
requirements vary depending on the nature of the compensation arrangement. ASC 450
should be applied to certain compensation or benefit plans that are not specifically
addressed by other authoritative accounting literature (e.g., certain cash bonus
arrangements).
In addition, certain compensation arrangements are accounted for in
accordance with ASC 710 and not ASC 450 when specific conditions are met. For
instance, certain postemployment benefits within the scope of ASC 7121 that meet the following conditions as defined in ASC 710-10-25-1 are accounted
for in accordance with ASC 710-10:
- The employer’s obligation to provide an employee with postemployment compensation is attributed to the employee’s services already rendered.
- “The obligation relates to rights that vest or accumulate.”
- “Payment of the compensation is probable.”
- “The amount can be reasonably estimated.”
However, ASC 712-10-25-5 requires that certain postemployment benefits that do not
meet the above conditions be accounted for in accordance with ASC 450-20-25-2 when
the loss is probable and can be reasonably estimated.
Example 2-1
Postemployment
Benefits
Two weeks of workers’ compensation benefits
may be available to employees in the event of a disability.
Additional years of service do not result in an increased
workers’ compensation benefit. This type of nonvesting and
nonaccumulating postemployment benefit plan is accounted for
in accordance with ASC 450-20-25-2. Upon the occurrence of
the event that gives rise to the liability (i.e., the injury
that entitles the employee to disability benefits), the
associated estimated stream of future cash flows is accrued.
In contrast, ASC 712-10-25-4 requires that postemployment
benefits that vest or accumulate be accrued as service is
performed.
See Section 2.3.2.7 for a discussion of the recognition of
liabilities related to annual bonus plans.
2.2.3 Collectibility of Receivables
Entities must apply the current expected credit loss (CECL) model to
receivables and other financial instruments that are within the scope of ASC 326-20.
Under the CECL model, receivables that are expected to be uncollectible but do not
yet meet the “probable” threshold will result in recognition of losses. Accordingly,
credit losses resulting from receivables and other financial instruments within the
scope of ASC 326-20 are outside the scope of ASC 450-20. However, the incurred loss
model in ASC 450-20 continues to apply to certain financial instruments that are not
within the scope of ASC 326-20. For more information about the scope, recognition,
and measurement guidance in ASC 326-20, see Deloitte’s Roadmap Current Expected Credit
Losses.
2.2.4 Differentiating Between Contingent Liabilities and Contractual or Legal Liabilities
Contingent liabilities involve uncertainty about whether a loss has
been incurred and differ from contractual liabilities. Therefore, an entity must
distinguish between a contingent liability, which is within the scope of ASC 450-20,
and a contractual or legal liability, which is not. Contingent liabilities comprise
only liabilities in which an entity’s obligation to pay another entity is uncertain.
Contractual or legal liabilities are debts or obligations between two or more
parties that are typically settled by the transfer of cash, assets, or services; for
these liabilities, there is generally little to no uncertainty about the likelihood
of occurrence of the future settlement. A liability is not an unasserted claim or
assessment under ASC 450-20 if the settlement of the liability is required by law or
by contract.
Liabilities established by law or by contract are recorded at the
stated amounts due unless otherwise indicated in U.S. GAAP. The probability of
payment is not relevant to the accounting for such liabilities.2 If an entity is required by law, regulation, or contract to make a future
payment associated with an event that has already occurred, that event imposes a
present duty upon the entity. An entity’s uncertainty about whether an obligee will
require performance does not allow the entity to choose to avoid the future
sacrifice, nor does the uncertainty relieve the entity of the obligation. That is,
when the obligating event has occurred, the entity has incurred a liability;
accordingly, there is no contingency. For example, an entity must recognize accounts
payable on the basis of the amount that it is contractually required to pay. The
entity may not recognize accounts payable on the basis of the amount that it would
expect to ultimately pay if the creditor filed suit to collect the liability. This
conclusion is supported by analogy to ASC 410-20-25-15, which states that an
“unambiguous requirement that gives rise to an asset retirement obligation coupled
with a low likelihood of required performance still requires recognition of a
liability.” Once recognized, a contractual or legal liability that is not deferred
revenue (i.e., a contract liability under ASC 606) should be derecognized only when
the conditions for liability derecognition in ASC 405-20-40-1 have been met.
