Chapter 2 — Loss Contingencies and Commitments

2.3 Recognition

ASC 450-20

25-1 When a loss contingency exists, the likelihood that the future event or events will confirm the loss or impairment of an asset or the incurrence of a liability can range from probable to remote. As indicated in the definition of contingency, the term loss is used for convenience to include many charges against income that are commonly referred to as expenses and others that are commonly referred to as losses. The Contingencies Topic uses the terms probable, reasonably possible, and remote to identify three areas within that range.

25-2 An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

Information available before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. Date of the financial statements means the end of the most recent accounting period for which financial statements are being presented. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
The amount of loss can be reasonably estimated.

The purpose of those conditions is to require accrual of losses when they are reasonably estimable and relate to the current or a prior period. Paragraphs 450-20-55-1 through 55-17 and Examples 1–2 (see paragraphs 450-20-55-18 through 55-35) illustrate the application of the conditions. As discussed in paragraph 450-20-50-5, disclosure is preferable to accrual when a reasonable estimate of loss cannot be made. Further, even losses that are reasonably estimable shall not be accrued if it is not probable that an asset has been impaired or a liability has been incurred at the date of an entity’s financial statements because those losses relate to a future period rather than the current or a prior period. Attribution of a loss to events or activities of the current or prior periods is an element of asset impairment or liability incurrence.

When an entity obtains information before the financial statements are issued or available to be issued, indicating that it is probable that a future event will confirm a financial statement loss that occurred on or before the date of the financial statements, the entity should accrue such a loss contingency provided that the loss can be reasonably estimated.

The flowchart below outlines the criteria for recognition of a contingent liability, taking into consideration all information about the loss that becomes available before the financial statements are issued (or are available to be issued).

A contingent liability is not recognized when either (1) it is not probable that a future event will confirm that a loss had been incurred on or before the date of the financial statements or (2) the amount of the loss is not reasonably estimable. The entity should carefully evaluate whether appropriate disclosure is necessary to keep the financial statements from being misleading. See additional disclosure requirements in Section 2.8.

2.3.1 Assessing the Probability of Whether a Loss Has Been Incurred

2.3.1.1 “Probable,” “Reasonably Possible,” and “Remote”

For an entity to recognize a loss contingency under ASC 450-20, it must be probable that one or more future events will occur or fail to occur, thereby confirming a loss. In the ASC 450-20 glossary, loss contingencies are categorized on the basis of the likelihood of occurrence as follows:

ASC 450-20 — Glossary

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.

Although ASC 450-20 defines each of these terms, it provides no quantitative thresholds. The word “probable” is not intended to mean that virtual certainty is required before a loss is accrued. However, “likely to occur” is a higher threshold than “more likely than not,” which is generally considered as indicating a chance of occurrence of more than 50 percent.

While no codified guidance defines the quantitative thresholds, an entity that is evaluating these thresholds may find it useful to consider interpretive guidance from paragraph 160 of AICPA Statement of Position 96-1, which states, in part:

If the FASB Statement No. 5 criteria of remote, reasonably possible, and probable were mapped onto a range of likelihood of the existence of a loss spanning from zero to 100 percent, the reasonably possible portion would span a significant breadth of the range starting from remote and ending with probable.

“Probable” is discussed in paragraph 49 of the Background Information and Basis for Conclusions of FASB Statement 114, which states, in part:

“ ‘[P]robable’ . . . has, in the case of banks, come to mean ‘virtually certain,’ rather than ‘more likely than not,’ ” and “the ‘probable’ requirement as it is sometimes applied has unduly delayed loss recognition . . . of problem assets.” The Board did not intend “probable” to mean “virtually certain to occur.” The Statement 5 definition of probable states that “the future event or events are likely to occur” (emphasis added). The Board recognizes that application of the term probable in practice requires judgment, and to clarify its intent the Board has reiterated the guidance in paragraph 84 of Statement 5 in paragraph 10 of this Statement. The term probable is used in this Statement consistent with its use in Statement 5. This Statement does not specify how a creditor should determine that it is probable that it will be unable to collect all amounts due according to a loan’s contractual terms.

In addition, the SEC’s November 16, 2011, staff paper comparing U.S. GAAP with IFRS® Accounting Standards states the following regarding the quantitative threshold used to recognize environmental obligations:

Both IFRS and U.S. GAAP contain a “probable” threshold for the recognition of an environmental liability. Probable within IFRS is defined as more likely than not (i.e., more than 50%), whereas probable is not as clearly defined under U.S. GAAP (but is interpreted in this context to be a percentage somewhat greater than 50%).

ASU 2014-15 discusses “probable” in the context of determining what constitutes substantial doubt about an entity’s ability to continue as a going concern. In ASU 2014-15, the FASB observes that “probable” in the ASC master glossary’s definition of “substantial doubt about an entity’s ability to continue as a going concern” carries the same meaning that it does in ASC 450’s definition of the word. The ASU’s general discussion of a Board member’s dissenting view indicates, in part:

As mentioned in paragraph BC17, a commonly cited academic paper (Boritz, 1991) noted that the threshold for the substantial doubt likelihood of an entity being unable to meet its obligations is between 50 and 70 percent. The guidance in this Update increases that threshold to probable, which many assert as being in the 70–75 percent range.

While there is diversity in practice related to the likelihood percentage that “probable” represents, in a manner consistent with the discussion in ASU 2014-15, the threshold for “probable” would need to be at least 70 percent. Further, although the term “remote” is not discussed quantitatively in any guidance issued by the FASB, it is used in practice to indicate a likelihood of 10 percent or less.

A loss contingency is recognized only when the likelihood of a future event’s occurrence indicates that it is probable that a loss has occurred (provided that the loss contingency is also reasonably estimable). If the likelihood of a future event’s occurrence is only reasonably possible, entities should provide appropriate disclosures in accordance with ASC 450-20-50, although loss accrual is not appropriate. For events for which the likelihood that a loss has been incurred is remote, recognition is not appropriate and disclosure is not required under ASC 450-20; however, entities should use judgment in determining whether omitting disclosures would cause the financial statements to be misleading. See Section 2.8 for disclosure considerations.

Entities may need to consider various factors and use significant judgment in determining the likelihood of a future event’s occurrence or nonoccurrence that will confirm whether a loss has been incurred on the date of the financial statements. Specifically, in the case of class action lawsuits or litigation, an entity may need to consider (among other things) the opinion of in-house or external legal counsel, the entity’s history and experience with similar cases, prior case law, how the entity intends to respond, and the nature of the settlement mechanism.

