2.4 Measurement
ASC 450-20
30-1 If some amount
within a range of loss appears at the time to be a better
estimate than any other amount within the range, that amount
shall be accrued. When no amount within the range is a better
estimate than any other amount, however, the minimum amount in
the range shall be accrued. Even though the minimum amount in
the range is not necessarily the amount of loss that will be
ultimately determined, it is not likely that the ultimate loss
will be less than the minimum amount. Examples 1–2 (see
paragraphs 450-20-55-18 through 55-35) illustrate the
application of these initial measurement standards.
Once the recognition criteria under ASC 450-20-25-2 are met, entities
should accrue the estimated loss with a charge to income. If the amount of the loss is a
range, the amount that appears to be a better estimate within that range should be
accrued. If no amount within the range is a better estimate, the minimum amount within
the range should be accrued, even though the minimum amount may not represent the
ultimate settlement amount. See Section 2.3.2.3 for examples illustrating the application of ASC
450-20-30-1.
A contingent liability should be estimated independently from any
possible claim for recovery (see Chapter 4 for the accounting for loss recoveries). For example, entities
may enter into certain insurance contracts to protect themselves from a litigation loss,
but the presence of insurance does not relieve the entity from being the primary
obligor, since an entity generally would be unable to transfer to an insurance company
its primary obligation to a potential claimant without the claimant’s consent. Because a
potential claimant typically is not asked to consent to an insurance contract between
the entity and an insurance company, the entity may be unclear about the circumstances
in which its primary obligation to a potential claimant could shift to the insurance
company under an insurance contract.
Some have asserted that since workers’ compensation arrangements and other similar
insurance arrangements arise from and are governed by state law, it is possible for the
insurance company, rather than the insured entity, to be the primary obligor to the
claimant/employee by operation of law. In a typical workers’ compensation arrangement,
an entity purchases a policy from a third-party insurance company and the insurance
company pays the full cost of all claims directly to the employees, subject only to the
deductible. Actual claim experience will not further affect the entity’s potential
economic upside or downside aside from any insurance provisions that allow rates to be
adjusted retrospectively.
While such arrangements may exist, it is expected to be rare that a
legal analysis of the insurance contract and the applicable workers’ compensation laws
and regulations would support an assertion that the insurance company is the primary
obligor. An entity that asserts that it no longer is a primary obligor in those or
similar circumstances would need sufficient analysis and documentation to support its
conclusion.
2.4.1 Offer to Settle Litigation
Entities will often make offers to settle litigation. An offer by management to
settle litigation creates a presumption that it is probable that a liability has
been incurred. The settlement offer establishes a low end of the range under ASC
450-20-30-1, resulting in accrual of a liability. Withdrawal of a settlement
offer before acceptance and before issuance of the financial statements
generally would not change this conclusion since the existence of the offer
provides evidence that the company may be willing to settle the litigation for
at least that amount.
The presumption that a settlement offer triggers accrual of a
liability and the establishment of a low end of the range is generally
considered to be a high hurdle to overcome, and its rebuttal should be based on
persuasive evidence. The evidence should substantiate that it is not probable
that the offer will be accepted. In addition, the evidence should substantiate
that it is not probable that further negotiations will lead to an out-of-court
settlement for which the entity will owe payment to the counterparty. In certain
circumstances, an out-of-court settlement may be the only realistic litigation
strategy because a trial is deemed too risky. In such circumstances, the
extension of an offer to settle out of court is a strong indicator that the
entity will ultimately settle with the counterparty for an equal or greater
amount. Accordingly, when an offer has been extended to settle out of court, it
must be at least reasonably possible that the litigation will ultimately be
settled via court proceedings or arbitration and that the entity will not be
obligated to make a payment. An entity that believes that the presumption has
been overcome should consider consulting with its accounting advisers.
It may not always be appropriate to accrue a contingent liability at the amount
of a settlement offer. For example, if the counterparty to the settlement offer
has rejected the offer and proposed a higher settlement amount, the amount an
entity should accrue for the loss may exceed the settlement offer made by the
entity. In such situations, an entity should use judgment and consider the
relevant facts and circumstances.
