3.4 Legal Disputes and Legislative or Regulatory Approval

Company W, which produces and sells construction materials, has a dispute with Company O, a contractor it engaged to perform construction services. Company O ceases the work before its completion, and W subsequently declares the contract canceled because of various issues concerning O’s performance of its obligations under the contract. Company W files a claim against O, and the parties enter into arbitration. The arbitrator declares that O is to pay W $4 million. The arbitrator’s judgment may be appealed to a higher court. Because there is no direct linkage between the arbitration award granted and the costs W previously incurred under the contract with O, the arbitration award is a gain contingency rather than the recovery of a previously incurred loss, and W should not recognize the $4 million award before its realization or when it is considered realizable.

Company R is a plaintiff in a class action lawsuit against several drug manufacturers. After a lengthy appeals process, a final settlement is reached. The drug manufacturers place the funds in an escrow account because there is no agreement on how to allocate the settlement among the attorneys and each respective plaintiff. Because R does not know the amount of cash to be received, gain recognition is inappropriate.

Assume the same facts as in the example above, except that the amount to be paid to Company R and to all other plaintiffs is known. In addition, the cash has already been placed in escrow and will be paid by the court-appointed escrow holder after it performs various administrative tasks (i.e., preparing and processing the wire payments to plaintiffs). None of the other plaintiffs are contesting the outcome or allocation of the settlement. The cash is nonrefundable and there is no potential for appeal or reversal. Company R has not identified any additional facts or circumstances related to this gain contingency that call into question whether the gain has been realized. After consulting with its accounting advisers, R concludes that gain recognition is appropriate if sufficient disclosure is provided about the status of realization. Company R’s realized claim to payment, as detailed in the agreement, would represent a contractual receivable subject to an impairment assessment.

Company Q, a builder of homes and condominiums, estimates that it has been overcharged by the city for sewer tap fees over a period of several years. Subsequently, Q and the city negotiate a settlement on the basis of the estimated overcharges that requires the city to refund $1 million in cash and provide Q with $1 million in credits toward future sewer tap fees. Because the overcharges are estimates and there is no direct linkage to previous costs incurred, the entire settlement amount is a gain contingency. The settlement is negotiated and signed by a representative of the city but is contingent on approval by the city council. Company Q believes that such approval is perfunctory and has obtained a legal opinion that the sewer credits can be used immediately upon the signing of the agreement. Since the agreement is expressly conditioned on approval by the city council, all levels of governmental approval have not yet been obtained. Therefore, recognition of the gain should be deferred.

Company A sells power to Municipal Agency M under a long-term supply contract. Because power prices have fallen substantially below those M has agreed to pay, M has notified A that it plans to terminate the supply contract. Under the contract’s terms, termination will result in a payment of $100 million from M to A. After considering expenses associated with terminating the agreement, A believes that it will recognize a $50 million gain upon termination.

Municipal Agency M cannot terminate the agreement until it obtains written approval from the state’s energy regulatory agency, which is not expected until after year-end. Company A knows the criteria that the state’s energy regulatory agency will use to evaluate the agreement termination and has no doubt that A has met the criteria. An expectation of approval by the regulatory agency, even with the understanding of the regulatory agency’s approval criteria, would not be sufficient for A to recognize the gain. The gain is subject to regulatory approval and should not be recognized until it has been obtained.