Certain contingencies are not considered probable until the underlying future events occur because of various external factors associated with the determination of the probability threshold. Examples of such underlying future events include casualty events, the enactment of proposed legislation, the successful completion of an initial public offering (IPO), and the occurrence of a business combination, all of which are discussed below.

2.3.1.2 Occurrence of a Business Combination or Successful Completion of an IPO

Certain liabilities are contingent on the occurrence of a business combination or the completion of an IPO. For example, an amount may be payable upon completion of an IPO, or a restructuring plan may be adopted upon consummation of a business combination.

There are many external factors and uncertainties that can affect the successful completion of an IPO or the consummation of a business combination. These external factors and uncertainties make it difficult to determine whether the probability threshold has been met before the effective date of an IPO or a business combination. Therefore, the incurrence of a liability contingent on an IPO or a business combination cannot be considered probable until the transaction is completed. This position does not affect or apply to freestanding derivative contracts or embedded derivative features that are within the scope of ASC 815 (e.g., a put option contingent on an IPO).

A business combination is an event for which discrete accounting is required when the combination is consummated. Accordingly, when the occurrence of a liability is contingent on the completion of a business combination, one of the events that obligates the entity and therefore gives rise to the liability has not occurred until the combination has occurred. Because of the uncertainties involved in, and the discrete nature of, business combinations, a liability should not be accrued until the business combination is consummated.3

However, in certain situations, a liability may exist even if a proposed business combination is not consummated. The fact that an entity has agreed to settle a preexisting litigation matter as a condition to completing such a business combination does not necessarily mean that the contingent liability should be recognized only on completion of the business combination. See further discussion in Example 2-7.

Example 2-7

Settlement of Litigation in Conjunction With a Business Combination

Company A has entered into a proposed merger with Company B for which the approval of the U.S. Department of Justice (DOJ) is required. Before the proposed merger, the DOJ asserted that A is liable for false claims made against a department of the U.S. government. While A is contesting the lawsuit on the basis that it is not guilty of the DOJ’s allegations, if A loses the lawsuit, it could be subject to civil penalties and damages of up to $200 million.

The DOJ has informed A that it will not approve the merger until the lawsuit with A is resolved. Further, the DOJ has offered to settle the lawsuit with A for $50 million; such settlement will occur coterminously with the closing of the merger. If, however, the merger does not close, A is not obligated to settle the lawsuit for $50 million and would continue to defend itself against the lawsuit. In such cases, the outcome would be uncertain.

For financial reporting periods ending before completion of the business combination with B, it would not be acceptable for A to avoid recognizing a liability for the lawsuit solely on the basis that it is contingent on the merger with B. This is because the lawsuit is unrelated to the proposed merger. Rather, A should consider all facts and circumstances related to the case, including the settlement offer, in determining the amount (if any) to recognize as a contingent liability for the lawsuit.

2.3.1.3 Proposed Legislation

The enactment of legislation by a governmental authority may give rise to a liability. In some circumstances, a company may expect that pending legislation will give rise to a liability upon enactment. However, a liability should not be accrued in advance of enactment even if the entity believes such enactment to be probable. Future laws or changes in laws should not be anticipated when an entity is accruing a liability in accordance with ASC 450-20-25-2. Before enactment of a law, the specific content of the final law is uncertain. Substantive changes to the law may materially affect the nature, timing, and extent of resources a company will be required to expend. The accounting for liabilities should reflect the provisions of enacted laws on a jurisdiction-by-jurisdiction basis. This treatment is consistent with the guidance on changes in income tax laws in ASC 740.

Connecting the Dots

The enactment date is the date on which all steps in the process for legislation to become law have been completed (e.g., in the United States, this could be the case when the president signs the legislation and it becomes law). For rules and regulations issued by federal regulatory agencies to implement enacted U.S. laws, the enactment date is generally the date on which final rules or regulations promulgated by the federal regulatory agency are published in the Federal Register, which may differ from the effective date of such rules or regulations. Entities may need to exercise considerable judgment and obtain the assistance of legal counsel in determining (1) the enactment date of laws and regulations implemented in jurisdictions (i.e., local, state, federal, or foreign) or (2) when regulations issued by governmental agencies to implement and interpret these laws are enacted. For an illustrative example of an enacted rule published in the Federal Register, see Section 5.5.1 of Deloitte’s Roadmap Environmental Obligations and Asset Retirement Obligations.

Example 2-8

Legal Liabilities as a Result of the Enactment of Legislation

The European Parliament and the Council of the European Union (the “Council”) issue two types of legislation: (1) regulations and (2) directives. Regulations become law upon passage by the European Parliament and the Council. Directives are fundamental objectives to be achieved by laws, regulations, and administrative provisions enacted by the individual member states of the European Union. Although directives must be passed by the European Parliament and the Council, they do not become law until implemented by laws, regulations, and administrative provisions of the respective member states. To comply with a directive, member states must enact such a measure within 18 months of the directive’s passage by the European Parliament and the Council.

The passage of a directive by the European Parliament and the Council does not satisfy the criteria for recognition of a liability under ASC 450-20-25-2 because a legal obligation has not been established. The obligating event is the enactment of laws, regulations, and administrative provisions to comply with a directive. Although it may be probable that passage of a directive by the European Parliament and the Council will result in the enactment of measures needed to comply with the directive, future laws or changes in laws should not be anticipated. Rather, liabilities should be recognized in a manner that reflects the provisions of enacted laws on a jurisdiction-by-jurisdiction basis.

2.3.1.4 Assessing Whether a Loss Is Reasonably Estimable

When accruing a loss, an entity must determine, in accordance with the recognition criteria in ASC 450-20-25-2, whether the loss is probable and reasonably estimable. Recognition of a loss that cannot be reasonably estimated, even if it is probable that the loss has been incurred, would impair the integrity of the financial statements. Alternatively, the entity should not delay accrual of a loss because of the inability to estimate a single amount. The ability to estimate a loss within a range would indicate that some amount of a loss has occurred and that the entity should therefore accrue a liability in accordance with ASC 450-20-25-2(b). The entity may use past experience or other information to demonstrate its ability to reasonably estimate the loss.

If both recognition criteria under ASC 450-20-25-2 are met, the estimated loss will be charged to income. ASC 450-20-25-7 indicates that if a loss cannot be accrued in the period in which it is determined that it is probable that a loss has been incurred “because the amount of loss cannot be reasonably estimated, the loss shall be charged to the income of the period in which the loss can be reasonably estimated and shall not be charged retroactively to an earlier period. All estimated losses for loss contingencies shall be charged to income rather than charging some to income and others to retained earnings as prior period adjustments.”

