Deloitte's Roadmap: Contingencies, Loss Recoveries, and Guarantees
Preface
Preface
We are pleased to present the 2025
edition of Contingencies, Loss Recoveries, and Guarantees. This Roadmap
provides Deloitte’s insights into and interpretations of the accounting guidance in
ASC 4501 on loss contingencies, gain contingencies, and
loss recoveries and addresses the accounting guidance in ASC 460 on guarantees.
Although the guidance in ASC 450 has not changed
significantly for decades, the application of the existing framework remains
challenging at times because an entity may be required to use significant judgment
in applying this guidance (e.g., legal interpretations are likely to be needed).
Similarly, although the guidance in ASC 460 has not changed significantly for two
decades, it may remain challenging to apply given the complexity of determining
whether a guarantee is within the scope of ASC 460 as well as how guarantees should
be accounted for in periods after their initial recognition and measurement.
In addition to summarizing the
accounting framework in ASC 450 and ASC 460 and providing an in-depth discussion of
key concepts, this Roadmap includes examples to illustrate how these concepts may be
applied in practice. This publication is not, however, a substitute for the exercise
of professional judgment, which is often essential to applying the requirements of
ASC 450 and ASC 460, or for consulting with Deloitte professionals on complex
accounting questions and transactions.
Be sure to check out On the
Radar (also available as a stand-alone
publication), which briefly summarizes emerging
issues and trends related to the accounting and financial
reporting topics addressed in the Roadmap.
We hope that you find this
publication a valuable resource when considering the accounting guidance on loss
contingencies, gain contingencies, loss recoveries, and guarantees.
Footnotes
1For the full titles of standards, topics, and
regulations used in this publication, see Appendix B. For a list of abbreviations
used in this publication, see Appendix C.
On the Radar
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. The staff also often asks about
estimates of reasonably possible losses or comments
when a registrant omits disclosure of a loss or
range of losses because its estimates lack precision
and confidence.
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.
Contacts
Contacts
|
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Andrew Pidgeon
Audit & Assurance
Partner
Deloitte & Touche LLP
+1 415 783 6426
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Ashley Carpenter
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 203 761 3197
|
For information about Deloitte’s
service offerings related to contingencies, loss recoveries, and guarantees, please
contact:
|
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Will Braeutigam
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 713 982 3436
|
Chapter 1 — Overview
Chapter 1 — Overview
1.1 Introduction
This Roadmap discusses the application of the guidance in ASC 450 on
contingencies and loss recoveries as well as the guidance in ASC 460 on
guarantees.
The accounting for contingencies is derived from FASB Statement 5, which the FASB
issued in 1975 and which was codified in ASC 450. That guidance has remained
substantially unchanged. Questions about the guidance’s scope and how to apply its
recognition, measurement, and disclosure requirements continue to arise given the
inherent uncertainty related to the accounting for contingencies and loss
recoveries.
The accounting for guarantees is derived from FASB Interpretation 45, which the FASB issued in 2002 and which was codified in ASC 460. Other than relatively minor FASB Staff Positions released between 2003 and 2005, the guidance that was originally issued as part of Interpretation 45 has remained substantially
unchanged. Nevertheless, it can be challenging for an entity to apply ASC 460 when
determining whether a guarantee is within the scope of the (1) initial recognition,
measurement, and disclosure guidance; (2) only the disclosure guidance; or (3)
neither. Further complexities arise because ASC 460 does not provide comprehensive
guidance on measurement in periods after the guarantee’s initial recognition and
measurement.
Throughout this Roadmap, “date of the financial statements” means
the end of the most recent accounting period for which financial statements are
being presented (i.e., December 31, 20X9, for an entity with a calendar year-end
that presents annual comparative financial statements for periods ended December 31,
20X8, and 20X9).
1.2 History of Guidance on Contingencies
FASB Statement 5 established an accounting and reporting framework
for loss contingencies and carried forward the conclusions of ARB 50 with respect to
gain contingencies and other disclosures. In 1976, the FASB clarified the use of a
range as part of the estimation of a contingent liability in FASB Interpretation
14.
In July 2010, the FASB issued a proposed ASU that would have amended the ASC 450 disclosure
requirements for loss contingencies in response to concerns raised by investors and
users of financial reporting that disclosures about loss contingencies under the
existing guidance in ASC 450 did not provide adequate and timely information to help
them assess the likelihood, timing, and amount of future cash outflows associated
with such contingencies. In particular, the proposed ASU stated that “[d]isclosure
of asserted but remote loss contingencies may be necessary, due to their nature,
potential magnitude, or potential timing (if known) to inform users about the
entity’s vulnerability to a potential severe impact.” Further, the proposed ASU
stated that “[t]his proposed change in the disclosure threshold would expand the
population of loss contingencies that are required to be disclosed to achieve more
timely disclosure of remote loss contingencies with a potentially severe impact.”
The FASB did not proceed with finalizing the proposed ASU after considering the
comments received but directed the FASB staff to work with the SEC and PCAOB staffs
to understand their efforts to address investors’ concerns about the disclosure of
certain loss contingencies through increased focus on compliance with existing
rules. In July 2012, the Board ultimately decided to remove the project on
disclosures of certain loss contingencies from its technical agenda. Given the
concerns expressed by investors and users, compliance with the disclosure
requirements of ASC 450 historically has been and continues to be an area of focus
by the SEC staff in its review of a registrant’s periodic filings.
ASC Master Glossary
Contingency
An existing condition, situation, or set of
circumstances involving uncertainty as to possible gain
(gain contingency) or loss (loss contingency) to an entity
that will ultimately be resolved when one or more future
events occur or fail to occur.
Loss Contingency
An existing condition, situation, or set of
circumstances involving uncertainty as to possible loss to
an entity that will ultimately be resolved when one or more
future events occur or fail to occur. The term loss is used
for convenience to include many charges against income that
are commonly referred to as expenses and others that are
commonly referred to as losses.
Contingent liabilities are liabilities for which the possible loss
outcome is unknown or uncertain, such as those associated with pending litigation.
The likelihood that a liability has been incurred ranges from “remote” to
“reasonably possible” to “probable.” The ASC master glossary’s definitions of these
terms provide no quantitative thresholds; accordingly, entities need to exercise
judgment when applying the terms.
ASC Master Glossary
Probable
The future event or events are likely to
occur.
Reasonably
Possible
The chance of the future event or events
occurring is more than remote but less than likely.
Remote
The chance of the future event or events
occurring is slight.
A gain contingency also includes characteristics of uncertainty but
differs from a loss contingency in that the resolution of the uncertainty could
potentially result in a gain. The recognition threshold for a gain contingency is
substantially higher than that of a loss contingency.
ASC Master Glossary
Gain Contingency
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.
Chapter
2 provides an overview of the scope, recognition, measurement, and
disclosure requirements for loss contingencies, along with certain interpretive
guidance on accounting for loss contingencies. Chapter 3 provides similar information in the
context of gain contingencies. See Chapter 4 for guidance on how to apply the loss recovery model to a
recognized loss and possible recovery proceeds.
Because the accounting for a contingency involves the evaluation of
the likelihood of occurrence or nonoccurrence of a future event that may confirm a
previous loss, impairment of an asset, or incurrence of a liability, contingencies
may be at risk for being overlooked for recognition or disclosure purposes. It is
important to disclose certain contingencies, even those that are not recognized, so
that financial statement users can understand an entity’s risks and how they could
potentially affect the financial statements.
Management should have processes in place to capture, evaluate, and
document the recognition, measurement, and disclosure of contingencies. Entities
should thoroughly document key judgments, the completeness and the accuracy of
information used in reaching those judgments (including contradictory information,
if any), and their support for any significant assumptions. In addition, when
management engages a specialist or expert, management retains overall responsibility
for overseeing the specialist’s or expert’s activities and for the resulting
product, including ownership of the amounts determined by the engaged specialist or
expert as well as the design, implementation, and maintenance of internal control
over financial reporting (ICFR).