Connecting the Dots
An entity should carefully consider all facts and
circumstances when assessing whether an “offer” has been extended to
settle litigation. Questions may arise about distinguishing when a
formal offer has been made from when parties have explored potential
settlement amounts. In determining whether there is a formal offer to
settle, an entity should consider whether approval from additional
members of management or the board of directors is required. Further,
the evidence available to substantiate that an offer does not constitute
the low end of the range is often subjective, and the entity should be
careful when evaluating whether the presumption can be overcome.
Example 2-16
Offer to Settle Litigation
Company X is in the medical device
business and has been named as the defendant in a
lawsuit alleging personal injury resulting from use of
one of its surgical devices. After year-end but before
issuance of the financial statements, X offers to settle
the litigation for $10 million. The plaintiff has not
responded to the offer, and X believes that if the
matter ultimately goes to trial, the outcome is
uncertain. Company X’s management believes that the
parties are still far from deciding on a settlement
value and therefore that the plaintiff is not likely to
accept the offer. However, given the significant
exposure X faces in a trial, it is probable that the
matter will eventually be settled.
The offer to settle is significant objective evidence
that it is probable that a liability has been incurred
as of the date of the financial statements and that the
amount of the offer constitutes the minimum amount in
the range and should be accrued in the financial
statements in accordance with ASC 450-20-30-1. Company X
must also disclose any additional reasonably possible
exposure to loss in its financial statements if the
disclosure requirements in ASC 450-20-50-3 are met.
2.4.2 Comparison of the “Probability-Based” and “Expected Value Cash Flow” Accounting Models
The liability measurement guidance in FASB Concepts Statement 7 should not be applied to the measurement of contingent liabilities recognized in accordance with ASC 450-20 because the expected value cash flow model in Concepts Statement 7 differs from the probability-based accounting model in ASC 450-20-25-2. Although the expected value cash flow model in Concepts Statement 7 is
probability-weighted, it addresses the measurement of expected cash flows that may incorporate events into its measurement that are not considered probable from a loss contingency perspective under ASC 450-20. Alternatively, the probability-based accounting model in ASC 450-20-25-2 addresses the recognition of an uncertain event. Differences of this nature are further discussed in paragraph B35 of the Basis for Conclusions of FASB Statement 143 (superseded), which states, in part:
Statement 5 and Concepts Statement 7 deal with uncertainty in
different ways. Statement 5 deals with uncertainty about whether a loss has been
incurred by setting forth criteria to determine when to recognize a loss
contingency. Concepts Statement 7, on the other hand, addresses measurement of
liabilities and provides a measurement technique to deal with uncertainty
about the amount and timing of the future cash flows necessary to settle the
liability. Because of the Board’s decision to incorporate probability into the
measurement of an asset retirement obligation, the guidance in Statement 5 and
FASB Interpretation No. 14, Reasonable Estimation of the Amount of a
Loss, is not applicable.
Therefore, it is not appropriate to use the measurement guidance in Concepts Statement 7 when measuring a contingent liability in accordance with ASC 450-20. Further, the use of the fair value measurement guidance in ASC 820 is also inappropriate in such situations because a fair value measurement is similar to the expected cash flow approach in Concepts Statement 7 and such an approach does not
satisfy the measurement objective in ASC 450-20 for the reasons described above.
2.4.3 Application of Present-Value Techniques to the Measurement of a Contingent Liability
The objective of recognizing and measuring a loss contingency is to
accrue a liability that will equal or approximate the ultimate settlement amount
when the uncertainty related to the loss contingency is finally resolved. In limited
instances, it may be appropriate to use present-value techniques to discount a
contingent liability recognized in accordance with ASC 450-20-25-2. However, it is
not appropriate to discount contingent liabilities unless both the timing and
amounts of future cash flows are fixed or reliably determinable on the basis of
objective and verifiable information. In most situations, as of the date the timing
and amount of future cash flows become fixed or determinable, the obligation will no
longer represent a contingency (i.e., it will be a contractual obligation). Thus, an
entity is generally not permitted to discount contingent liabilities.
The application of discounting to liabilities recognized in
accordance with ASC 450-20-25-2 differs from the present-value-based measurements
required by other accounting standards. The sections below provide additional
guidance on applying present-value techniques.
2.4.3.1 Guidance That Applies to Discounting Contingent Liabilities
ASC 450-20 does not provide guidance on whether it is
appropriate to discount a contingent liability that is within its scope.