2.3.1.5 General Reserves and Risk of Loss From Future Events

ASC 450-20-25-8 specifically indicates that “[g]eneral or unspecified business risks” should not be accrued in the financial statements since they do not meet the “probable” and “reasonably estimable” requirements of ASC 450-20-25-2. Therefore, it is not acceptable to record an accrual for general contingencies in an attempt to address uncertainties in the financial statements that may not be probable or reasonably estimable.

In addition, mere exposure because of uninsured or underinsured risk of loss or damage of an entity’s property by fire, explosion, or other hazards does not mean that an asset has been impaired or a liability has been incurred; therefore, such risk of loss should not be accrued as a liability under ASC 450-20. To recognize such a liability related to exposure because of uninsured or underinsured risk would be to recognize a liability under ASC 450-20 when it is not probable that the uncertain future events will confirm that a loss occurred on or before the date of the financial statements. As noted in ASC 450-20-55-7 by way of example, “an entity with a fleet of vehicles should not accrue for injury to others or damage to the property of others that might be caused by those vehicles in the future even if the amount of those losses may be reasonably estimable.” However, ASC 450-20-55-8 indicates that an uninsured loss resulting from injury to others or damage to property of others is accrued as a loss contingency if that event took place before the date of the financial statements and the entity is able to reasonably estimate the amount of such a loss through prior experience or available information.

A risk of loss from future events that interrupt the normal course of business is not considered “probable” until those events occur. Further, the costs of insurance coverage and the availability of coverage for certain types of risk (e.g., professional malpractice, product liability, director’s and officer’s liability, and pollution liability) have a significant effect on many companies. To minimize premium costs or to satisfy insurers, some companies have modified the terms of their coverage (e.g., by increasing the amounts of deductibles, reducing coverage, or both); others are forming captive insurance companies by using a self-insurance method. It is not appropriate to accrue for uninsured or underinsured expected losses in a systematic fashion before such losses occur. Before the issuance of FASB Statement 5, many entities that did not carry insurance against certain risks, such as property damage from fire or explosion, charged earnings in a systematic fashion (e.g., as if an insurance premium were being expensed) to establish an insurance reserve against which actual losses could then be charged. However, charges in lieu of insurance are not permitted under ASC 450.

2.3.2 Other Recognition Considerations

2.3.2.1 Unasserted Claims

Unasserted claims are possible claims or assessments of which an entity has not yet been notified by the injured party or potential claimant. Entities often are exposed to financial loss before the commencement of a formal claim. Litigation may be expected as a result of a past action. Alternatively, an entity may expect a current government investigation to result in a formal claim upon the investigation’s completion.

To determine under which circumstances an unasserted claim should be accrued, an entity must first determine whether a past event has triggered a loss contingency. If such a past event has occurred, the entity must then determine the probability that (1) a lawsuit will be filed or a claim will be asserted against it and (2) such a lawsuit or claim will result in an unfavorable outcome for the entity. If it is probable that an unasserted claim will result in an unfavorable outcome for the entity, and if the amount of the loss can be reasonably estimated, the entity should accrue a loss contingency in accordance with ASC 450-20-25-2. Additional disclosure may be required if it is reasonably possible that there is exposure to loss in excess of the amount accrued.

If an unfavorable outcome is only reasonably possible, or if the amount of the loss cannot be reasonably estimated, an amount should not be accrued but disclosure would be required under ASC 450-20-50. See Section 2.8 for disclosure considerations.

Entities may incur losses as a result of incidents that occur before the date of the financial statements but are not reported by a claimant until a later date. ASC 720-20-25-14 requires the accrual for incurred but not reported (IBNR) claims if both criteria in ASC 450-20-25-2 are met. Examples 2-9 and 2-10 illustrate the application of the recognition criteria under ASC 450-20 to unasserted claims.

SEC Considerations

For certain IBNR claims, such as asbestos liability claims, entities may establish a liability for a rolling fixed number of years (i.e., the entity is able to reliably estimate its expected liability for IBNR for the next 20 years of claims, but it is unable to reliably estimate a liability for the period beyond 20 years). Typically, these liabilities have years, and sometimes decades, of settlement claims history. The SEC staff has frequently commented on these rolling fixed-term liabilities and has asked companies to provide more detail about the process undertaken, including the related ICFR, by management to conclude that it could not estimate for the period beyond a specific time horizon.

Example 2-9

Assessing Accrual Related to an Outcome of an Incomplete Investigation

Company R is being investigated by a government agency for potential breach of contract and allegations of illegal pricing for prior sales transactions. As of year-end, the government has not filed any charges or specified a monetary penalty against R for these matters. To determine whether accrual or disclosure of the contingency is appropriate in R’s year-end financial statements, R’s management must first determine the probability that a lawsuit will be filed or a claim will be asserted against R. If the filing of a lawsuit or the assertion of a claim is probable in management’s judgment, management must determine the probability that such a lawsuit or claim will result in an unfavorable outcome for R. If an unfavorable outcome is probable and the amount of the loss can be reasonably estimated, accrual of the loss is required. If the amount of the loss cannot be reasonably estimated, no accrual is required; however, R should disclose the contingency. Further, if an unfavorable outcome is only reasonably possible but not probable, R should disclose the contingency.

Example 2-10

Accrual of Probable Settlement Costs

Company T has decided to abandon certain distributor agreements that it had in place. Company T believes that it will be involved in legal actions brought by the distributors and that it is probable that the company will incur costs to settle these actions. To the extent that it is probable that these claims will be asserted and will result in an unfavorable outcome for T, it should accrue a loss under ASC 450-20 if the settlement amount can be reasonably estimated.

2.3.2.2 Loss Recognition Before the Occurrence of a Casualty Event for an Insurance Company

One of the most controversial issues addressed in ASC 450-20 is related to whether a property and casualty insurance company should recognize a liability for future losses resulting from catastrophes. When an insurance company issues a policy, it assumes the risk that a catastrophe (e.g., a hurricane) might occur within the policy coverage period. Insurance companies have asserted that they are able to predict the occurrence rate of catastrophes and related losses by using actuarial methods based on past occurrences. Insurance companies use such methods for rate-setting purposes; therefore, many believe that the losses are reasonably estimable and should be accrued.

However, ASC 944-40-55-3 indicates that catastrophe reserves fail to satisfy the conditions of ASC 450-20 for accrual because losses from potential future catastrophes over the relatively short periods covered by policies in force cannot be reasonably estimated. In addition, unless a catastrophe occurs within the policy period, no asset is impaired and no liability is incurred as of the date of the financial statements; therefore, no accrual for a catastrophe loss should be made. On the other hand, a property and casualty insurer is required to accrue losses from catastrophes that occurred before the date of the financial statements even though claims have not been submitted by policyholders if (1) it is probable that those claims will be made and (2) a reasonable estimate of the loss can be made. Accrual of a premium deficiency is also required by ASC 450-20 and ASC 944-60.