1.3 History of Guidance on Guarantees
In the early 2000s, a high-profile corporate failure highlighted an
existing practice in which an entity could issue a guarantee to certain
nonconsolidated entities but did not have to recognize the guarantee in its
financial statements or provide transparent disclosures regarding the previously
issued guarantee. After this corporate failure, the FASB undertook a project to
amend certain aspects of the consolidation accounting guidance. In deliberating the
project, the FASB concluded that there was sufficient diversity in practice related
to the recognition and disclosure of guarantees issued by an entity to warrant a
separate standard-setting project on guarantees. The FASB’s conclusion ultimately
led to its issuance of Interpretation 45 in November 2002. The guidance in
Interpretation 45 (codified in ASC 460) has remained largely unchanged, other than
minor revisions made by FASB Staff Positions issued in 2003 through 2005.
As a result of the recognition and disclosure complexity described
above, it may be challenging to determine whether an agreement represents a
guarantee that is within the scope of ASC 460. The lack of a definition of
“guarantee” in the ASC master glossary adds to the complexity of this determination.
Because a guarantee may take many forms (e.g., derivative, product warranty, letter
of credit) and may be used for various business purposes, it is difficult to provide
one succinct definition of this term. Given the detailed nature of ASC 460’s scope
guidance and the multiple sections of the Codification that address guarantee
contracts, a significant portion of Chapter 5 on guarantees (specifically
Section 5.2) is
dedicated to providing additional guidance on the scope of ASC 460.
Another challenge with applying the guidance in ASC 460 is that it
does not comprehensively address how to subsequently measure guarantees that are
recognized in accordance with the standard’s initial recognition and measurement
provisions. Many entities will need to apply significant judgment to determine how
they are released from risk under the guarantee and, therefore, the period over
which the guarantee liability should be released to earnings.
Although much of the guidance in ASC 450 is unrelated to that in ASC
460, both of these Codification topics address the accounting for uncertainties. A
guarantor that issues a guarantee is obligated to the guaranteed party in two ways:
(1) a noncontingent stand-ready obligation and (2) a contingent obligation. The
guidance in ASC 460 on the recognition and measurement of the contingent obligation
aspect of a guarantee is described in Sections 5.3.2.2 and 5.4.2. This contingent aspect
is accounted for in accordance with the principle outlined in ASC 450, which is
described throughout Chapter
2.
Chapter 2 — Loss Contingencies and Commitments
Chapter 2 — Loss Contingencies and Commitments
2.1 Overview
ASC 450 defines a loss contingency as “[a]n existing condition, situation, or set of
circumstances involving uncertainty as to possible loss to an entity that will
ultimately be resolved when one or more future events occur or fail to occur.”
Resolution of uncertainty in the context of a loss contingency may confirm the loss,
the impairment of an asset, or the incurrence of a liability. This chapter provides
an overview of the scoping, recognition, measurement, and disclosure requirements
for loss contingencies, along with certain interpretive guidance on accounting for
them.
Contingent liabilities are liabilities for which the possible loss
outcome is unknown or uncertain, such as pending or threatened litigation, actual or
possible claims, or product defects. Uncertainty is inherent in all loss
contingencies. The terms “probable,” “reasonably possible,” and “remote” in ASC
450-20 are used to determine the likelihood of the future event that will confirm a
loss, an impairment of an asset, or the incurrence of a liability. No quantitative
characteristics are provided in the codified definitions; accordingly, entities need
to exercise judgment when applying the terms.
Accrual of a loss contingency is required when (1) it is probable that a loss has
been incurred and (2) the amount can be reasonably estimated. An entity must
determine the probability of the uncertain event and demonstrate its ability to
reasonably estimate the loss from it to accrue a loss contingency. Loss
contingencies that do not meet both of these criteria for recognition may need to be
disclosed in the financial statements.
Typically, under the accounting literature, an entity uses either a
probability-based model or a fair value model when dealing with uncertainty related
to losses. The probability-based recognition guidance in ASC 450-20 differs from
that in other Codification topics under which an entity measures liabilities in
accordance with a fair value objective. To measure a liability at fair value, an
entity must consider events whose occurrence is less than probable. Therefore, a
fair value measurement will result in the recognition of a liability for a
conditional obligation for which the likelihood of future settlement, although more
than zero, is less than probable; a liability would not be recognized in this
situation under the guidance in ASC 450-20 that applies to loss contingencies.
2.1.1 Relationship Between Recognized Loss Contingencies and Reserves
As indicated in ASC 450-20-05-8 and 05-9, when accruing a loss contingency, an
entity does not create or set aside funds to lessen the possible financial
impact of a loss. ASC 450-20-05-8 states, in part:
Confusion
exists between accounting accruals (sometimes referred to as accounting
reserves) and the reserving or setting aside of specific assets to be used
for a particular purpose or contingency. Accounting accruals are simply a
method of allocating costs among accounting periods and have no effect on an
entity’s cash flow. Those accruals in no way protect the assets available to
replace or repair uninsured property that may be lost or damaged, or to
satisfy claims that are not covered by insurance, or, in the case of
insurance entities, to satisfy the claims of insured parties. Accrual, in
and of itself, provides no financial protection that is not available in the
absence of accrual.
In addition, ASC 450-20-05-9 states:
An
entity may choose to maintain or have access to sufficient liquid assets to
replace or repair lost or damaged property or to pay claims in case a loss
occurs. Alternatively, it may transfer the risk to others by purchasing
insurance. The accounting standards set forth in this Subtopic do not affect
the fundamental business economics of that decision. That is a financial
decision, and if an entity’s management decides to do neither, the presence
or absence of an accrued credit balance on the balance sheet will have no
effect on the consequences of that decision. Insurance or reinsurance
reduces or eliminates risks and the inherent earnings fluctuations that
accompany risks. Unlike insurance and reinsurance, the use of accounting
reserves does not reduce or eliminate risk. The use of accounting reserves
is not an alternative to insurance and reinsurance in protecting against
risk. Earnings fluctuations are inherent in risk retention, and they are
reported as they occur.
Further, in a manner consistent with ASC 450-20-50-1, which
requires entities to disclose the nature of recognized accruals, entities should
refrain from using the term “reserves” when referring to the accrual of a loss
contingency.
2.2 Scope
ASC 450-20
15-2 The
following transactions are excluded from the scope of this
Subtopic because they are addressed elsewhere in the
Codification:
- Stock issued to employees, which is discussed in Topic 718.
- Employment-related costs, including deferred compensation contracts, which are discussed in Topics 710, 712, and 715. However, certain postemployment benefits are included in the scope of this Subtopic through application of paragraphs 712-10-25-4 through 25-5.
- Uncertainty in income taxes, which is discussed in Section 740-10-25.
- Accounting and reporting by insurance entities, which is discussed in Topic 944.
- Measurement of credit losses for instruments within the scope of Topic 326 on measurement of credit losses.
All loss contingencies should be evaluated under ASC 450-20 unless
they are within the scope of other authoritative literature. The table below
contains a nonexhaustive list of examples of contingencies or uncertainties that are
within the scope of other authoritative literature.
The sections below address certain scope-related topics.
2.2.1 Firmly Committed Executory Contracts
Although the ASC master glossary does not define “executory contract,” an entity
may find the following considerations useful in assessing the meaning of this
term:
- Although never finalized and ultimately removed from the EITF’s agenda, EITF Issue 03-17 refers to an executory contract as “a contract that remains wholly unperformed or for which there remains something to be done by either or both parties of the contract.”
- IAS 37 refers to an executory contract as a contract “under which neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent.”
The ASC master glossary defines a firm purchase commitment as “an agreement with
an unrelated party, binding on both parties and usually legally enforceable,”
that is both (1) specific in “all significant terms, including the price and
timing of the transaction,” and (2) “includes a disincentive for nonperformance
that is sufficiently large to make performance probable.” Disincentives for
nonperformance may be, for example, in the form of (1) a fixed payment
requirement for each period under the agreement regardless of whether the
purchaser takes delivery or (2) the inability of a purchaser to change the
contractual delivery and payment terms with a supplier without a penalty payment
for nonperformance.