ASC 405-20
40-1 Unless addressed by other
guidance (for example, paragraphs 405-20-40-3 through 40-4
or paragraphs 606-10-55-46 through 55-49), a debtor shall
derecognize a liability if and only if it has been
extinguished. A liability has been extinguished if either of
the following conditions is met:
- The debtor pays the creditor and is
relieved of its obligation for the liability. Paying
the creditor includes the following:
- Delivery of cash
- Delivery of other financial assets
- Delivery of goods or services
- Reacquisition by the debtor of its outstanding debt securities whether the securities are cancelled or held as so-called treasury bonds.
- The debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor. For purposes of applying this Subtopic, a sale and related assumption effectively accomplish a legal release if nonrecourse debt (such as certain mortgage loans) is assumed by a third party in conjunction with the sale of an asset that serves as sole collateral for that debt.
A contractual or legal liability is subject to the above liability
derecognition guidance regardless of whether an entity believes that, on the basis
of a probability assessment, such a liability can be settled for less than the
stated legal obligation.
The examples below illustrate the accounting for a liability for
which payment is required by law or contract but detection and settlement are
uncertain.
Example 2-2
Probability Assessment
Related to Sales Tax Liability for Which Payment Is
Required by Law but Detection and Settlement Are
Uncertain
Entity Z has sold goods in Jurisdiction Y
for 15 years and continues to sell them. By law, those sales
would be subject to sales tax in Y if Z had nexus there. To
assess whether Z has sales tax nexus in Y and should record
a sales tax liability, Z diligently reviews prior-period
sales records and interviews sales managers. Through this
analysis, Z determines and documents that sales tax nexus in
Y has existed for the past 15 years. Therefore, Z’s products
have always been taxable and subject to sales tax
collection; however, Z has never collected sales tax or
filed sales tax returns in Y. Entity Z has never been
audited or contacted regarding a sales tax audit by tax
authorities in Y. Entity Z believes that the risk of
detection by the tax authorities in Y is low. However, if
the tax authorities in Y were presented with all the facts
about Z’s activities, Z believes that it is probable that Y
would assert that Z is liable for uncollected sales taxes
and demand payment. Entity Z believes that Y would settle
for an amount less than the full liability.
Entity Z should record a sales tax liability
on the basis of its sales activities for the full amount
that it is legally obligated to remit to the tax authorities
in Y. The sale of goods triggers the obligation to make the
related sales tax payments. In measuring its sales tax
liability, Z may not consider that the risk of detection by
the tax authorities in Y is low. Further, Z must assume that
the tax authorities in Y have all the relevant facts about
Z’s operations in Y. Interest and penalties should also be
included in the estimate of the liability if the imposition
of interest and penalties is required by law.
Note that some state tax authorities may
have a widely understood administrative practice and
precedent in which, in the event of an examination and in
the absence of a voluntary disclosure agreement, the tax
authority would look back no more than a certain number of
years to determine the amount of sales tax deficiency due.
Alternatively, a statute of limitations may exist. Thus, Z
should evaluate whether the tax authorities in Y will assess
Z back to the first year of taxable sales (i.e., the full 15
years) or whether the liability will be limited by a statute
of limitations or Y’s administrative policies. In performing
this evaluation, Z must use judgment to determine what
constitutes “widely understood.” If Z asserts that an
administrative practice and precedent is widely understood,
Z should document the basis of that assertion as well as any
evidence to support it. Such evidence may include reliable
knowledge of the tax authority’s past dealings with Z on the
same tax matter when the facts and circumstances were
similar. An assessment of what Z believes it could negotiate
as a settlement with the tax authority would generally not
represent a “widely understood” administrative practice and
precedent.
Similarly, Z should also adjust its
liability to the extent that its customers have paid use tax
on any portion of Z’s sales during any part of the look-back
period. However, because the obligating event is the sale of
goods, Z should not record a sales tax liability for future
sales until those sales actually occur.
Entity Z should regularly assess its sales
tax obligations in the jurisdictions in which it conducts
business. If Z has any uncertainty about those obligations,
Z might need to obtain legal opinions. Sales tax liabilities
should be adjusted upward as sales are made and should be
adjusted downward only when the liability is paid or
otherwise extinguished. (Note that sales taxes are not
within the scope of ASC 740.)
Example 2-3
Royalty Liability for
Which Payment Is Required by Contract but Detection and
Settlement Are Uncertain
Company Y manufactures technical equipment
and has a contractual obligation to pay, on the basis of
sales volume, royalties to various patent holders. The
amount of royalties paid each period is calculated by Y. In
accordance with this obligation, patent holders have the
right to audit Y’s sales volume, but they have rarely
exercised this right.