2.3.2.3 Litigation, Claims, and Assessments

A common uncertainty many entities will encounter is the risk of litigation. Class actions, product liabilities, lawsuits, and actions brought by government agencies are not uncommon, and an entity may need to accrue or disclose contingencies related to the risk of such litigation (e.g., the potential future obligation to pay an uncertain amount as a result of past activities) in the financial statements.

Adverse consequences of litigation could include the obligation to pay damages, the imposition of fines and penalties, the need to repay consideration from a revenue contract that was previously received, and even discontinuation of certain operations. Further, the entire nature of the entity may change as a result of the litigation (e.g., the entity may seek protection from the litigation through bankruptcy).

Types of litigation that an entity may face include the following:

Antitrust.
Restraint of trade.
Breach of contract.
Patent infringement.
Product liability.
Violation of federal securities laws.
Government actions.
Discrimination.
Environmental protection matters.
Violation of wage and price guidelines or controls.
Renegotiation of government contracts.
Income tax disputes.
Violation of other laws and regulations (e.g., the Foreign Corrupt Practices Act).

In determining whether an accrual is required in connection with litigation, claims, and assessments, an entity should consider various factors that include, but are not limited to, the following:

The nature of the settlement mechanism — The parties involved may have agreed to use a settlement mechanism other than the court system that is binding on the parties. Accordingly, it is necessary to evaluate, on the basis of the specific facts and circumstances, the ability of the party that is subject to an adverse legal judgment to appeal the matter.
The progress of the case — If a planned appeal is not the entity’s first appeal of an adverse judgment (i.e., the entity has been unsuccessful in prior appeals of the judgment), the entity should consider the results or findings of the earlier rulings when assessing its evidence for and against liability recognition.
The opinions or views of legal counsel and other advisers:
- A legal analysis usually will include counsel’s opinion regarding the likelihood that the entity will prevail on appeal. For example, a legal opinion may state counsel’s belief that the entity’s chance for a successful appeal is probable, more likely than not, or reasonably possible. The terms “probable” and “reasonably possible” do not signify precise quantitative thresholds and may be interpreted and applied differently by different parties, as described in Section 2.3.1.1. The meaning of such terms should be understood in the context of the legal opinion related to the entity’s specific facts and circumstances so that management’s assertions about the likelihood of success on appeal can be compared with those of counsel. An indication from legal counsel that an entity plans to vigorously defend itself against a claim does not relieve the entity from evaluating the probability of a future loss.
- Management should review the basis for counsel’s conclusions and assess whether the reasons cited by counsel to support its assessment are consistent with the evidence used by the entity to support its decision about whether to record a loss contingency.
- Management should fully consider any qualifications or conditions that counsel identified as affecting its assessment. In interpreting language used by counsel to explain its conclusion, management may find it helpful to consider the guidance in AU-C Sections 620 and 501 of the AICPA’s auditing standards, which apply to financial statement audits.
- Counsel’s opinion is a critical piece of evidence that needs to be analyzed carefully. Counsel’s expression of an opinion that an entity will be successful on appeal does not, in itself, support a conclusion that an accrual of a loss is not warranted. In addition, ASC 450-20-55-12(c) notes that “the fact that legal counsel is unable to express an opinion that the outcome will be favorable to the entity should not necessarily be interpreted to mean that the condition in paragraph 450-20-25-2(a) is met.” However, when the entity has received an adverse legal judgment, counsel’s inability to express an opinion may leave the entity with insufficient positive evidence to overcome the judgment.
The experience of the entity or other entities in similar cases — The prior experiences of the entity or other entities with similar litigation may serve as additional evidence of the entity’s likelihood of success. For example, management could consider possible outcomes specific to (1) certain jurisdictions, (2) certain courts, (3) the use of certain defense strategies, or (4) other related aspects of the litigation.
Prior case law for similar cases — Gaining an understanding of prior case law may enable the entity to identify certain precedents that could affect the likelihood of its success.
Management’s decision regarding how the entity intends to respond:
- Although certain adverse legal judgments may be appealed, the entity’s decision to appeal will depend on a variety of factors. The entity should consider its specific facts and circumstances when assessing the likelihood that it will seek an appeal.
- Because an adverse legal judgment may involve multiple components, the entity should analyze each component thoroughly to determine whether a litigation accrual should be recorded. For example, the entity should determine whether it will appeal all components of the judgment or only selected components.
The entity’s intended basis for an appeal — As discussed above, an understanding of the legal basis for the entity’s appeal, combined with a review of prior case law or the experiences of the entity or other entities in similar cases, may serve as evidence that helps the entity gauge the likelihood that it will prevail on appeal.
The audit committee’s assessment of the entity’s opportunity for appeal — The audit committee’s assessment of the entity’s opportunity for appeal, considered along with the assessments of internal or outside counsel and the entity’s management, may constitute additional information about the entity’s defense strategy and its chances for success on appeal.

Example 1 in ASC 450-20-55-18, Cases A through D of Example 2 in ASC 450-20-55-22, and Example 2-11 illustrate the accounting for various litigation scenarios.

ASC 450-20

Example 1: Litigation Open to Considerable Interpretation

55-18 An entity may be litigating a dispute with another party. In preparation for the trial, it may determine that, based on recent developments involving one aspect of the litigation, it is probable that it will have to pay $2 million to settle the litigation. Another aspect of the litigation may, however, be open to considerable interpretation, and depending on the interpretation by the court the entity may have to pay an additional $8 million over and above the $2 million.

55-19 In that case, paragraph 450-20-25-2 requires accrual of the $2 million if that is considered a reasonable estimate of the loss.

55-20 Paragraphs 450-20-50-1 through 50-2 require disclosure of the nature of the accrual, and depending on the circumstances, may require disclosure of the $2 million that was accrued.

55-21 Paragraphs 450-20-50-3 through 50-8 require disclosure of the additional exposure to loss if there is a reasonable possibility that the additional amounts will be paid.

Example 2: Multiple Case Litigation Example

55-22 The following Cases illustrate application of the accrual and disclosure requirements in the following stages of litigation:

The trial is complete but the damages are undetermined (Case A).
The trial is incomplete but an unfavorable outcome is probable (Case B).
The trial is incomplete and unfavorable outcome is reasonably possible (Case C).
There is a range of loss and one amount is a better estimate than any other (Case D).