At the inception of a firmly committed executory contract, both parties to the
contract expect to receive benefits from the contract that are equal to or
greater than the costs to be incurred under the contract. However, during the
term of the contract, the fair value of the remaining contractual rights may
unexpectedly decline below the remaining costs to be incurred, resulting in a
firmly committed executory “loss contract.”
When determining whether to recognize a contingent liability for
such a loss contract, entities should first consider the applicability of any
industry- and transaction-specific guidance. Firmly committed executory
contracts addressed under U.S. GAAP include the following:
- A firm purchase commitment for goods or inventory under ASC 330.
- Construction or production-type contracts within the scope of ASC 605-35 (see Deloitte’s Roadmap Revenue Recognition for a discussion of onerous performance obligations).
- Certain executory contracts subject to ASC 420 related to exit or disposal activities.
- An insurance contract with a premium deficiency subject to ASC 944-60.
- Certain derivative contracts within the scope of ASC 815.
The EITF discussed loss recognition for all other firmly
committed executory contracts (i.e., contracts not otherwise within the scope of
authoritative literature that provides recognition and measurement guidance on
losses in accordance with firmly committed executory arrangements) from the
perspective of the (1) buyer and (2) seller. However, the EITF was unable to
reach a consensus on these issues because of their broad scope and recommended
that the FASB add a project on executory contracts to its agenda. Currently,
there is no authoritative accounting guidance, other than that referred to
above, that would support the recognition of a contingent liability when the
fair value of remaining contractual rights under a firmly committed executory
contract declines below the remaining costs to be incurred.
While the EITF did not provide authoritative guidance on the
recognition of a liability for a loss contract, on the basis of comments by the
SEC staff, it is generally inappropriate to accrue for a loss related to a
firmly committed executory contract unless there is specific authoritative
literature to the contrary. However, regardless of whether an entity has
recognized a liability related to a firmly committed executory contract, the
entity should consider the need for disclosure of the arrangement in the
financial statements to prevent the financial statements from being misleading.
In addition, SEC registrants should consider whether commitments related to
executory contracts should be included in their SEC Regulation S-K disclosures
(e.g., within MD&A). See Section 2.8.4 for a discussion of the disclosure requirements
for firmly committed executory contracts.
2.2.2 Application of ASC 450 to Employee Benefit Arrangements
Compensation to executives and employees in addition to base salary
or wages can take many forms, including (1) share-based payment arrangements; (2)
deferred compensation or bonus plans; and (3) postemployment benefit, postretirement
benefit, and special termination or early retirement plans. The specific accounting
requirements vary depending on the nature of the compensation arrangement. ASC 450
should be applied to certain compensation or benefit plans that are not specifically
addressed by other authoritative accounting literature (e.g., certain cash bonus
arrangements).
In addition, certain compensation arrangements are accounted for in
accordance with ASC 710 and not ASC 450 when specific conditions are met. For
instance, certain postemployment benefits within the scope of ASC 7121 that meet the following conditions as defined in ASC 710-10-25-1 are accounted
for in accordance with ASC 710-10:
- The employer’s obligation to provide an employee with postemployment compensation is attributed to the employee’s services already rendered.
- “The obligation relates to rights that vest or accumulate.”
- “Payment of the compensation is probable.”
- “The amount can be reasonably estimated.”
However, ASC 712-10-25-5 requires that certain postemployment benefits that do not
meet the above conditions be accounted for in accordance with ASC 450-20-25-2 when
the loss is probable and can be reasonably estimated.
Example 2-1
Postemployment
Benefits
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.
See Section 2.3.2.7 for a discussion of the recognition of
liabilities related to annual bonus plans.
2.2.3 Collectibility of Receivables
Entities must apply the current expected credit loss (CECL) model to
receivables and other financial instruments that are within the scope of ASC 326-20.
Under the CECL model, receivables that are expected to be uncollectible but do not
yet meet the “probable” threshold will result in recognition of losses. Accordingly,
credit losses resulting from receivables and other financial instruments within the
scope of ASC 326-20 are outside the scope of ASC 450-20. However, the incurred loss
model in ASC 450-20 continues to apply to certain financial instruments that are not
within the scope of ASC 326-20. For more information about the scope, recognition,
and measurement guidance in ASC 326-20, see Deloitte’s Roadmap Current Expected Credit
Losses.
2.2.4 Differentiating Between Contingent Liabilities and Contractual or Legal Liabilities
Contingent liabilities involve uncertainty about whether a loss has
been incurred and differ from contractual liabilities. Therefore, an entity must
distinguish between a contingent liability, which is within the scope of ASC 450-20,
and a contractual or legal liability, which is not. Contingent liabilities comprise
only liabilities in which an entity’s obligation to pay another entity is uncertain.
Contractual or legal liabilities are debts or obligations between two or more
parties that are typically settled by the transfer of cash, assets, or services; for
these liabilities, there is generally little to no uncertainty about the likelihood
of occurrence of the future settlement. A liability is not an unasserted claim or
assessment under ASC 450-20 if the settlement of the liability is required by law or
by contract.
Liabilities established by law or by contract are recorded at the
stated amounts due unless otherwise indicated in U.S. GAAP. The probability of
payment is not relevant to the accounting for such liabilities.2 If an entity is required by law, regulation, or contract to make a future
payment associated with an event that has already occurred, that event imposes a
present duty upon the entity. An entity’s uncertainty about whether an obligee will
require performance does not allow the entity to choose to avoid the future
sacrifice, nor does the uncertainty relieve the entity of the obligation. That is,
when the obligating event has occurred, the entity has incurred a liability;
accordingly, there is no contingency. For example, an entity must recognize accounts
payable on the basis of the amount that it is contractually required to pay. The
entity may not recognize accounts payable on the basis of the amount that it would
expect to ultimately pay if the creditor filed suit to collect the liability. This
conclusion is supported by analogy to ASC 410-20-25-15, which states that an
“unambiguous requirement that gives rise to an asset retirement obligation coupled
with a low likelihood of required performance still requires recognition of a
liability.” Once recognized, a contractual or legal liability that is not deferred
revenue (i.e., a contract liability under ASC 606) should be derecognized only when
the conditions for liability derecognition in ASC 405-20-40-1 have been met.
ASC 405-20
40-1 Unless addressed by other
guidance (for example, paragraphs 405-20-40-3 through 40-4
or paragraphs 606-10-55-46 through 55-49), a debtor shall
derecognize a liability if and only if it has been
extinguished. A liability has been extinguished if either of
the following conditions is met:
- The debtor pays the creditor and is
relieved of its obligation for the liability. Paying
the creditor includes the following:
- Delivery of cash
- Delivery of other financial assets
- Delivery of goods or services
- Reacquisition by the debtor of its outstanding debt securities whether the securities are cancelled or held as so-called treasury bonds.
- The debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor. For purposes of applying this Subtopic, a sale and related assumption effectively accomplish a legal release if nonrecourse debt (such as certain mortgage loans) is assumed by a third party in conjunction with the sale of an asset that serves as sole collateral for that debt.
A contractual or legal liability is subject to the above liability
derecognition guidance regardless of whether an entity believes that, on the basis
of a probability assessment, such a liability can be settled for less than the
stated legal obligation.
The examples below illustrate the accounting for a liability for
which payment is required by law or contract but detection and settlement are
uncertain.
Example 2-2
Probability Assessment
Related to Sales Tax Liability for Which Payment Is
Required by Law but Detection and Settlement Are
Uncertain
Entity Z is preparing financial statements
for the first time. 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.)
Example 2-3
Royalty Liability for
Which Payment Is Required by Contract but Detection and
Settlement Are Uncertain
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.
Connecting the Dots
There may be uncertainty about whether an entity is subject to or within the
scope of a current law, regulation, or contract owing to ambiguity about the
interpretation of the current law, regulation, or contract. Examples include
uncertainties related to a tax based on gross receipts, revenue, or capital.
