Chapter 3 — Gain Contingencies
Chapter 3 — Gain Contingencies
3.1 Overview
ASC 450-30-20 defines a gain contingency as an “existing condition,
situation, or set of circumstances involving uncertainty as to possible gain to an
entity that will ultimately be resolved when one or more future events occur or fail
to occur.” This chapter provides an overview of the accounting and disclosure
requirements for gain contingencies, along with certain interpretive guidance on how
to apply the gain contingency model. Chapter 4
provides an overview of the accounting model for gain contingencies that arise when
recovery proceeds expected to be received are in excess of the related loss
previously recognized in the financial statements.
The standard for recognition of gain contingencies is substantially
higher than that for recognition of loss contingencies. ASC 450-30 indicates that a
gain contingency should usually not be recognized before realization.
ASC 450-30
25-1 A
contingency that might result in a gain usually should not
be reflected in the financial statements because to do so
might be to recognize revenue before its realization.
A gain contingency should not be recognized even if realization is
considered probable. The notion of “probable” is relevant in accounting for a loss
contingency, but it is not relevant in accounting for a gain contingency.
3.2 Gain Contingency Scope
All gain contingencies should be evaluated under ASC 450-30-25-1
unless another source of authoritative literature specifically prescribes a
different accounting model. The table below provides a nonexhaustive list of
examples of uncertainties related to the timing or amounts of future cash flows to
be received that are within the scope of other literature.
3.3 Application of the Gain Contingency Model
ASC 450-30-25-1 indicates that a gain contingency should not be recognized “before its realization.” The realization of a gain occurs at the earlier of when the gain is realized or when it is realizable. This view is based on paragraph 83 of FASB Concepts Statement 5 (codified in ASC 450), which states, in
part:
Revenues and gains of an enterprise during a period
are generally measured by the exchange values of the assets (goods or services)
or liabilities involved, and recognition involves consideration of two factors,
(a) being realized or realizable and (b) being earned, with sometimes one and
sometimes the other being the more important consideration.
- Realized or realizable. Revenues and gains generally are not recognized until realized or realizable. Revenues and gains are realized when products (goods or services), merchandise, or other assets are exchanged for cash or claims to cash. Revenues and gains are realizable when related assets received or held are readily convertible to known amounts of cash or claims to cash. Readily convertible assets have (i) interchangeable (fungible) units and (ii) quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price. [Footnote omitted]
An entity must often use significant judgment to determine when
realization of a gain has occurred. Substantially all uncertainties about the
realization of a gain contingency should be resolved before the gain contingency is
considered realized or realizable and recognized in the financial statements. A gain
is realized when cash or a claim to cash has been received and the cash (or claim to
cash) is not subject to refund or clawback. A claim to cash supporting realization
of a gain will often be in the form of a receivable. Such receivables may arise
through (1) legally binding contractual arrangements detailing payment terms or (2)
evidence provided by an insurer that all contingencies have been resolved and that
the insurer will pay the insured party’s claim with no right to repayment. It may be
appropriate to recognize a gain contingency when it is realizable, although we would
generally not expect this to be a common occurrence. A gain is realizable when
assets received or held are readily convertible to a known amount of cash (or claim
to cash).
An entity must thoroughly analyze all relevant facts and
circumstances related to the gain contingency to support a conclusion that (1) a
gain has been realized or (2) assets are readily convertible to cash in a known
amount and the gain is therefore realizable. For an entity to recognize a gain
contingency, the claim to cash must meet the definition of an asset in paragraphs
E16 and E17 of FASB Concepts Statements 8, Chapter 4. Paragraph E17 states, in part:
An asset has the following two essential characteristics:
- It is a present right.
- The right is to an economic benefit.
Connecting the Dots
Upon a litigation settlement determined by the courts or
other authoritative bodies, an agreement often is executed that outlines the
payments to be made by one or both of the parties and the timing thereof. In
these situations, there is no longer a gain contingency because the
agreement represents a claim to cash and the gain therefore has been
realized. The executed agreement represents a contractual receivable since
no contingencies remain. The party with the right to receive cash proceeds
would assess the contractual receivable for impairment as described in
Section
2.2.3.