Case A: Trial Is Complete but Damages Are Undetermined

55-23 An entity is involved in litigation at the close of its fiscal year and information available indicates that an unfavorable outcome is probable. Subsequently, after a trial on the issues, a verdict unfavorable to the entity is handed down, but the amount of damages remains unresolved at the time the financial statements are issued or are available to be issued (as discussed in Section 855-10-25). Although the entity is unable to estimate the exact amount of loss, its reasonable estimate at the time is that the judgment will be for not less than $3 million or more than $9 million. No amount in that range appears at the time to be a better estimate than any other amount.

55-24 In this Case, paragraph 450-20-30-1 requires accrual of the $3 million (the minimum of the range) at the close of the fiscal year.

55-25 Paragraphs 450-20-50-1 through 50-2 require disclosure of the nature of the contingency and, depending on the circumstances, may require disclosure of the amount of the accrual.

55-26 Paragraphs 450-20-50-3 through 50-8 require disclosure of the exposure to an additional amount of loss of up to $6 million.

Case B: Trial Is Incomplete but Unfavorable Outcome Is Probable

55-27 Assume the same facts as in Case A, except it is probable that a verdict will be unfavorable and the trial has not been completed before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25). In that situation, the condition in paragraph 450-20-25-2(a) would be met because information available to the entity indicates that an unfavorable verdict is probable. An assessment that the range of loss is between $3 million and $9 million would meet the condition in paragraph 450-20-25-2(b).

55-28 In this Case, if no single amount in that range is a better estimate than any other amount, paragraph 450-20-30-1 requires accrual of $3 million (the minimum of the range) at the close of the fiscal year.

55-29 Paragraphs 450-20-50-1 through 50-2 require disclosure of the nature of the contingency and, depending on the circumstances, may require disclosure of the amount of the accrual.

55-30 Paragraphs 450-20-50-3 through 50-8 require disclosure of the exposure to an additional amount of loss of up to $6 million.

Case C: Trial Is Incomplete and Unfavorable Outcome Is Reasonably Possible

55-31 Assume the same facts as in Case B, except the entity had assessed the verdict differently (for example, that an unfavorable verdict was not probable but was only reasonably possible). The condition in paragraph 450-20-25-2(a) would not have been met and no amount of loss would be accrued. Paragraphs 450-20-50-3 through 50-8 require disclosure of the nature of the contingency and any amount of loss that is reasonably possible.

Case D: Range of Loss and One Amount Is a Better Estimate Than Any Other

55-32 Assume that in Case A and Case B the condition in paragraph 450-20-25-2(a) has been met and a reasonable estimate of loss is a range between $3 million and $9 million but a loss of $4 million is a better estimate than any other amount in that range.

55-33 In this Case, paragraph 450-20-30-1 requires accrual of $4 million.

55-34 Paragraphs 450-20-50-1 through 50-2 require disclosure of the nature of the contingency and, depending on the circumstances, may require disclosure of the amount of the accrual.

55-35 Paragraphs 450-20-50-3 through 50-8 require disclosure of the exposure to an additional amount of loss of up to $5 million.

Example 2-11

Broker-Dealer Dispute With Investors

Company A, a broker-dealer, markets and sells investments in certain financial products. The investments do not contain an option for investors to put the investments back to A. Company A later faces criticism and potential litigation for misleading investors about the economic characteristics of the investments. As a result, A enters into a settlement agreement that gives each investor the right to demand that A repurchase the investment for cash equal to its par value on a specified future date (or range of dates) upon physical delivery of the investment to A.

The accounting considerations depend on whether A has entered into a legally enforceable settlement agreement that meets the definition of a firm commitment (i.e., an “enforceable settlement agreement”).

Accounting Before Settlement Agreement

Before an enforceable settlement agreement or the resolution of any associated litigation, the potential that a broker-dealer has incurred a loss in connection with its past selling or marketing of investments is a loss contingency within the scope of ASC 450-20 and should be evaluated as a contingent liability for recognition and disclosure purposes.

Under ASC 450-20-25-2, the broker-dealer should accrue a liability for the contingency and recognize a related charge in current-period income if information that is available before the financial statements are issued (or before they are available to be issued) indicates that (1) it is probable that a liability has been incurred as of the date of the financial statements in connection with the broker-dealer’s past selling or marketing of investments and (2) the amount of the loss can be reasonably estimated. ASC 450-20-50-3 and 50-4 specify that if it is reasonably possible that a loss or an additional loss in excess of the amount of the loss accrued may have been incurred or the loss amount cannot be reasonably estimated, the broker-dealer should disclose the “nature of the contingency” and an “estimate of the possible loss or range of loss or a statement that such an estimate cannot be made.”

Accounting Once a Settlement Agreement Becomes Legally Enforceable

On the date A enters into an enforceable settlement agreement, the uncertainty regarding whether a loss has been incurred is resolved, and A must recognize an obligation for issuing the written put option.

If A determines that the written put option does not meet the definition of a derivative instrument under ASC 815-10, it would account for the option as a guarantee contract under ASC 460-10. Accordingly, at initial recognition of the obligation undertaken in issuing the guarantee, A should apply ASC 460-10-30-3, which states, in part, that the amount initially recognized in connection with the written put option should be the greater of:

The amount that satisfies the fair value objective as discussed in the preceding paragraph
The contingent liability amount required to be recognized at inception of the guarantee by Section 450-20-30.

ASC 460-10-35 does not address subsequent measurement in detail; however, A would be expected to subsequently measure the put option in a manner consistent with the SEC staff’s long-standing position that written options should be marked to fair value through current-period earnings.

2.3.2.4 Evaluating the Impact of an Adverse Legal Judgment on the Recognition and Measurement of a Loss Contingency

In some cases, an entity may receive an adverse legal judgment for payment of a specific amount related to an event that occurred on or before the date of the financial statements. This judgment may be determined before the date of the financial statements, or after the date of the financial statements but before the financial statement issuance or the date on which the financial statements are available to be issued. The entity may not have previously recognized a contingent liability for this matter because it did not believe that the criteria in ASC 450-20-25-2 had been met.

The rendering of an adverse legal judgment against an entity does not automatically trigger recognition of a liability for a loss contingency since the entity may be successful in overturning all or part of the original judgment on appeal. As mentioned above, ASC 450-20-25-2 requires entities to accrue, by a charge to income, an estimated loss from a loss contingency if (1) it is probable that a “liability had been incurred” and (2) the “amount of loss can be reasonably estimated.” In determining the probability and the estimate of the loss, the entity must analyze all available information.