In these circumstances, an entity should evaluate the uncertainty in
accordance with the flowchart below.
The example below illustrates the analysis an entity would perform
in determining whether (1) it has a liability that is subject to contract, law, or
regulation or (2) the uncertainty should instead be accounted for in accordance with
ASC 450-20.
Example 2-4
Determining Whether an
Entity Is Subject to a Disputed Contractual Executory
Agreement
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.
2.2.5 Elements of a Litigation Settlement
There may be litigation settlements in which the settlement
agreement includes past obligations and disputes and modifies the ongoing
contractual terms of the business relationship. When accounting for a litigation
settlement that also includes a separate element (such as a revenue element) and
bifurcating the elements, an entity should consider a speech made by Eric West, associate chief accountant in the
SEC’s Office of the Chief Accountant, at the 2007 AICPA Conference on Current SEC
and PCAOB Developments. We consider the interpretive guidance shared by Mr. West to
be relevant and useful to private companies in addition to SEC registrants. Mr. West
summarized a settlement arrangement as follows:
[A] company pays
cash and conveys licenses to a plaintiff in order to settle a patent
infringement and misappropriation of trade secrets claim. In exchange for the
payment and licenses given, the company receives a promise to drop the patent
infringement lawsuit, a covenant not to sue with respect to the misappropriation
of trade secrets claim, and a license to use the patents subject to the
litigation.
Mr. West noted that the different elements of the arrangement should
be identified and that an entity will need to understand the nature of each item to
make this identification. In addition to the litigation settlement component, there
could be recognizable intangible assets related to the covenant not to sue and for
patent licenses received. Regarding the license to patents given to the plaintiff,
Mr. West noted:
If the licenses are expected to be used by the
plaintiff in their operations, it may be appropriate for the company to
recognize revenue or income with a corresponding increase in litigation
settlement expense. However, if the licenses are given as part of a litigation
defense strategy and don’t have value to the plaintiff, it seems unlikely that
any revenue should be recognized.
With respect to the amount of consideration to allocate to each element of the
transaction, Mr. West noted the following:
While EITF 00-21 was written for
multiple element revenue arrangements, we believe that its allocation guidance
is also useful to determine how to allocate consideration paid in a multiple
element legal settlement. In this regard, we believe that it would be acceptable
to value each element of the arrangement and allocate the consideration paid to
each element using relative fair values. [Footnote omitted]
Even though Mr. West was speaking about the separation guidance in EITF Issue 00-21, which was codified in ASC 605-25 and has been superseded by ASC
606, it is still appropriate for an entity to consider the principles of separation
of performance obligations within the context of the revenue guidance in ASC 606.
Specifically, as shown below, ASC 606 includes guidance on how to allocate
consideration to different elements of a contract with a customer that are partially
within the scope of ASC 606 and partially within the scope of another topic.
ASC 606-10
15-4 A contract with a customer
may be partially within the scope of this Topic and
partially within the scope of other Topics listed in
paragraph 606-10-15-2.
- If the other Topics specify how to separate and/or initially measure one or more parts of the contract, then an entity shall first apply the separation and/or measurement guidance in those Topics. An entity shall exclude from the transaction price the amount of the part (or parts) of the contract that are initially measured in accordance with other Topics and shall apply paragraphs 606-10-32-28 through 32-41 to allocate the amount of the transaction price that remains (if any) to each performance obligation within the scope of this Topic and to any other parts of the contract identified by paragraph 606-10-15-4(b).
- If the other Topics do not specify how to separate and/or initially measure one or more parts of the contract, then the entity shall apply the guidance in this Topic to separate and/or initially measure the part (or parts) of the contract.
Connecting the Dots
In an agreement that contains a settlement of a litigation
component and a revenue contract with a customer, an entity should bifurcate
the revenue element and the nonrevenue element (i.e., litigation) and
allocate the consideration to both elements in a manner consistent with Mr.
West’s remarks and ASC 606. There may be situations in which the entity has
clear, compelling evidence that there is little to no value related to the
litigation settlement; in those situations, the entire arrangement should be
accounted for as a single element under ASC 606. When the entity determines
that the entire arrangement should be accounted for as a single element
under ASC 606, it may be appropriate to allocate consideration for the
entire arrangement to the revenue element; however, the entity should not
apply the residual method and allocate all of the proceeds to the revenue
element by default..
The discussion above applies to both gain and loss
contingencies that are settled by entering into a revenue contract with a
customer. See Chapter
3 of Deloitte’s Roadmap Revenue Recognition for further
discussion of contracts that include both revenue and nonrevenue elements.
Chapter 7
of Deloitte’s Roadmap Revenue Recognition addresses estimating
stand-alone selling prices, including application of the residual
method.
Further, the same allocation principle applies when the
settlement does not contain a revenue element and is therefore entirely
outside the scope of ASC 606 (i.e., the settlement is not with a customer,
and none of the components constitute an output of the entity’s ordinary
activities). In those circumstances, an entity should still consider the
allocation principle described in Mr. West’s remarks and ASC 606 by
analogy.
2.2.6 Incurrence of a Future Cost of Doing Business
The incurrence of an obligation may represent the settlement of a past liability or a
future cost of doing business. The settlement of a lawsuit by agreeing to make a
cash payment in the absence of other elements of the settlement clearly represents
the settlement of a past liability that should be accrued immediately. Signing an
employment contract that guarantees an executive a fixed salary clearly represents a
future cost of doing business that should be accrued as the executive performs
service. However, it is not always clear how to distinguish between settlement of a
past liability and the incurrence of a future cost of doing business. Companies
sometimes settle litigation by altering the terms of future business arrangements,
which calls into question whether a present liability has been incurred.
Accordingly, an entity must consider all facts and circumstances to determine whether
an obligation represents the settlement of past liabilities or a cost of doing
business in the future. Sometimes it can be argued that the facts and circumstances
support both views, as demonstrated in the example below.
Example 2-5
Differentiating Between Settlement of a Past Liability and
a Future Cost of Doing Business
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.
The incurrence of a future cost of doing business is often indicated
by a payment stream that is contingent on the future sale of products or services in
the ordinary course of business (e.g., royalties due to a licensor for the license
and use of intellectual property). The future sale would be considered the event
giving rise to the liability. Additional evidence that a payment is, in substance, a
future cost of doing business is the inability to currently estimate the amount. It
may not be possible to reasonably estimate a payment that is contingent on a measure
such as future sales volume. Thus, a future cost of doing business would often fail
to qualify for recognition under ASC 450-20-25-2 because the obligating event has
not yet occurred, the amount is not reasonably estimable, or both.
Example 2-6
Liability Settled by
Incurring 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.
An entity may sometimes agree to settle a claim by agreeing to offer
the claimant(s) a price concession on future purchases of the entity’s goods or
services by the claimant(s). In such a scenario, the claimant(s) will be required to
make an independent future purchasing decision to realize the benefit of the
settlement. An entity that is obligated to provide such price concessions in
connection with a settlement will need to assess whether the settlement (1)
represents a liability that should be currently recognized for the estimated
settlement amount or (2) should be accounted for as a sales incentive in accordance
with ASC 606, which generally results in the entity’s accounting for the sales
incentive at the time the claimant or claimants use the price concession in
connection with the purchase of the entity’s goods or services.