Company Y should record a royalty liability
for the full amount that it is contractually obligated to
pay according to the royalty agreements. The contracts
require Y to make royalty payments on the basis of sales
volume. Therefore, Y is under an obligation to the patent
holders as the equipment is sold (i.e., Y has a present duty
to the patent holders). The liability should be adjusted
upward as sales are made and should be adjusted downward
only when the liability is paid or otherwise extinguished in
accordance with ASC 405-20-40-1.
In a scenario in which a patent holder
cannot be located, Y should consider whether liability
derecognition has occurred once the escheat laws of the
relevant jurisdiction are complied with and the obligation
no longer exists. Company Y’s uncertainty about whether a
patent holder will audit the sales volume does not allow it
to avoid future payment. Finally, Y should not record a
royalty liability for future sales until those sales
actually occur.
Connecting the Dots
There may be uncertainty about whether an entity is subject to or within the
scope of a current law, regulation, or contract owing to ambiguity about the
interpretation of the current law, regulation, or contract. Examples include
uncertainties related to a tax based on gross receipts, revenue, or capital.
In these circumstances, an entity should evaluate the uncertainty in
accordance with the flowchart below.
The example below illustrates the analysis an entity would perform
in determining whether (1) it has a liability that is subject to contract, law, or
regulation or (2) the uncertainty should instead be accounted for in accordance with
ASC 450-20.
Example 2-4
Determining Whether an
Entity Is Subject to a Disputed Contractual Executory
Agreement
Company B manufactures and sells glass
containers for beverages and food. On January 6, B enters
into a contractual agreement with Vendor T to develop an
inventory management system, customized to B’s specific
needs. It is estimated that the project will take 18 months
and will cost $1.5 million, payable in equal quarterly
installments or $250,000 for services provided to date. The
agreement can be terminated only for cause and includes no
termination penalty; however, B will be liable for $1.5
million unless T breaches the contract.
Six months into the system development,
despite assurance provided by T, B realizes that the system
T is developing will not be able to perform certain
functions B deems essential to a new glass bottle
manufacturing and distribution inventory management system.
On September 1, before the third quarterly installment is
due to T for services performed to date, B’s legal counsel
sends a breach of contract notice to T. The notice indicates
that B is not receiving the inventory management system it
had contracted for. Upon receipt of the notice, T ceases
performing all services on September 1. Because B has
terminated the executory contract with T by providing a
breach of contract notice, and T has ceased performing
services, as of the third quarter ended September 30, B
determines that it is not contractually obligated for any
remaining unpaid amounts in accordance with the contract for
unperformed services. Accordingly, B compensates T for
third-quarter services received through September 1. Company
B will separately assess, in accordance with ASC 450-20,
whether a contingent liability exists for amounts that would
have otherwise been due (through either September 30 or the
end of the 18-month contract term) if the contract had not
been terminated. If B determines that T is disputing the
termination of the executory contract, B should determine
whether the contingent liability recognition criteria have
been met in accordance with ASC 450-20-25 and should provide
adequate disclosures related to the contract and
dispute.
2.2.5 Elements of a Litigation Settlement
There may be litigation settlements in which the settlement
agreement includes past obligations and disputes and modifies the ongoing
contractual terms of the business relationship. When accounting for a litigation
settlement that also includes a separate element (such as a revenue element) and
bifurcating the elements, an entity should consider a speech made by Eric West, associate chief accountant in the
SEC’s Office of the Chief Accountant, at the 2007 AICPA Conference on Current SEC
and PCAOB Developments. We consider the interpretive guidance shared by Mr. West to
be relevant and useful to private companies in addition to SEC registrants. Mr. West
summarized a settlement arrangement as follows:
[A] company pays
cash and conveys licenses to a plaintiff in order to settle a patent
infringement and misappropriation of trade secrets claim. In exchange for the
payment and licenses given, the company receives a promise to drop the patent
infringement lawsuit, a covenant not to sue with respect to the misappropriation
of trade secrets claim, and a license to use the patents subject to the
litigation.
Mr. West noted that the different elements of the arrangement should
be identified and that an entity will need to understand the nature of each item to
make this identification. In addition to the litigation settlement component, there
could be recognizable intangible assets related to the covenant not to sue and for
patent licenses received. Regarding the license to patents given to the plaintiff,
Mr. West noted:
If the licenses are expected to be used by the
plaintiff in their operations, it may be appropriate for the company to
recognize revenue or income with a corresponding increase in litigation
settlement expense. However, if the licenses are given as part of a litigation
defense strategy and don’t have value to the plaintiff, it seems unlikely that
any revenue should be recognized.