An adverse legal judgment constitutes significant objective evidence of the probability that an entity has incurred a liability as of the date of the financial statements. Consequently, for an entity that intends to appeal the judgment to conclude that no liability has been incurred as of the date of the financial statements, evidence supporting nonrecognition must be sufficient to counterbalance the external legal determination (i.e., the adverse legal judgment) and any other similar evidence. That is, to support nonrecognition, the evidence as a whole must reduce the likelihood that a liability has been incurred as of the date of the financial statements to a level below the probable threshold under ASC 450-20; otherwise, a liability should be recognized as long as the amount of the liability is reasonably estimable.

After analyzing all of the available information, the entity that received the adverse legal judgment may conclude that no loss contingency accrual is necessary because one or both of the conditions in ASC 450-20-25-2 have not been met. However, the entity would still be required to disclose the contingency (in accordance with ASC 450-20-50-3) if it is at least reasonably possible that a loss has been incurred as of the date of the financial statements. It is unlikely that an entity that has received an adverse legal judgment will have sufficient information to conclude that the likelihood of a loss is remote. Also, it is likely that the disclosure would need to contain sufficient information to enable financial statement users to understand the status of the litigation, the fact that an adverse judgment had been determined, and the factors the entity considered to determine that the loss should not be recognized.

If the entity is unable to or does not intend to appeal the adverse judgment, or otherwise concludes in accordance with ASC 450-20-25-2(a) that it is probable that a liability has been incurred, the entity should determine whether the liability can be reasonably estimated in accordance with ASC 450-20-25-2(b). If a reasonable estimate of the liability is a range, the entity should apply the guidance in ASC 450-20-25-5 and ASC 450-20-30-1. That is, when one amount within a range appears to be a better estimate than any other amount within the range, that amount should be accrued; when no amount within the range is a better estimate than any other amount, the minimum amount in the range should be recorded.

2.3.2.5 Accrual of Future Legal Costs

In determining the amount to accrue for a loss contingency involving litigation, entities must consider whether expected legal fees related to the litigation should be accrued when the loss contingency is initially recognized or when the legal services are actually provided at a future date. Practice related to this issue has varied owing to the absence of definitive guidance. As a result, the SEC staff suggested that the EITF Agenda Committee consider the need to add an item to the EITF’s agenda to address this issue.

The EITF Agenda Committee discussed this potential issue before the January 1997 meeting but did not reach a recommendation for the Task Force. The Agenda Committee considered whether the Task Force should recommend that the FASB undertake the project so that it receives adequate due process, but the Agenda Committee did not reach a conclusion. The Agenda Committee also discussed the existing practice related to the accrual of legal fees associated with a loss contingency and determined that it might be helpful to ask the Task Force for input on whether such practice is diverse. The SEC observer indicated that the SEC staff will need to consider whether to provide interim guidance while the EITF or the FASB decides whether to address this issue.

In addition, the minutes of the January 23, 1997, EITF meeting contain the following discussion of this issue, which is also summarized in an SEC staff announcement codified in ASC 450-20-S99-2:

The Task Force Chairman reported on the meeting of the EITF Agenda Committee. The Task Force discussed a potential new issue relating to the accounting for legal costs expected to be incurred in connection with a FASB Statement No. 5, Accounting for Contingencies [codified as ASC 450-20], loss contingency. Some Task Force members observed that they believe practice typically has expensed such costs as incurred; however, other Task Force members suggested that practice may not be consistent in this area. The Task Force also discussed whether it should recommend that the FASB address this potential new issue but decided not to take any action. The Task Force declined to add this potential new issue to its agenda. The SEC Observer indicated that the SEC staff will attempt to better understand what practice is in this area and monitor the issue. The SEC Observer also noted that he would expect a registrant’s accounting policy to be applied consistently and APB Opinion No. 22, Disclosure of Accounting Policies [codified as ASC 235], requires disclosure of material accounting policies and the methods of applying those policies.

In the absence of further guidance from the FASB or the SEC staff, entities should apply the guidance above, which indicates that the decision to accrue legal costs on the basis of an estimate of future legal costs or expense when incurred is a matter of accounting policy that should be consistently applied and disclosed, when material. Factors an entity needs to consider when determining the accounting policy for legal fees include whether the policy provides for meaningful presentation of the balance sheet and income statement, whether the policy improves comparability among entities that may have ongoing litigation exposure, and whether the accrual of legal fees is representative of the way in which the entity manages its litigation exposure (when resolution and legal defense costs are so directly interrelated that they are inseparable from the overall liability determination). Whether expensed as incurred or accrued in advance, litigation expense should generally be classified as an operating expense in the statement of operations.

2.3.2.6 Measurement Date for Stock Issued in Settlement of Litigation

A company may settle a legal action by issuing shares of its stock or other equity-classified instruments to the counterparty. ASC 450 does not provide specific guidance on measuring equity instruments for settlement of a contingent liability. The scope of ASC 718, as indicated in ASC 718-10-15-3, is “all share-based payment transactions in which a grantor acquires goods or services to be used or consumed in the grantor’s own operations or provides consideration payable to a customer by issuing (or offering to issue) its shares, share options, or other equity instruments or by incurring liabilities to an employee or a nonemployee that meet either of the following conditions” (emphasis added). The settlement of a legal action does not represent the acquisition of goods or services to be used or consumed in the grantor’s operations. Although such a transaction is not within the scope of ASC 718, depending on the facts and circumstances specific to the legal matter, it may be appropriate to apply certain principles from ASC 718 by analogy.

Parties to litigation may reach a preliminary agreement, subject to court approval, on the number of shares to be issued. Under an agreement that is subject to court approval, the court approval date is the appropriate measurement date for stock issued in settlement of litigation. The court’s approval of a settlement is a substantive event rather than an administrative matter or a formality. The approval of a legal settlement by a court that serves as the ultimate judge of fairness (i.e., approval is not perfunctory) represents the final “future event” that gave rise to the original characterization of the loss as a contingency under ASC 450-20. This view is consistent with the definition of the grant date in ASC 718-20, which indicates that for plans that are subject to shareholder approval, a measurement date for a stock award is the date when shareholder approval is obtained. Therefore, the total expense recognized in connection with the final settlement of a lawsuit should be measured on the court approval date.

When determining the share price to be used in measuring a liability that is recognized as of a balance sheet date before final settlement in situations in which a party offers to issue equity instruments to settle a claim, it may be appropriate for an entity to analogize to the guidance in ASC 718 regarding the measurement of liability-classified share-based payment award transactions and to use the period-end share price. In other arrangements, information that becomes available after the balance sheet date but before the financial statements are issued (or available to be issued) may be relevant to the measurement as of the balance sheet date (e.g., a settlement offer). Alternatively, when shares are used as “currency” to settle the liability, an entity may measure the contingent liability on the basis of its best estimate of the amount of loss that has been incurred. An entity should carefully evaluate such transactions in determining the appropriate share price to use in measuring the liability at period-end. The accounting may ultimately depend on whether the dispute involves the issuance of shares or whether an entity is merely using its shares as “currency” to resolve a matter.