Although ASC 410-30 specifically addresses environmental remediation
liabilities, an entity may find this guidance useful in evaluating whether
discounting is appropriate for similar loss contingencies. ASC 410-30-35-12
states that the “measurement of the liability, or of a component of the
liability, may be discounted to reflect the time value of money if the aggregate
amount of the liability or component and the amount and timing of cash payments
for the liability or component are fixed or reliably determinable.”
The SEC has provided guidance on discounting claims liabilities
related to short-duration insurance contracts. The SEC staff’s interpretive
response to Question 1 of SAB Topic 5.N
(codified in ASC 944-20-S99-1) states, in part:
The staff
is aware of efforts by the accounting profession to assess the circumstances
under which discounting may be appropriate in financial statements. Pending
authoritative guidance resulting from those efforts however, the staff will
raise no objection if a registrant follows a policy for GAAP reporting
purposes of: . . .
- Discounting liabilities with respect to settled
claims under the following circumstances:(1) The payment pattern and ultimate cost are fixed and determinable on an individual claim basis, and(2) The discount rate used is reasonable on the facts and circumstances applicable to the registrant at the time the claims are settled.
By analogy to the above guidance, discounting of a contingent liability is
permitted, but not required, if both the timing and amounts of future cash flows
are fixed or reliably determinable. However, because the timing and amounts of
future cash flows of many contingent liabilities are inherently subjective, it
is often difficult for an entity to meet the criteria for discounting a
contingent liability (e.g., in the early phases of litigation and environmental
remediation efforts).
The SEC staff has indicated that it continues to scrutinize
compliance with this requirement and that the notion of “reliably determinable”
is inconsistent with a disclosure that additional losses beyond amounts accrued
are reasonably possible. Similarly, if the low end of a range of possible losses
were accrued in accordance with ASC 450-20-30-1, discounting would not be
appropriate because the aggregate obligation is not fixed or reliably
determinable.
SEC Considerations
The SEC staff’s interpretive response to Question 1 of
SAB Topic 5.Y (codified in ASC
450-20-S99-1) states that if a contingent liability is recognized on a
discounted basis, the “notes to the financial statements should, at a
minimum, include disclosures of the discount rate used, the expected
aggregate undiscounted amount, expected payments for each of the five
succeeding years and the aggregate amount thereafter, and a
reconciliation of the expected aggregate undiscounted amount to amounts
recognized in the statements of financial position.”
By analogy to ASC 410-30-35-10 and 35-11, if a contingent liability is
discounted, any related asset recognized as a result of a third-party recovery
also should be discounted.
In addition, ASC 835-30 provides guidance on discounting
payables. ASC 835-30-15-2 applies to “payables that represent . . . contractual
obligations to pay money on fixed or determinable dates, whether or not there is
any stated provision for interest.” However, ASC 835-30-15-3(a) specifically
exempts from present-value techniques those “[p]ayables arising from
transactions with suppliers in the normal course of business that are due in
customary trade terms not exceeding approximately one year.”
Example 2-17
Discounted Environmental Obligation
Company C is subject to environmental obligations in
connection with groundwater contamination at several of
its domestic plants. Company C has substantially
satisfied all initial remediation costs but expects to
incur charges for monitoring costs on an ongoing basis
at several plant sites. The exact term of the monitoring
activities is not specified in the remediation agreement
approved by the Environmental Protection Agency, but C
expects that, on the basis of past experience and
internal estimates, the likely term for such monitoring
activities is 30 years. Company C has estimated the
costs for these monitoring activities each year by
adjusting current annual maintenance costs at each plant
for inflation and productivity improvements. It has
proposed to use an appropriate rate to discount this
future obligation.
The absence of a definitive required post-remediation
monitoring term does not preclude discounting this
element of an environmental remediation liability.
Similarly, the need to estimate inflation, productivity
improvements, or both does not, in and of itself, lead
to the conclusion that the cash flows are not reliably
determinable. A rate appropriately blending such factors
with the discount rate would be reasonable in this
circumstance.
Although discounting of a contingent liability may be considered
inappropriate, ASC 450-20 does not preclude an entity from measuring a
contingent liability on the basis of its best estimate of the current amount it
would be required to pay to another party to settle a dispute. To the extent
that the plaintiff would accept a lump sum payment that inherently reflects the
time value of money, the entity would not be precluded from recognizing that
amount as the contingent liability. Such an approach is not considered to
involve an inappropriate form of discounting.