While an entity may need to use significant judgment to determine
the appropriate accounting, a settlement with an existing customer (or group of
customers) that entitles such customer(s) to future price concessions for goods or
services, when the entity believes on the basis of compelling evidence that such
customer(s) would have purchased the goods or services in the absence of the
concession, could lead the entity to conclude that liability recognition is
appropriate provided that a reasonable estimate can be made. Alternatively, a
settlement with a claimant or claimants for future price concessions of the entity’s
goods or services, when there was no preexisting customer/vendor relationship, may
represent a situation in which such a settlement is in substance more akin to a
future price concession that should be accounted for in accordance with ASC 606
rather than a settlement of a prior liability. If the former view was taken for such
a fact pattern (i.e., the settlement is accounted for as a liability), the entity
may nonetheless conclude that it is unable to reasonably estimate the future price
concession (e.g., in a circumstance in which there is an insufficient sales history
with the claimant(s) or the concession is stated as a percentage of future sales of
an unknown quantity), meaning that not all of the recognition criteria in ASC
450-20-25-2 are met. Irrespective of when the future price concession is accounted
for, any settlement with a customer or a vendor would need to be evaluated in
accordance with ASC 606 or ASC 705-20, respectively, regarding the income statement
presentation of the settlement. See below for further discussion of the income
statement presentation for settlements with customers and vendors.
2.2.6.1 Income Statement Classification for Settlements With Customers and Vendors
When determining the appropriate income statement classification
of a litigation settlement with a counterparty that is a customer, the entity
should first look to the guidance on consideration payable to a customer in ASC
606-10-32-25 through 32-27 to determine whether the consideration is for a
distinct good or service for which the entity can reasonably estimate fair value
and, if so, classify such settlement payments in accordance with applicable U.S.
GAAP. Similarly, when a litigation settlement involves a counterparty that is a
vendor, the entity must consider ASC 705-20 to determine the appropriate income
statement presentation of the settlement.
When the settlement counterparty is a customer or a vendor and
the entity is able to determine the distinct litigation settlement benefit and
can reasonably estimate the fair value of the litigation settlement benefit, the
entity may recognize some or all of the settlement amount as an expense. To
determine the appropriate amount to recognize as an expense, entities should
consider the factors discussed in a speech made by Eric West, associate chief
accountant in the SEC’s Office of the Chief Accountant, at the 2007 AICPA
Conference on Current SEC and PCAOB Developments. Mr. West summarized the
classification of a settlement arrangement as follows:
Classification of the
Settlement
In the fact pattern that I’ve talked about so far it
would be appropriate to record the consideration allocated to the
litigation within operating expenses since the company did not have a
prior relationship with the plaintiff. However, we believe that a
different answer may result if the plaintiff is also a customer of the
defendant. Assume a company settles a claim for over
billing its customers for an amount that is in excess of the amounts
they over billed. The company believed that the excess payment was
necessary to preserve the customer relationship and had induced the
customer to settle the claim. In this case we do not believe that
classification of the entire payment as a settlement expense would
be consistent with existing GAAP. Since the settlement payment was
made to the company’s customers, we believe that the payment is
within the scope of EITF 01-9. [Footnote omitted] As you may know, this EITF addresses the accounting
for consideration given by a vendor to a customer. The scope is
broadly written and includes all consideration given by a vendor to
a customer. It also requires that cash consideration paid be
classified as a reduction of revenues unless the vendor receives an
identifiable benefit and the fair value of that benefit can be
reliably measured. In this fact pattern, we believe that the excess amount paid to the customer represents both a payment to retain the customer and settle the litigation. However, if the company is unable to determine the fair value of each of these components, we believe that EITF 01-9 requires the entire payment to be classified as a
reduction of revenues. Had the company been able to
directly value the litigation, classification of that portion of the
settlement payment as an expense may have been appropriate.
[Emphasis added]
Even though Mr. West was speaking about the guidance in EITF Issue 01-9 on consideration payable to a customer, which was codified in ASC
605-25 and has been superseded by ASC 606, it is still appropriate for an entity
to consider the principles outlined in the speech since the principle underlying
the guidance in ASC 605-25 remains relatively consistent under ASC 606. Mr. West
acknowledged that classification of a litigation component as an expense is
appropriate in certain circumstances, specifically when (1) a prior
customer/vendor relationship with the plaintiff does not exist or (2) a prior
customer/vendor relationship does exist and the vendor receives an identifiable
benefit for which the fair value of that benefit can be reliably measured.
Further, in evaluating the income statement classification of a litigation
settlement in situations in which the counterparty is a vendor or customer, the
entity should consider whether the settlement amount was based on an agreed-upon
formula (e.g., whether it was based on total product sales to a customer or
supplies purchased from a vendor) in such a way that there is a direct and
observable correlation between the settlement amount and the previous revenue or
purchase transaction. Such a correlation may be an indication that the
settlement amount should be recognized as an adjustment to the transaction price
received from a customer or to the cost of goods or services purchased from a
vendor.
If settlement consideration payable to a customer is in exchange
for a distinct good or service but the fair value cannot be reasonably
estimated, the settlement consideration should be recognized entirely as a
reduction in transaction price. For example, in a litigation settlement with a
customer, an entity may determine that an element of the consideration pertains
to settling the litigation and therefore is representative of a distinct
benefit. The entity may have historical experience in settling similar cases and
therefore may be able to readily determine the distinct litigation settlement
benefit; however, unless the entity can reasonably estimate the fair value of
the litigation settlement element, the entire settlement amount should be
accounted for as a reduction in transaction price. For more information about
consideration payable to a customer, see Chapter 6 of Deloitte’s Roadmap Revenue
Recognition.
Similarly, regarding classification of the settlement when
payments are received from a vendor, entities should consider ASC 705-20, as
discussed in Chapter
6 of Deloitte’s Roadmap Revenue Recognition, as well as the
gain contingency recognition guidance addressed in Chapter 3 of this Roadmap.
Footnotes
1
See ASC 712-10-15-3 and 15-4 for a discussion of
transactions that could be subject to the scope of ASC 710.
2
For example, the issue of how an entity should account for
uncertain tax positions and breakage when a customer is not expected to
exercise all of its contractual rights to goods or services in a revenue
contract is specifically addressed in U.S. GAAP. Chapter 4 of Deloitte’s Roadmap
Income Taxes
addresses uncertain tax positions. Section 8.8 of
Deloitte’s Roadmap Revenue Recognition addresses breakage associated
with certain revenue contracts.
2.3 Recognition
ASC 450-20
25-1 When a loss contingency
exists, the likelihood that the future event or events will
confirm the loss or impairment of an asset or the incurrence
of a liability can range from probable to remote. As
indicated in the definition of contingency, the term
loss is used for convenience to include many
charges against income that are commonly referred to as
expenses and others that are commonly referred to as losses.
The Contingencies Topic uses the terms probable,
reasonably possible, and remote to
identify three areas within that range.
25-2 An estimated loss from a
loss contingency shall be accrued by a charge to income if
both of the following conditions are met:
- Information available before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. Date of the financial statements means the end of the most recent accounting period for which financial statements are being presented. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
- The amount of loss can be reasonably estimated.
The purpose of those conditions is to
require accrual of losses when they are reasonably estimable
and relate to the current or a prior period. Paragraphs
450-20-55-1 through 55-17 and Examples 1–2 (see paragraphs
450-20-55-18 through 55-35) illustrate the application of
the conditions. As discussed in paragraph 450-20-50-5,
disclosure is preferable to accrual when a reasonable
estimate of loss cannot be made. Further, even losses that
are reasonably estimable shall not be accrued if it is not
probable that an asset has been impaired or a liability has
been incurred at the date of an entity’s financial
statements because those losses relate to a future period
rather than the current or a prior period. Attribution of a
loss to events or activities of the current or prior periods
is an element of asset impairment or liability
incurrence.
When an entity obtains information before the financial statements
are issued or available to be issued, indicating that it is probable that a future
event will confirm a financial statement loss that occurred on or before the date of
the financial statements, the entity should accrue such a loss contingency provided
that the loss can be reasonably estimated.
The flowchart below outlines the criteria for recognition of a
contingent liability, taking into consideration all information about the loss that
becomes available before the financial statements are issued (or are available to be
issued).
A contingent liability is not recognized when either (1) it is not
probable that a future event will confirm that a loss had been incurred on or before
the date of the financial statements or (2) the amount of the loss is not reasonably
estimable. The entity should carefully evaluate whether appropriate disclosure is
necessary to keep the financial statements from being misleading. See additional
disclosure requirements in Section 2.8.