Example 2-12

Litigation Settlement in Shares Subject to Court Approval

Entities A and Z are parties to ongoing litigation that is subject to a court-mandated mediation process. Once the mediator, A, and Z agree on a settlement amount, final court approval is needed for the settlement to be finalized. On March 3, 20X9, as a result of the mediation process, A agrees to issue 200,000 shares to Z to settle the litigation, subject to the court’s final approval.

Before March 3, 20X9, A had previously recognized a contingent liability related to the litigation for $1.75 million because A had concluded that it was probable that a loss had been incurred and $1.75 million was its estimate for the loss. On the agreement date, March 3, 20X9, the fair value of A’s shares was $10 per share and A adjusted its recognized liability to $2 million ($10 per share × 200,000 shares) by debiting expense and crediting a contingent liability for $250,000. This adjustment is considered a change in accounting estimate.

On March 30, 20X9, the court approves the settlement agreement of 200,000 shares to be issued by A to Z. On the court approval date, the fair value of A’s shares was $11 per share. Entity A must recognize the incremental $200,000 [($11 per share − $10 per share) × 200,000 shares] loss in income at this time since the court approval was a substantive part of the litigation settlement. The measurement date for the ultimate liability is the court approval date of March 30, 20X9. Upon issuance of its shares, A should debit the total contingent liability recognized of $2.2 million, with a corresponding credit to equity. This adjustment is considered a change in accounting estimate.

2.3.2.7 Recognition of Annual Bonus Plan Liabilities

Many companies use cash bonus plans to compensate employees. Annual bonus plans may be based on specific formulas and performance targets or may be at the discretion of management and the compensation committee of the company’s board of directors. In some plans, annual bonus amounts are determined after the end of a fiscal year and may not be determined until after the financial statements are issued. Bonuses also may be forfeited if an employee is terminated or resigns.

The recognition criteria of ASC 450-20 should be used to estimate the amount of a bonus whose payment is probable when the cash bonus plan is not subject to other applicable U.S. GAAP (such as ASC 718). If the amount of a bonus that will be achieved or granted is uncertain, a range should be computed under ASC 450-20-30-1. If “no amount within the range is [considered] a better estimate than any other amount,” the low end of the range should be selected. Entities must carefully evaluate bonuses that are based on achievement of a target to determine whether such achievement is probable.

Once an entity has determined the amount of the probable bonus, it should recognize the amount over the service period. Recognizing compensation expense in this manner is analogous to recognizing expense in connection with stock-based compensation arrangements over the related service period, as required by ASC 718. Under this model, the obligating event giving rise to the liability is considered the employee’s performance of service. Recognition of a bonus liability should not be delayed just because the bonus would not be paid if an employee were to terminate employment before the end of the service period. Rather, if a reliable estimate of employee turnover is possible, the entity may factor this estimate into the range of estimates when determining the probable liability. Any difference between the actual bonus paid and the amount accrued is considered a change in accounting estimate.

Example 2-13

Employee Benefit Arrangements

Company P is preparing its financial statements for the fiscal year ending December 31, 20X4. On January 2, 20X4, P initiates an incentive compensation plan for its senior executives. Under the plan, each executive is allocated a portion of a pool of 500 units. The value of each unit will be determined as of the plan measurement date (December 31, 20X5) in accordance with a plan formula that uses as its basis the difference between P’s net income in 20X5 and P’s net income in 20X4. On December 31, 20X6, each executive who has remained with P in uninterrupted service during the period from January 1, 20X4, through December 31, 20X6, will receive a cash bonus based on this calculation of unit value.

Although P annually prepares a projection of its net income for the year, there is uncertainty about whether the amount will ultimately be attained since the company has failed to achieve its targets in recent years. Management has calculated that if P meets its forecasted level of net income in fiscal year 20X5, the bonus (payable at the end of 20X6 under the plan) could be as high as $8 million.

Company P should use all available information to reasonably estimate its liability for the cash bonus plan and accrue in fiscal year 20X4 the percentage of the liability that is related to the 20X4 service period. When considering its forecast of net income for fiscal year 20X5, P should take into account any recent trends or developments and the accuracy of its prior projections.

The probable percentage of the liability that is related to the expired service period, which is estimated by management to be 33.3 percent (calculated on the basis of one of three fiscal years for which the executive is required to have been employed), should be accrued as of December 31, 20X4. The remaining 66.7 percent should be accrued over the following two years. The amount of the probable bonus should be reconsidered in each subsequent reporting period.

In accordance with ASC 450-20-30-1, if P determines that the range of the bonus amount could be from $1 million to $8 million and no amount within the range is considered a better estimate than any other amount, it would be appropriate for P to accrue a liability on the basis of the $1 million low end of the range.

However, since it is reasonably possible that a liability greater than $1 million has been incurred, ASC 450-20-50-4 requires P to disclose in its fiscal year 20X4 financial statements a complete description of the plan and an estimate of the possible bonus amount or range of bonus amount or a statement that such an estimate cannot be made.

2.3.2.7.1 Interim Considerations

When allocating annual bonuses to interim periods, entities should consider the guidance in ASC 270-10-45-8 through 45-10. Costs and expenses should be allocated to interim periods so that each interim period bears a reasonable portion of the annual expense. Each quarter, entities should determine the amount of bonus for which achievement is probable in accordance with ASC 450-20-25-2 and recognize this amount so that each interim period bears a reasonable portion of the annual expense. Entities must exercise judgment in determining the appropriate allocation method, and they should apply the selected method consistently in each reporting period.

For example, an entity may have a discretionary bonus plan that provides for the payment of annual bonuses to certain employees on the basis of the entity’s overall achievement of specific key financial metrics. In accordance with ASC 450-20, in each reporting period, the entity would estimate the amount of bonus for which payment is probable and recognize an amount that bears a reasonable portion of the annual expense. The entity may conclude that, as a result of recognizing the bonus on a straight-line basis over the performance period, each interim period bears a reasonable portion of the annual bonus expense. Alternatively, the entity may conclude that each interim period bears a reasonable portion of the annual bonus as a result of recognizing the annual bonus on the basis of the entity’s proportionate achievement of specific key financial metrics. The entity would apply the method used consistently in each reporting period.