2.4.3.2 Selection of an Appropriate Discount Rate
If an entity has determined that a contingent liability
qualifies for discounting, the entity should consider the appropriate discount
rate. ASC 835-30 provides guidance on the selection of a discount rate; however,
that guidance does not apply to contingent liabilities.
The SEC staff’s interpretive response to Question 1 of SAB Topic
5.Y states that the discount “rate used to discount the cash payments should be
the rate that will produce an amount at which the . . . liability could be
settled in an arm’s-length transaction with a third party. . . . [T]he discount
rate used to discount the cash payments should not exceed the interest rate on
monetary assets that are essentially risk free and have maturities comparable to
that of the . . . liability” (footnote omitted). Discount rates based on the
registrant’s incremental cost of capital, incremental borrowing rate, or
investment portfolio yields are not appropriate. In most cases, it will be
difficult for an SEC registrant to justify a discount rate higher than the
risk-free rate because market transactions are rarely available. SEC registrants
should apply this guidance in selecting an appropriate discount rate for all
contingent liabilities. An entity that proposes using a credit-adjusted discount
rate should consider consultation with the SEC staff on a preclearance
basis.
Non-SEC registrants may also consider the preceding guidance in
SAB Topic 5.Y. However, there is diversity in practice among non-SEC
registrants, and selection of a discount rate for contingent liabilities on the
basis of a measure other than the risk-free rate (e.g., high-quality
fixed-income debt securities) may also be acceptable.
2.4.3.3 Accounting for Subsequent Changes in the Discount Rate
Entities that elect to discount contingent liabilities must consider the impact
of changing discount rates when adjusting the amount of the liability as of each
balance sheet date. Entities should select their discounting approach as part of
their accounting policies to be applied consistently to all contingencies.
Two methods are used in practice to account for the change in a liability
attributable to fluctuations in the discount rate. One alternative, the
immediate recognition approach, is to remeasure the liability at the current
discount rate and recognize any increase or decrease in the liability through
earnings.
Alternatively, a “lock-in” approach may be used. Under the
lock-in approach, an entity would effectively create a separate layer of
liability each time the obligation is remeasured. The lock-in principle is
discussed in an AICPA issues paper, The Use of Discounting in Financial
Reporting for Monetary Items With Uncertain Terms Other Than Those Covered
by Existing Authoritative Literature. Issue 4B of this paper concludes
that “changes in the discount rate should not be recognized in the financial
statements and the original discount rate should be used in all subsequent
periods (that is, locked in).” The conclusion also indicates that “[i]If the
lock-in concept is adopted, . . . there are situations where a discount rate
other than the rate used in the initial recording of the item may be used.” For
example, if changes in circumstances subsequently resulted in an upward
adjustment to the liability, the incremental liability would be recorded at a
current discount rate rather than the discount rate used to measure the original
liability.
Connecting the Dots
The above guidance does not apply to contractual liabilities subject to
ASC 835-30. An entity does not adjust the discount rate used at
inception to initially recognize a contractual obligation unless (1) the
fair value option is applied to the liability or (2) the liability
represents a floating-rate obligation.
2.4.3.4 Change in Accounting Policy Related to Discounting of Contingent Liabilities
For those contingent liabilities that qualify for discounting,
the election to discount is a matter of accounting policy that should be
consistently applied and disclosed. An entity contemplating discounting a
contingent liability accounted for under ASC 450 should consider the guidance in
ASC 250-10-45-12 to determine whether discounting would be considered a
voluntary change in accounting principle that is preferable. If the entity
concludes that discounting a contingent liability is an allowable but not
preferred method, a change in accounting principle is not allowed. A voluntary
change in accounting principle would be accounted for in accordance with ASC
250-10.
On the other hand, if a change in the entity-specific facts and
circumstances regarding the predictability in the timing and amount of the
liability payments causes the contingent liability to no longer qualify for
discounting, a change to measuring the liability on an undiscounted basis would
not constitute a voluntary change in accounting principle; rather, it would be
accounted for as a change in accounting estimate in accordance with ASC
250-10.