2.3.1 Assessing the Probability of Whether a Loss Has Been Incurred
2.3.1.1 “Probable,” “Reasonably Possible,” and “Remote”
For an entity to recognize a loss contingency under ASC 450-20,
it must be probable that one or more future events will occur or fail to occur,
thereby confirming a loss. In the ASC 450-20 glossary, loss contingencies are
categorized on the basis of the likelihood of occurrence as follows:
ASC 450-20 — Glossary
Probable
The future event or events are likely to
occur.
Reasonably
Possible
The chance of the future event or events
occurring is more than remote but less than likely.
Remote
The chance of the future event or events
occurring is slight.
Although ASC 450-20 defines each of these terms, it provides no
quantitative thresholds. The word “probable” is not intended to mean that
virtual certainty is required before a loss is accrued. However, “likely to
occur” is a higher threshold than “more likely than not,” which is generally
considered as indicating a chance of occurrence of more than 50 percent.
While no codified guidance defines the quantitative thresholds,
an entity that is evaluating these thresholds may find it useful to consider
interpretive guidance from paragraph 160 of AICPA Statement of Position 96-1,
which states, in part:
If the FASB Statement No. 5 criteria
of remote, reasonably possible, and probable were mapped onto a range of
likelihood of the existence of a loss spanning from zero to 100 percent, the
reasonably possible portion would span a significant breadth of the range
starting from remote and ending with probable.
“Probable” is discussed in paragraph 49 of the Background Information and Basis for Conclusions of FASB Statement 114, which states, in
part:
“ ‘[P]robable’ . . . has, in the case of banks,
come to mean ‘virtually certain,’ rather than ‘more likely than not,’ ” and
“the ‘probable’ requirement as it is sometimes applied has unduly delayed
loss recognition . . . of problem assets.” The Board did not intend
“probable” to mean “virtually certain to occur.” The Statement 5 definition
of probable states that “the future event or events are likely to
occur” (emphasis added). The Board recognizes that application of
the term probable in practice requires judgment, and to clarify its intent
the Board has reiterated the guidance in paragraph 84 of Statement 5 in
paragraph 10 of this Statement. The term probable is used in this Statement
consistent with its use in Statement 5. This Statement does not specify how
a creditor should determine that it is probable that it will be unable to
collect all amounts due according to a loan’s contractual terms.
In addition, the SEC’s November 16, 2011, staff paper comparing
U.S. GAAP with IFRS® Accounting Standards states the following
regarding the quantitative threshold used to recognize environmental
obligations:
Both IFRS and U.S. GAAP contain a
“probable” threshold for the recognition of an environmental liability.
Probable within IFRS is defined as more likely than not (i.e., more than
50%), whereas probable is not as clearly defined under U.S. GAAP (but is
interpreted in this context to be a percentage somewhat greater than
50%).
ASU
2014-15 discusses “probable” in the context of determining
what constitutes substantial doubt about an entity’s ability to continue as a
going concern. In ASU 2014-15, the FASB observes that “probable” in the ASC
master glossary’s definition of “substantial doubt about an entity’s ability to
continue as a going concern” carries the same meaning that it does in ASC 450’s
definition of the word. The ASU’s general discussion of a Board member’s
dissenting view indicates, in part:
As mentioned in
paragraph BC17, a commonly cited academic paper (Boritz, 1991) noted that
the threshold for the substantial doubt likelihood of an entity being unable
to meet its obligations is between 50 and 70 percent. The guidance in this
Update increases that threshold to probable, which many assert as being in
the 70–75 percent range.
While there is diversity in practice related to the likelihood
percentage that “probable” represents, in a manner consistent with the
discussion in ASU 2014-15, the threshold for “probable” would need to be at
least 70 percent. Further, although the term “remote” is not discussed
quantitatively in any guidance issued by the FASB, it is used in practice to
indicate a likelihood of 10 percent or less.
A loss contingency is recognized only when the likelihood of a
future event’s occurrence indicates that it is probable that a loss has occurred
(provided that the loss contingency is also reasonably estimable). If the
likelihood of a future event’s occurrence is only reasonably possible, entities
should provide appropriate disclosures in accordance with ASC 450-20-50,
although loss accrual is not appropriate. For events for which the likelihood
that a loss has been incurred is remote, recognition is not appropriate and
disclosure is not required under ASC 450-20; however, entities should use
judgment in determining whether omitting disclosures would cause the financial
statements to be misleading. See Section 2.8 for disclosure
considerations.
Entities may need to consider various factors and use
significant judgment in determining the likelihood of a future event’s
occurrence or nonoccurrence that will confirm whether a loss has been incurred
on the date of the financial statements. Specifically, in the case of class
action lawsuits or litigation, an entity may need to consider (among other
things) the opinion of in-house or external legal counsel, the entity’s history
and experience with similar cases, prior case law, how the entity intends to
respond, and the nature of the settlement mechanism.
Certain contingencies do not obligate the entity until the
underlying future events occur. Although the entity may consider the underlying
future event probable to occur, a liability would not be recognized since the
event that drives the obligation has not yet occurred. If the underlying event
does not occur, the entity is not obligated to pay the liability. Examples of
such underlying future events include casualty events, the enactment of proposed
legislation, the successful completion of an initial public offering (IPO), and
the occurrence of a business combination, all of which are discussed below.
2.3.1.2 Occurrence of a Business Combination or Successful Completion of an IPO
Certain liabilities are contingent on the occurrence of a
business combination or the completion of an IPO. For example, an amount may be
payable upon completion of an IPO, or a restructuring plan may be adopted upon
consummation of a business combination.
There are many external factors and uncertainties that can
affect the successful completion of an IPO or the consummation of a business
combination. These external factors and uncertainties make it difficult to
determine whether the probability threshold has been met before the effective
date of an IPO or a business combination. Therefore, the incurrence of a
liability contingent on an IPO or a business combination cannot be considered
probable until the transaction is completed. This position does not affect or
apply to freestanding derivative contracts or embedded derivative features that
are within the scope of ASC 815 (e.g., a put option contingent on an IPO).
A business combination is an event for which discrete accounting
is required when the combination is consummated. Accordingly, when the
occurrence of a liability is contingent on the completion of a business
combination, one of the events that obligates the entity and therefore gives
rise to the liability has not occurred until the combination has occurred.
Because of the uncertainties involved in, and the discrete nature of, business
combinations, a liability should not be accrued until the business combination
is consummated.3
However, in certain situations, a liability may exist even if a
proposed business combination is not consummated. The fact that an entity has
agreed to settle a preexisting litigation matter as a condition to completing
such a business combination does not necessarily mean that the contingent
liability should be recognized only on completion of the business combination.
See further discussion in Example 2-7.
Example 2-7
Settlement of
Litigation in Conjunction With a Business
Combination
Company A has entered into a proposed merger with Company
B for which the approval of the U.S. Department of
Justice (DOJ) is required. Before the proposed merger,
the DOJ asserted that A is liable for false claims made
against a department of the U.S. government. While A is
contesting the lawsuit on the basis that it is not
guilty of the DOJ’s allegations, if A loses the lawsuit,
it could be subject to civil penalties and damages of up
to $200 million.
The DOJ has informed A that it will not approve the
merger until the lawsuit with A is resolved. Further,
the DOJ has offered to settle the lawsuit with A for $50
million; such settlement will occur coterminously with
the closing of the merger. If, however, the merger does
not close, A is not obligated to settle the lawsuit for
$50 million and would continue to defend itself against
the lawsuit. In such cases, the outcome would be
uncertain.
For financial reporting periods ending before completion
of the business combination with B, it would not be
acceptable for A to avoid recognizing a liability for
the lawsuit solely on the basis that it is contingent on
the merger with B. This is because the lawsuit is
unrelated to the proposed merger. Rather, A should
consider all facts and circumstances related to the
case, including the settlement offer, in determining the
amount (if any) to recognize as a contingent liability
for the lawsuit.
