Chapter 2 — Loss Contingencies and Commitments

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.

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.)

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.

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.

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.

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.

Company S is a defendant in a lawsuit filed in 20X2 by a competitor, Company Z. In 20X4, a jury finds in favor of Z and awards damages of $10 million. Company S’s management determines that it is probable that a liability has been incurred despite its intent to appeal the verdict, and S recognizes a loss in the 20X4 financial statements. In December 20X8, the appeals court sets aside the previous jury verdict and remands the case back to the lower court for another trial. Company S has obtained an opinion from its legal counsel that says S has meritorious defenses and that the outcome of the new trial is uncertain after taking into account the reasons for the findings of the appeals court. Company S therefore derecognizes the previously recognized contingent liability given that it has determined that the evidence supported a conclusion that it was no longer probable that it would incur a loss in accordance with the litigation.

Company S should ensure that it has properly disclosed the change in facts and circumstances in the financial statements. In addition, although this illustrative example is provided to present the analysis an entity may undertake to determine when to derecognize a contingent liability, as a practical matter, entities may often find it challenging to obtain sufficiently compelling evidence to support a conclusion to reverse some or all of an existing contingent liability before complete elimination of the uncertainty. Company S will need to consider the totality of evidence available, including counsel’s views.