With respect to the amount of consideration to allocate to each element of the
transaction, Mr. West noted the following:
While EITF 00-21 was written for
multiple element revenue arrangements, we believe that its allocation guidance
is also useful to determine how to allocate consideration paid in a multiple
element legal settlement. In this regard, we believe that it would be acceptable
to value each element of the arrangement and allocate the consideration paid to
each element using relative fair values. [Footnote omitted]
Even though Mr. West was speaking about the separation guidance in EITF Issue 00-21, which was codified in ASC 605-25 and has been superseded by ASC
606, it is still appropriate for an entity to consider the principles of separation
of performance obligations within the context of the revenue guidance in ASC 606.
Specifically, as shown below, ASC 606 includes guidance on how to allocate
consideration to different elements of a contract with a customer that are partially
within the scope of ASC 606 and partially within the scope of another topic.
ASC 606-10
15-4 A contract with a customer
may be partially within the scope of this Topic and
partially within the scope of other Topics listed in
paragraph 606-10-15-2.
- If the other Topics specify how to separate and/or initially measure one or more parts of the contract, then an entity shall first apply the separation and/or measurement guidance in those Topics. An entity shall exclude from the transaction price the amount of the part (or parts) of the contract that are initially measured in accordance with other Topics and shall apply paragraphs 606-10-32-28 through 32-41 to allocate the amount of the transaction price that remains (if any) to each performance obligation within the scope of this Topic and to any other parts of the contract identified by paragraph 606-10-15-4(b).
- If the other Topics do not specify how to separate and/or initially measure one or more parts of the contract, then the entity shall apply the guidance in this Topic to separate and/or initially measure the part (or parts) of the contract.
Connecting the Dots
In an agreement that contains a settlement of a litigation
component and a revenue contract with a customer, an entity should bifurcate
the revenue element and the nonrevenue element (i.e., litigation) and
allocate the consideration to both elements in a manner consistent with Mr.
West’s remarks and ASC 606. There may be situations in which the entity has
clear, compelling evidence that there is little to no value related to the
litigation settlement; in those situations, the entire arrangement should be
accounted for as a single element under ASC 606. When the entity determines
that the entire arrangement should be accounted for as a single element
under ASC 606, it may be appropriate to allocate consideration for the
entire arrangement to the revenue element; however, the entity should not
apply the residual method and allocate all of the proceeds to the revenue
element by default..
The discussion above applies to both gain and loss
contingencies that are settled by entering into a revenue contract with a
customer. See Chapter
3 of Deloitte’s Roadmap Revenue Recognition for further
discussion of contracts that include both revenue and nonrevenue elements.
Chapter 7
of Deloitte’s Roadmap Revenue Recognition addresses estimating
stand-alone selling prices, including application of the residual
method.
Further, the same allocation principle applies when the
settlement does not contain a revenue element and is therefore entirely
outside the scope of ASC 606 (i.e., the settlement is not with a customer,
and none of the components constitute an output of the entity’s ordinary
activities). In those circumstances, an entity should still consider the
allocation principle described in Mr. West’s remarks and ASC 606 by
analogy.
2.2.6 Incurrence of a Future Cost of Doing Business
The incurrence of an obligation may represent the settlement of a past liability or a
future cost of doing business. The settlement of a lawsuit by agreeing to make a
cash payment in the absence of other elements of the settlement clearly represents
the settlement of a past liability that should be accrued immediately. Signing an
employment contract that guarantees an executive a fixed salary clearly represents a
future cost of doing business that should be accrued as the executive performs
service. However, it is not always clear how to distinguish between settlement of a
past liability and the incurrence of a future cost of doing business. Companies
sometimes settle litigation by altering the terms of future business arrangements,
which calls into question whether a present liability has been incurred.
Accordingly, an entity must consider all facts and circumstances to determine whether
an obligation represents the settlement of past liabilities or a cost of doing
business in the future. Sometimes it can be argued that the facts and circumstances
support both views, as demonstrated in the example below.
Example 2-5
Differentiating Between Settlement of a Past Liability and
a Future Cost of Doing Business
The Coal Industry Retiree Health Benefit Act of 1992 (the
“Act”) imposed a requirement on certain entities in the coal
industry to make payments to fund medical and death benefits
for retirees. ASC 930-715-25-1 states that “[e]ntities that
currently have operations in the coal industry shall account
for their obligation under the Act . . . either as
participation in a multiemployer plan,” which would be
expensed as payments are made, “or [as] a liability imposed
by the Act,” which would be accrued immediately. The
decision to allow such an accounting choice reflects the
difficulty of differentiating between the settlement of a
past liability and the incurrence of a future cost of doing
business.