In concluding that a gain has been realized or is realizable, an
entity should consider the nonexhaustive list of factors in the illustration below.
Sections 3.4 through
3.6 expand upon the factors shown in the illustration.
Besides the factors identified above, the entity should consider
additional facts and circumstances, the nature of the agreement, and consultation
with accounting advisers, as further discussed below.
3.4 Legal Disputes and Legislative or Regulatory Approval
Because of the number of uncertainties inherent in a litigation
proceeding, gain contingencies resulting from favorable legal settlements generally
cannot be recognized in income until cash or other forms of payment are received.
Gain recognition is not appropriate when a favorable legal settlement remains
subject to appeal or other potential reversals. Often, gain contingency recognition
will be deferred even after a court rules in favor of a plaintiff.
Example 3-1
Legal Dispute —
Declaration of Award
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.
Connecting the Dots
In the example above, Company W should not recognize the $4
million gain contingency award because all possible appeals have not yet
been exhausted and W’s gain contingency therefore is not considered realized
or realizable. This threshold for recognizing a gain contingency is higher
than the “probable and reasonably estimable” threshold required for
recognition of a loss contingency (see Chapter 2) or a loss recovery (see
Chapter
4).
Separately, Company O would recognize a loss contingency
after the arbitrator’s judgment because the criteria in ASC 450-20 have been
met. The arbitrator’s ruling is significant objective evidence of the
probability that O has incurred a liability, and O concludes that it does
not have sufficient evidence to counterbalance this adverse ruling. Further,
the $4 million that O will pay to W for settlement of the dispute is
reasonably estimable on the basis of the arbitrator’s ruling. Because the
thresholds for recognition of gain contingencies differ from those for
recognition of loss contingencies or loss recoveries, it is not uncommon for
one party in a dispute to recognize a loss contingency while the
counterparty does not recognize the gain contingency.
Although an entity may be certain that it will receive proceeds from
a legal settlement because there is no possibility of additional appeals, other
uncertainties may remain that indicate that the gain has not yet been realized. The
examples below illustrate contrasting scenarios in which the ultimate amount to be
received is not estimable in one case and is known in the other.
Example 3-2
Legal Dispute — Cash Is
Received in Escrow: Amount Not Estimable
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.
Example 3-3
Legal Dispute — Cash Is
Received in Escrow: Amount Known
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.
If a legal settlement is reached but is pending regulatory or
legislative approval, gain recognition is not appropriate until all required levels
of regulatory and legislative approval have been obtained. This is the case even if
the entity can demonstrate that the settlement meets all criteria that are evaluated
by a regulatory body when it is determining whether to grant approval.
Example 3-4
Legal Dispute —
Perfunctory Regulatory Approval
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.
Example 3-5
Legal Dispute —
Expectation of Regulatory Approval
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.
3.5 Settling Litigation by Entering Into an Ongoing Business Relationship
An entity may recognize gains related to the settlement of
litigation achieved by entering into an ongoing business relationship when the
revenue recognition criteria for such a relationship have been met. Such a situation
may exist when a litigation settlement agreement includes past obligations and
disputes and modifies the ongoing contractual terms of the business relationship.
When the contractual relationship is with a customer, the entity should apply ASC
606; otherwise, the entity may find it appropriate to apply ASC 610-20. In
accounting for a litigation settlement that also includes a revenue element, an
entity should consider bifurcating the settlement into its different elements, as
described in an SEC staff speech at the 2007 AICPA Conference on Current SEC and PCAOB
Developments (see Section
2.2.5 for further discussion).
In addition, regarding classification of the settlement, entities
should consider the guidance in ASC 606 when making payments to a customer and in
ASC 705-20 when receiving payments from a vendor. See Section 2.2.6.1 for further discussion.
3.6 Gain Realization Contingent on Future Performance Requirements
An entity’s realization of a gain may be contingent on whether the
entity meets a future performance requirement. Alternatively, realization of a gain
may be contingent on future events outside the entity’s control. In both cases,
uncertainty remains and recognition of the gain contingency is not appropriate.