2.3.2.8 Injury or Damage Caused by Products Sold

ASC 450-20

55-2 If it is probable that a claim resulting from injury or damage caused by a product defect will arise with respect to products or services that have been sold, accrual for losses may be appropriate. The condition in paragraph 450-20-25-2(a) would be met, for instance, with respect to a drug product or toys that have been sold if a health or safety hazard related to those products is discovered and as a result it is considered probable that liabilities have been incurred. The condition in paragraph 450-20-25-2(b) would be met if experience or other information enables the entity to make a reasonable estimate of the loss with respect to the drug product or the toys.

Entities may be subject to recalls on their products (e.g., pharmaceutical drugs, car engines, food products). While some product recalls are voluntary (e.g., the manufacturer has chosen to remove the product from the shelves or has notified consumers to cease using the product), other recalls may be required by law or a regulator (e.g., the FDA).

If an entity is not otherwise required by law or a regulator to initiate a product recall, the obligating event triggering liability recognition for the costs (i.e., repurchasing inventory) associated with a voluntary product recall would generally be the announcement of the recall. Except as provided for in a warranty arrangement, an entity has no legal obligation or duty associated with product design or manufacturing defects after the product is sold. Because there is no legal obligation, there is no event that gives rise to a probable loss until a recall is announced voluntarily. If, however, a warranty arrangement exists, the obligating event is the identification of a problem with the product or the need for product recall, not the voluntary recall announcement.

Alternatively, an entity may conclude, on the basis of current laws or regulations, that it is probable that such a law or regulation will require the entity to initiate a product recall as a result of adverse events or conditions associated with the product in the distribution channel (i.e., inventory that has been sold but has not yet been consumed). In such a situation, the obligating event triggering liability recognition for the costs of the recall is the existence of the current law or regulation, and liability recognition for the estimated costs of the recall would generally be required once the entity has concluded that it is probable that such a law or regulation will require a recall and the associated costs can be reasonably estimated. Further, such a conclusion could be reached before formal notification by a regulator that a recall will be mandated.

The above discussion regarding the obligation associated with a product recall does not take into account situations in which a product may have caused harm or damage that could result in potential loss against a company. In such a situation, a loss contingency would be recorded once the loss is deemed probable and reasonably estimable in accordance with ASC 450-20-25-2.

Unless other authoritative literature requires entities to classify costs of fulfilling product recalls in a particular manner (i.e., in accordance with the guidance in ASC 606 on consideration for a product returned from a customer), such costs should be classified as operating costs in the financial statements because they result from an inherent business risk.

Example 2-14

Voluntary Recall Initiated by an Entity

Big Pharma develops and manufactures health care products, including medicines and vaccines to advance wellness, prevention, treatments, and cures. In May and June, Big Pharma distributes 25,000 bottles of a pediatric drug to various distributors. The drug is commonly used to reduce fever and relieve symptoms from conditions such as the flu and a common head cold.

In August, Big Pharma discovers that 8,500 of the bottles, specifically the 3 oz. cherry flavor, were distributed with the incorrect dosage cups. The dosage instruction provides dosing in teaspoons, while the dosage cups included in the packaging were labeled in tablespoons. Since 1 tablespoon contains 3 teaspoons, Big Pharma is concerned that the usage of the tablespoon dosage cups could result in dangerous overdoses if the cups’ labeling was overlooked.

There is no law or regulation in place requiring Big Pharma to recall the drugs for including the incorrect dosage cups. In addition, no consumer lawsuits have been brought against Big Pharma regarding this matter. However, Big Pharma weighs the potential overdose risks of consumers’ overlooking the measurement metric on the dosage cup and decides to voluntarily recall the product. On August 11, 20X9, Big Pharma announces the recall for the 8,500 affected bottles. Upon announcing the recall, Big Pharma recognizes a liability for the estimated costs of removing the bottles from distributors and retail stores, replacing them, and notifying consumers. Because Big Pharma was not otherwise required by law to initiate the product recall, the obligating event triggering the liability recognition is the announcement of the recall on August 11, 20X9. Any liability related to potential consumer lawsuits would be accounted for in accordance with ASC 450-20. Such accounting would be separate from that for the costs Big Pharma expects to incur in connection with the recall.

Example 2-15

Recall Required by a Regulator

Mattress Store designs mattresses and sells them through various online retail Web sites. Mattress Store recently developed a new sleeper sofa that is available in various sizes, including twin, queen, and king, in a color choice of gray, blue, and black. Mattress Store begins selling the sleeper sofa in January. In March, Mattress Store discovers that the blue sleeper sofa is not in compliance with the mandatory federal flammability standard for mattresses and therefore poses a fire hazard. Although there have been no incidences reported or litigation brought against Mattress Store, the sleeper sofa is in violation of a federal law, and if it were reported to the U.S. Consumer Product Safety Commission, the commission would mandate a product recall and bar Mattress Store from selling the sleeper sofa. Therefore, Mattress Store announces a product recall in April to refund consumers who bought the sleeper sofa and reacquire all sold inventory.

Although the recall is announced in April and the regulator has not yet provided formal notification of a mandated recall for the sleeper sofa, Mattress Store had determined in March that it was probable that the U.S. Consumer Product Safety Commission would require the company to recall the sleeper sofa upon discovery of the violation of flammability standards. Further, Mattress Store concluded that sufficient information was available in March to make a reasonable estimate for the cost of the recall. Accordingly, Mattress Store records a liability for the product recall in March, before the April recall announcement or a regulator-mandated recall. Any liability related to potential consumer lawsuits would be accounted for in accordance with ASC 450-20. Such accounting would be separate from that for costs Mattress Store expects to incur in connection with the recall.

2.3.3 Threat of Expropriation

ASC 450-20-55-9 states that “[t]he threat of expropriation of assets is a contingency (as defined) because of the uncertainty about its outcome and effect.” The guidance requires recognition of a loss from threat of expropriation of assets only if (1) expropriation is imminent and (2) consideration received for the expropriated assets will be less than the carrying amount, resulting in a loss. With respect to (1), “[i]mminence may be indicated, for example, by public or private declarations of intent by a government to expropriate assets of the entity or actual expropriation of assets of other entities.” With respect to (2), an entity would recognize a loss only when the consideration received is less than the carrying value of the expropriated asset. The condition in ASC 450-20-25-2(b) requires that accrual be made only if the amount of loss can be reasonably estimated. In accordance with ASC 450-20-55-9, “[i]f the conditions for accrual are not met,” the entity should provide appropriate disclosures “if there is at least a reasonable possibility that an asset has been impaired” (see Section 2.8 for a discussion of disclosure requirements).

Footnotes

This position is consistent with the guidance in ASC 420 and ASC 805-20-55-50 and 55-51, which indicate that the liability for termination benefits and curtailment losses that will be triggered by the consummation of a business combination should be recognized only upon completion of the business combination.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.