The incurrence of a future cost of doing business is often indicated
by a payment stream that is contingent on the future sale of products or services in
the ordinary course of business (e.g., royalties due to a licensor for the license
and use of intellectual property). The future sale would be considered the event
giving rise to the liability. Additional evidence that a payment is, in substance, a
future cost of doing business is the inability to currently estimate the amount. It
may not be possible to reasonably estimate a payment that is contingent on a measure
such as future sales volume. Thus, a future cost of doing business would often fail
to qualify for recognition under ASC 450-20-25-2 because the obligating event has
not yet occurred, the amount is not reasonably estimable, or both.
Example 2-6
Liability Settled by
Incurring a Future Cost of Doing Business
A group of entities in the tobacco industry
settles litigation with a governmental body by agreeing to
higher future taxation. Under the terms of the agreement,
each company in the industry will pay a portion of the
settlement in proportion to its respective market share in
the preceding year. If a company exits the tobacco industry,
no additional payments are due.
The terms of the agreement specifically
preclude payment of the settlement out of existing assets;
rather, payments must be funded through future increases in
product prices. Because the settlement costs will be passed
through to the end consumer, the event giving rise to the
liability is the sale of products during future periods. No
present obligation has been incurred given that the tobacco
company could exit the tobacco industry immediately and
avoid the settlement payment. As a result, a liability
should be recorded when sales occur in the following year on
the basis of a pro rata portion of the following year’s
annual payment to the governmental body.
An entity may sometimes agree to settle a claim by agreeing to offer
the claimant(s) a price concession on future purchases of the entity’s goods or
services by the claimant(s). In such a scenario, the claimant(s) will be required to
make an independent future purchasing decision to realize the benefit of the
settlement. An entity that is obligated to provide such price concessions in
connection with a settlement will need to assess whether the settlement (1)
represents a liability that should be currently recognized for the estimated
settlement amount or (2) should be accounted for as a sales incentive in accordance
with ASC 606, which generally results in the entity’s accounting for the sales
incentive at the time the claimant or claimants use the price concession in
connection with the purchase of the entity’s goods or services.
While an entity may need to use significant judgment to determine
the appropriate accounting, a settlement with an existing customer (or group of
customers) that entitles such customer(s) to future price concessions for goods or
services, when the entity believes on the basis of compelling evidence that such
customer(s) would have purchased the goods or services in the absence of the
concession, could lead the entity to conclude that liability recognition is
appropriate provided that a reasonable estimate can be made. Alternatively, a
settlement with a claimant or claimants for future price concessions of the entity’s
goods or services, when there was no preexisting customer/vendor relationship, may
represent a situation in which such a settlement is in substance more akin to a
future price concession that should be accounted for in accordance with ASC 606
rather than a settlement of a prior liability. If the former view was taken for such
a fact pattern (i.e., the settlement is accounted for as a liability), the entity
may nonetheless conclude that it is unable to reasonably estimate the future price
concession (e.g., in a circumstance in which there is an insufficient sales history
with the claimant(s) or the concession is stated as a percentage of future sales of
an unknown quantity), meaning that not all of the recognition criteria in ASC
450-20-25-2 are met. Irrespective of when the future price concession is accounted
for, any settlement with a customer or a vendor would need to be evaluated in
accordance with ASC 606 or ASC 705-20, respectively, regarding the income statement
presentation of the settlement. See below for further discussion of the income
statement presentation for settlements with customers and vendors.
2.2.6.1 Income Statement Classification for Settlements With Customers and Vendors
When determining the appropriate income statement classification
of a litigation settlement with a counterparty that is a customer, the entity
should first look to the guidance on consideration payable to a customer in ASC
606-10-32-25 through 32-27 to determine whether the consideration is for a
distinct good or service for which the entity can reasonably estimate fair value
and, if so, classify such settlement payments in accordance with applicable U.S.
GAAP. Similarly, when a litigation settlement involves a counterparty that is a
vendor, the entity must consider ASC 705-20 to determine the appropriate income
statement presentation of the settlement.