2.3.1.3 Proposed Legislation
The enactment of legislation by a governmental authority may
give rise to a liability. In some circumstances, a company may expect that
pending legislation will give rise to a liability upon enactment. However, a
liability should not be accrued in advance of enactment even if the entity
believes such enactment to be probable. Future laws or changes in laws should
not be anticipated when an entity is accruing a liability in accordance with ASC
450-20-25-2. Before enactment of a law, the specific content of the final law is
uncertain. Substantive changes to the law may materially affect the nature,
timing, and extent of resources a company will be required to expend. The
accounting for liabilities should reflect the provisions of enacted laws on a
jurisdiction-by-jurisdiction basis. This treatment is consistent with the
guidance on changes in income tax laws in ASC 740.
Connecting the Dots
The enactment date is the date on which all steps in the
process for legislation to become law have been completed (e.g., in the
United States, this could be the case when the president signs the
legislation and it becomes law). For rules and regulations issued by
federal regulatory agencies to implement enacted U.S. laws, the
enactment date is generally the date on which final rules or regulations
promulgated by the federal regulatory agency are published in the
Federal Register, which may differ from the effective date of
such rules or regulations. Entities may need to exercise considerable
judgment and obtain the assistance of legal counsel in determining (1)
the enactment date of laws and regulations implemented in jurisdictions
(i.e., local, state, federal, or foreign) or (2) when regulations issued
by governmental agencies to implement and interpret these laws are
enacted. For an illustrative example of an enacted rule published in the
Federal Register, see Section 5.5.1 of Deloitte’s
Roadmap Environmental Obligations and Asset Retirement
Obligations.
Example 2-8
Legal Liabilities as
a Result of the Enactment of Legislation
The European Parliament and the Council
of the European Union (the “Council”) issue two types of
legislation: (1) regulations and (2) directives.
Regulations become law upon passage by the European
Parliament and the Council. Directives are fundamental
objectives to be achieved by laws, regulations, and
administrative provisions enacted by the individual
member states of the European Union. Although directives
must be passed by the European Parliament and the
Council, they do not become law until implemented by
laws, regulations, and administrative provisions of the
respective member states. To comply with a directive,
member states must enact such a measure within 18 months
of the directive’s passage by the European Parliament
and the Council.
The passage of a directive by the
European Parliament and the Council does not satisfy the
criteria for recognition of a liability under ASC
450-20-25-2 because a legal obligation has not been
established. The obligating event is the enactment of
laws, regulations, and administrative provisions to
comply with a directive. Although it may be probable
that passage of a directive by the European Parliament
and the Council will result in the enactment of measures
needed to comply with the directive, future laws or
changes in laws should not be anticipated. Rather,
liabilities should be recognized in a manner that
reflects the provisions of enacted laws on a
jurisdiction-by-jurisdiction basis.
2.3.1.4 Assessing Whether a Loss Is Reasonably Estimable
When accruing a loss, an entity must determine, in accordance
with the recognition criteria in ASC 450-20-25-2, whether the loss is probable
and reasonably estimable. Recognition of a loss that cannot be reasonably
estimated, even if it is probable that the loss has been incurred, would impair
the integrity of the financial statements. Alternatively, the entity should not
delay accrual of a loss because of the inability to estimate a single amount.
The ability to estimate a loss within a range would indicate that some amount of
a loss has occurred and that the entity should therefore accrue a liability in
accordance with ASC 450-20-25-2(b). The entity may use past experience or other
information to demonstrate its ability to reasonably estimate the loss.
If both recognition criteria under ASC 450-20-25-2 are met, the
estimated loss will be charged to income. ASC 450-20-25-7 indicates that if a
loss cannot be accrued in the period in which it is determined that it is
probable that a loss has been incurred “because the amount of loss cannot be
reasonably estimated, the loss shall be charged to the income of the period in
which the loss can be reasonably estimated and shall not be charged
retroactively to an earlier period. All estimated losses for loss contingencies
shall be charged to income rather than charging some to income and others to
retained earnings as prior period adjustments.”
2.3.1.5 General Reserves and Risk of Loss From Future Events
ASC 450-20-25-8 specifically indicates that “[g]eneral or
unspecified business risks” should not be accrued in the financial statements
since they do not meet the “probable” and “reasonably estimable” requirements of
ASC 450-20-25-2. Therefore, it is not acceptable to record an accrual for
general contingencies in an attempt to address uncertainties in the financial
statements that may not be probable or reasonably estimable.
In addition, mere exposure because of uninsured or underinsured
risk of loss or damage of an entity’s property by fire, explosion, or other
hazards does not mean that an asset has been impaired or a liability has been
incurred; therefore, such risk of loss should not be accrued as a liability
under ASC 450-20. To recognize such a liability related to exposure because of
uninsured or underinsured risk would be to recognize a liability under ASC
450-20 when it is not probable that the uncertain future events will confirm
that a loss occurred on or before the date of the financial statements. As noted
in ASC 450-20-55-7 by way of example, “an entity with a fleet of vehicles should
not accrue for injury to others or damage to the property of others that might
be caused by those vehicles in the future even if the amount of those losses may
be reasonably estimable.” However, ASC 450-20-55-8 indicates that an uninsured
loss resulting from injury to others or damage to property of others is accrued
as a loss contingency if that event took place before the date of the financial
statements and the entity is able to reasonably estimate the amount of such a
loss through prior experience or available information.
Although a risk of loss from future events that interrupt the
normal course of business may be considered probable to occur, the entity is not
obligated until the future event actually occurs; therefore, the liability is
not recognized until that point. Further, the costs of insurance coverage and
the availability of coverage for certain types of risk (e.g., professional
malpractice, product liability, director’s and officer’s liability, and
pollution liability) have a significant effect on many companies. To minimize
premium costs or to satisfy insurers, some companies have modified the terms of
their coverage (e.g., by increasing the amounts of deductibles, reducing
coverage, or both); others are forming captive insurance companies by using a
self-insurance method. It is not appropriate to accrue for uninsured or
underinsured expected losses in a systematic fashion before such losses occur.
Before the issuance of FASB Statement 5, many entities that did not carry
insurance against certain risks, such as property damage from fire or explosion,
charged earnings in a systematic fashion (e.g., as if an insurance premium were
being expensed) to establish an insurance reserve against which actual losses
could then be charged. However, charges in lieu of insurance are not permitted
under ASC 450.
2.3.2 Other Recognition Considerations
2.3.2.1 Unasserted Claims
Unasserted claims are possible claims or assessments of which an entity has not
yet been notified by the injured party or potential claimant. Entities often are
exposed to financial loss before the commencement of a formal claim. Litigation
may be expected as a result of a past action. Alternatively, an entity may
expect a current government investigation to result in a formal claim upon the
investigation’s completion.
To determine under which circumstances an unasserted claim
should be accrued, an entity must first determine whether a past event has
triggered a loss contingency. If such a past event has occurred, the entity must
then determine the probability that (1) a lawsuit will be filed or a claim will
be asserted against it and (2) such a lawsuit or claim will result in an
unfavorable outcome for the entity. If it is probable that an unasserted claim
will result in an unfavorable outcome for the entity, and if the amount of the
loss can be reasonably estimated, the entity should accrue a loss contingency in
accordance with ASC 450-20-25-2. Additional disclosure may be required if it is
reasonably possible that there is exposure to loss in excess of the amount
accrued.
If an unfavorable outcome is only reasonably possible, or if the
amount of the loss cannot be reasonably estimated, an amount should not be
accrued but disclosure would be required under ASC 450-20-50. See Section 2.8 for
disclosure considerations.
Entities may incur losses as a result of incidents that occur
before the date of the financial statements but are not reported by a claimant
until a later date. ASC 720-20-25-14 requires the accrual for incurred but not
reported (IBNR) claims if both criteria in ASC 450-20-25-2 are met. Examples 2-9 and
2-10 illustrate
the application of the recognition criteria under ASC 450-20 to unasserted
claims.