Other Codification topics prescribe different accounting treatment
when uncertainty or contingent events are outside or within the entity’s control. As
long as the uncertainty is within the scope of the gain contingency guidance in ASC
450-30, the entity should not analogize to other areas of guidance in U.S. GAAP when
evaluating the appropriateness of recognizing a gain contingency.
Example 3-6
Probable Occurrence of a
Contingent Future Event
Company J contracts to outsource its data
processing function to Company K for a period of seven
years. Approximately four years into the agreement term, K
seeks to terminate the agreement. Companies J and K sign a
termination agreement with the following terms:
- The agreement will fully terminate and K will cease processing transactions six months after the agreement is signed.
- Company J is required to find alternative outsourcing services before the end of the six-month term.
- Company K must pay J $5 million for signing the termination agreement. The payment from K to J is made when the agreement is signed but is subject to clawback if J fails to find alternative outsourcing services.
- If J fails to obtain the alternative outsourcing, K is required to provide such a service but may charge 150 percent of the standard monthly fee for doing so.
Company J believes that it is probable that
the conversion to a new provider will be accomplished within
the required time frame. Accordingly, J would like to
recognize the $5 million termination fee in income. However,
the recognition of the termination fee in income is
contingent on J’s ability to obtain alternative outsourcing
by the specified date. Therefore, the recognition of the
termination fee should be deferred until J has resolved all
uncertainties related to the termination agreement. This
will be achieved through successful negotiation of another
outsourcing agreement for J’s data processing function.
Example 3-7
Contingent Future Event
for Which No Additional Performance Is Required
Assume the same facts as in the example
above except that, in accordance with the termination
agreement, Company J can, and intends to, process its
transactions in-house after Company K ceases transaction
processing. That is, K has agreed to pay J $5 million to
terminate the agreement. There are no clawbacks. Since the
$5 million is realizable as of the date the termination
agreement is signed and becomes legally binding, J may
recognize the $5 million in earnings.
3.7 Gain Contingency Disclosure
ASC 450-30
50-1 Adequate
disclosure shall be made of a contingency that might result
in a gain, but care shall be exercised to avoid misleading
implications as to the likelihood of realization.
Even if insurance proceeds resulting in a gain or other gain
contingencies are not recognized in the financial statements because of unresolved
uncertainties, timely disclosure of the insurance gain contingency should be
considered. Information disclosed might include (1) the nature of the gain
contingency, including a description of any remaining uncertainties; (2) the parties
involved; (3) the timeline of previous events; (4) an expected timeline for
resolving the remaining uncertainties; and (5) the amount of the gain contingency,
including consideration of uncertainties in the determination of the amount. If the
entity is unable to determine the timeline for resolution or an estimate of the
amount that will ultimately be realized, the entity may need to disclose the factors
it considered in reaching these conclusions and update these disclosures in future
financial statements as additional information becomes available.
The entity should take care to avoid providing misleading
disclosures about the likelihood, timing, or amount of the potential gain
contingency. Disclosures should also include the entity’s accounting policy for
recognizing recovery proceeds of previously recognized losses as well as proceeds
expected to be received in excess of previously recognized losses (see further
discussion in Chapter
4).
For considerations related to gain contingency classification, see
Section 4.8.
3.8 Subsequent-Event Considerations
Entities should evaluate events that occur after the balance sheet
date but before the financial statements are issued or are available to be issued to
determine whether the events should be recognized in the current-period or
subsequent-period financial statements.
The recognition, measurement, and disclosure principles related to
gain contingencies that are described in this chapter apply to the period after the
balance sheet date but before the financial statements are issued or are available
to be issued.
The resolution of a gain contingency that results in a gain after
the balance sheet date but before the financial statements are issued or are
available to be issued generally should not be considered a recognized subsequent
event. ASC 855-10-15-5(c) indicates that gain contingencies “are rarely recognized
after the balance sheet date but before the financial statements are issued or are
available to be issued” and provides a cross-reference to ASC 450-30-25-1, which
states that “[a] contingency that might result in a gain usually should not be
reflected in the financial statements because to do so might be to recognize revenue
before its realization.”