When the settlement counterparty is a customer or a vendor and
the entity is able to determine the distinct litigation settlement benefit and
can reasonably estimate the fair value of the litigation settlement benefit, the
entity may recognize some or all of the settlement amount as an expense. To
determine the appropriate amount to recognize as an expense, entities should
consider the factors discussed in a speech made by Eric West, associate chief
accountant in the SEC’s Office of the Chief Accountant, at the 2007 AICPA
Conference on Current SEC and PCAOB Developments. Mr. West summarized the
classification of a settlement arrangement as follows:
Classification of the
Settlement
In the fact pattern that I’ve talked about so far it
would be appropriate to record the consideration allocated to the
litigation within operating expenses since the company did not have a
prior relationship with the plaintiff. However, we believe that a
different answer may result if the plaintiff is also a customer of the
defendant. Assume a company settles a claim for over
billing its customers for an amount that is in excess of the amounts
they over billed. The company believed that the excess payment was
necessary to preserve the customer relationship and had induced the
customer to settle the claim. In this case we do not believe that
classification of the entire payment as a settlement expense would
be consistent with existing GAAP. Since the settlement payment was
made to the company’s customers, we believe that the payment is
within the scope of EITF 01-9. [Footnote omitted] As you may know, this EITF addresses the accounting
for consideration given by a vendor to a customer. The scope is
broadly written and includes all consideration given by a vendor to
a customer. It also requires that cash consideration paid be
classified as a reduction of revenues unless the vendor receives an
identifiable benefit and the fair value of that benefit can be
reliably measured. In this fact pattern, we believe that the excess amount paid to the customer represents both a payment to retain the customer and settle the litigation. However, if the company is unable to determine the fair value of each of these components, we believe that EITF 01-9 requires the entire payment to be classified as a
reduction of revenues. Had the company been able to
directly value the litigation, classification of that portion of the
settlement payment as an expense may have been appropriate.
[Emphasis added]
Even though Mr. West was speaking about the guidance in EITF Issue 01-9 on consideration payable to a customer, which was codified in ASC
605-25 and has been superseded by ASC 606, it is still appropriate for an entity
to consider the principles outlined in the speech since the principle underlying
the guidance in ASC 605-25 remains relatively consistent under ASC 606. Mr. West
acknowledged that classification of a litigation component as an expense is
appropriate in certain circumstances, specifically when (1) a prior
customer/vendor relationship with the plaintiff does not exist or (2) a prior
customer/vendor relationship does exist and the vendor receives an identifiable
benefit for which the fair value of that benefit can be reliably measured.
Further, in evaluating the income statement classification of a litigation
settlement in situations in which the counterparty is a vendor or customer, the
entity should consider whether the settlement amount was based on an agreed-upon
formula (e.g., whether it was based on total product sales to a customer or
supplies purchased from a vendor) in such a way that there is a direct and
observable correlation between the settlement amount and the previous revenue or
purchase transaction. Such a correlation may be an indication that the
settlement amount should be recognized as an adjustment to the transaction price
received from a customer or to the cost of goods or services purchased from a
vendor.
If settlement consideration payable to a customer is in exchange
for a distinct good or service but the fair value cannot be reasonably
estimated, the settlement consideration should be recognized entirely as a
reduction in transaction price. For example, in a litigation settlement with a
customer, an entity may determine that an element of the consideration pertains
to settling the litigation and therefore is representative of a distinct
benefit. The entity may have historical experience in settling similar cases and
therefore may be able to readily determine the distinct litigation settlement
benefit; however, unless the entity can reasonably estimate the fair value of
the litigation settlement element, the entire settlement amount should be
accounted for as a reduction in transaction price. For more information about
consideration payable to a customer, see Chapter 6 of Deloitte’s Roadmap Revenue
Recognition.
Similarly, regarding classification of the settlement when
payments are received from a vendor, entities should consider ASC 705-20, as
discussed in Chapter
6 of Deloitte’s Roadmap Revenue Recognition, as well as the
gain contingency recognition guidance addressed in Chapter 3 of this Roadmap.
Footnotes
1
See ASC 712-10-15-3 and 15-4 for a discussion of
transactions that could be subject to the scope of ASC 710.
2
For example, the issue of how an entity should account for
uncertain tax positions and breakage when a customer is not expected to
exercise all of its contractual rights to goods or services in a revenue
contract is specifically addressed in U.S. GAAP. Chapter 4 of Deloitte’s Roadmap
Income Taxes
addresses uncertain tax positions. Section 8.8 of
Deloitte’s Roadmap Revenue Recognition addresses breakage associated
with certain revenue contracts.