On the Radar
Although the guidance in ASC 450 on accounting for contingencies has
not changed significantly for decades, it is often challenging to apply because of
the need for an entity to use significant judgment in doing so (e.g., when
developing legal interpretations). Similarly, the guidance in ASC 460 on accounting
for guarantee liabilities, which has existed for two decades, is often difficult to
apply because the determination of whether an arrangement constitutes a guarantee is
complex.
Contingent Liabilities
An entity must recognize a contingent liability when both (1) it is probable
that a loss has been incurred and (2) the amount of the loss is reasonably
estimable. In evaluating these two conditions, the entity must consider all
relevant information that is available as of the date the financial statements
are issued (or are available to be issued). The flowchart below provides an
overview of the recognition criteria, taking into account information about
subsequent events.
If the recognition criteria for a contingent liability are met, entities should
accrue an 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. Discounting contingent liabilities
is generally prohibited.
Common Pitfall
Entities often fail to recognize a contingent liability
even when they have made a substantive offer to the
plaintiff to settle the litigation. An offer to settle
litigation is presumed to constitute evidence that a
loss has been incurred and that the offer amount
represents the low end of the range of loss, resulting
in the need to accrue a contingent liability for at
least this amount. It is extremely difficult to overcome
this presumption even if an entity withdraws the offer
before the financial statements are issued (or are
available to be issued).
Entities must disclose
information about contingent liabilities unless the likelihood of a loss is
remote. The disclosures required by ASC 450-20 may include information about the
following:
The SEC staff has consistently
commented on and challenged registrants’ compliance
with the disclosure requirements for loss
contingencies. For example, the staff has often
challenged registrants when they recognize material
contingent liabilities but have not disclosed
information about such possible losses in prior
filings.
Contingent Gains and Loss Recoveries
The accounting for contingent gains differs significantly from the accounting for
loss recoveries. Most notably, loss recoveries may be recognized earlier than
gain contingencies. A gain contingency cannot be recognized before it is
realized or realizable.
Recoveries of recognized losses (e.g., insurance recoveries) may
be recognized when it is probable that they will be received and the amount is
reasonably estimable. However, such recoveries cannot be recognized in amounts
that exceed the recognized losses because such an excess represents a gain
contingency. It is often difficult to determine whether an amount to be received
represents a loss recovery, a gain contingency, or a combination of both.
Guarantee Liabilities
Four types of contracts
represent guarantees under ASC 460:
The determination of whether an arrangement qualifies as one of these types of
contracts is often difficult because there is limited interpretive guidance on
each type; an entity will therefore need to use judgment in making this
determination. Further, because ASC 460 only discusses the characteristics of
each type of guarantee contract, entities often focus on ASC 460’s examples of
the types of contracts that meet the definition of a guarantee in determining
whether a contract is subject to ASC 460. To make matters even more complex,
there are a number of scope exceptions related to applying the recognition
guidance, disclosure guidance, or both.
Guarantee liabilities must be initially recognized at fair value. A fair value
estimate for such liabilities will include an amount for an entity’s stand-ready
(noncontingent) obligation that it assumes when the contract is issued. However,
ASC 460 does not address the subsequent measurement of such liabilities other
than to require that an entity apply the guidance on contingent liabilities to
any contingent loss arising from the contract. As a result, an entity needs to
adopt accounting policies that address both (1) the release of the liability
recognized at the inception of the contract and (2) the accounting for
contingent losses that arise, including how the recognition of those losses
intersects with the previous recognition of the amounts for the noncontingent
component. Because of the lack of specific guidance on this topic, diversity in
practice exists.
In addition to the disclosure requirements for contingent liabilities in ASC
450-20, entities must comply with ASC 460’s disclosure requirements that
specifically apply to guarantees.
Product Warranties
ASC 460 includes specific guidance on warranty obligations incurred in connection
with the sale of goods or services (i.e., product warranties). All product
warranties are within the scope of the disclosure requirements in ASC 460;
however, certain product warranties are outside the scope of ASC 460’s
recognition and measurement guidance and are accounted for in accordance with
ASC 606. The recognition and measurement of product warranties that are within
the scope of ASC 460 differs from the general recognition and measurement
guidance that applies to guarantees.
Common Pitfall
An entity accounts for an arrangement as an assurance- or
service-type warranty when it meets the definition of a
guarantee obligation that is subject to the general
recognition and measurement guidance in ASC 460.
This Roadmap comprehensively discusses
the accounting for contingencies, loss recoveries, and
guarantees.