SEC Considerations
For certain IBNR claims, such as asbestos liability
claims, entities may establish a liability for a rolling fixed number of
years (i.e., the entity is able to reliably estimate its expected
liability for IBNR for the next 20 years of claims, but it is unable to
reliably estimate a liability for the period beyond 20 years).
Typically, these liabilities have years, and sometimes decades, of
settlement claims history. The SEC staff has frequently commented on
these rolling fixed-term liabilities and has asked companies to provide
more detail about the process undertaken, including the related ICFR, by
management to conclude that it could not estimate for the period beyond
a specific time horizon.
Example 2-9
Assessing Accrual
Related to an Outcome of an Incomplete
Investigation
Company R is being investigated by a
government agency for potential breach of contract and
allegations of illegal pricing for prior sales
transactions. As of year-end, the government has not
filed any charges or specified a monetary penalty
against R for these matters. To determine whether
accrual or disclosure of the contingency is appropriate
in R’s year-end financial statements, R’s management
must first determine the probability that a lawsuit will
be filed or a claim will be asserted against R. If the
filing of a lawsuit or the assertion of a claim is
probable in management’s judgment, management must
determine the probability that such a lawsuit or claim
will result in an unfavorable outcome for R. If an
unfavorable outcome is probable and the amount of the
loss can be reasonably estimated, accrual of the loss is
required. If the amount of the loss cannot be reasonably
estimated, no accrual is required; however, R should
disclose the contingency. Further, if an unfavorable
outcome is only reasonably possible but not probable, R
should disclose the contingency.
Example 2-10
Accrual of Probable
Settlement Costs
Company T has decided to abandon certain
distributor agreements that it had in place. Company T
believes that it will be involved in legal actions
brought by the distributors and that it is probable that
the company will incur costs to settle these actions. To
the extent that it is probable that these claims will be
asserted and will result in an unfavorable outcome for
T, it should accrue a loss under ASC 450-20 if the
settlement amount can be reasonably estimated.
2.3.2.2 Loss Recognition Before the Occurrence of a Casualty Event for an Insurance Company
One of the most controversial issues addressed in ASC 450-20 is
related to whether a property and casualty insurance company should recognize a
liability for future losses resulting from catastrophes. When an insurance
company issues a policy, it assumes the risk that a catastrophe (e.g., a
hurricane) might occur within the policy coverage period. Insurance companies
have asserted that they are able to predict the occurrence rate of catastrophes
and related losses by using actuarial methods based on past occurrences.
Insurance companies use such methods for rate-setting purposes; therefore, many
believe that the losses are reasonably estimable and should be accrued.
However, ASC 944-40-55-3 indicates that catastrophe reserves
fail to satisfy the conditions of ASC 450-20 for accrual because losses from
potential future catastrophes over the relatively short periods covered by
policies in force cannot be reasonably estimated. In addition, unless a
catastrophe occurs within the policy period, no asset is impaired and no
liability is incurred as of the date of the financial statements; therefore, no
accrual for a catastrophe loss should be made. On the other hand, a property and
casualty insurer is required to accrue losses from catastrophes that occurred
before the date of the financial statements even though claims have not been
submitted by policyholders if (1) it is probable that those claims will be made
and (2) a reasonable estimate of the loss can be made. Accrual of a premium
deficiency is also required by ASC 450-20 and ASC 944-60.
2.3.2.3 Litigation, Claims, and Assessments
A common uncertainty many entities will encounter is the risk of litigation.
Class actions, product liabilities, lawsuits, and actions brought by government
agencies are not uncommon, and an entity may need to accrue or disclose
contingencies related to the risk of such litigation (e.g., the potential future
obligation to pay an uncertain amount as a result of past activities) in the
financial statements.
Adverse consequences of litigation could include the obligation to pay damages,
the imposition of fines and penalties, the need to repay consideration from a
revenue contract that was previously received, and even discontinuation of
certain operations. Further, the entire nature of the entity may change as a
result of the litigation (e.g., the entity may seek protection from the
litigation through bankruptcy).
Types of litigation that an entity may face include the following:
-
Antitrust.
-
Restraint of trade.
-
Breach of contract.
-
Patent infringement.
-
Product liability.
-
Violation of federal securities laws.
-
Government actions.
-
Discrimination.
-
Environmental protection matters.
-
Violation of wage and price guidelines or controls.
-
Renegotiation of government contracts.
-
Income tax disputes.
-
Violation of other laws and regulations (e.g., the Foreign Corrupt Practices Act).
In determining whether an accrual is required in connection with litigation,
claims, and assessments, an entity should consider various factors that include,
but are not limited to, the following:
- The nature of the settlement mechanism — The parties involved may have agreed to use a settlement mechanism other than the court system that is binding on the parties. Accordingly, it is necessary to evaluate, on the basis of the specific facts and circumstances, the ability of the party that is subject to an adverse legal judgment to appeal the matter.
- The progress of the case — If a planned appeal is not the entity’s first appeal of an adverse judgment (i.e., the entity has been unsuccessful in prior appeals of the judgment), the entity should consider the results or findings of the earlier rulings when assessing its evidence for and against liability recognition.
- The opinions or views of legal counsel and other advisers:
- A legal analysis usually will include counsel’s opinion regarding the likelihood that the entity will prevail on appeal. For example, a legal opinion may state counsel’s belief that the entity’s chance for a successful appeal is probable, more likely than not, or reasonably possible. The terms “probable” and “reasonably possible” do not signify precise quantitative thresholds and may be interpreted and applied differently by different parties, as described in Section 2.3.1.1. The meaning of such terms should be understood in the context of the legal opinion related to the entity’s specific facts and circumstances so that management’s assertions about the likelihood of success on appeal can be compared with those of counsel. An indication from legal counsel that an entity plans to vigorously defend itself against a claim does not relieve the entity from evaluating the probability of a future loss.
- Management should review the basis for counsel’s conclusions and assess whether the reasons cited by counsel to support its assessment are consistent with the evidence used by the entity to support its decision about whether to record a loss contingency.
- Management should fully consider any qualifications or conditions that counsel identified as affecting its assessment. In interpreting language used by counsel to explain its conclusion, management may find it helpful to consider the guidance in AU-C Sections 620 and 501 of the AICPA’s auditing standards, which apply to financial statement audits.
- Counsel’s opinion is a critical piece of evidence that needs to be analyzed carefully. Counsel’s expression of an opinion that an entity will be successful on appeal does not, in itself, support a conclusion that an accrual of a loss is not warranted. In addition, ASC 450-20-55-12(c) notes that “the fact that legal counsel is unable to express an opinion that the outcome will be favorable to the entity should not necessarily be interpreted to mean that the condition in paragraph 450-20-25-2(a) is met.” However, when the entity has received an adverse legal judgment, counsel’s inability to express an opinion may leave the entity with insufficient positive evidence to overcome the judgment.
- The experience of the entity or other entities in similar cases — The prior experiences of the entity or other entities with similar litigation may serve as additional evidence of the entity’s likelihood of success. For example, management could consider possible outcomes specific to (1) certain jurisdictions, (2) certain courts, (3) the use of certain defense strategies, or (4) other related aspects of the litigation.
- Prior case law for similar cases — Gaining an understanding of prior case law may enable the entity to identify certain precedents that could affect the likelihood of its success.
- Management’s decision regarding how the entity intends to
respond:
-
Although certain adverse legal judgments may be appealed, the entity’s decision to appeal will depend on a variety of factors. The entity should consider its specific facts and circumstances when assessing the likelihood that it will seek an appeal.
-
Because an adverse legal judgment may involve multiple components, the entity should analyze each component thoroughly to determine whether a litigation accrual should be recorded. For example, the entity should determine whether it will appeal all components of the judgment or only selected components.
-
-
The entity’s intended basis for an appeal — As discussed above, an understanding of the legal basis for the entity’s appeal, combined with a review of prior case law or the experiences of the entity or other entities in similar cases, may serve as evidence that helps the entity gauge the likelihood that it will prevail on appeal.
-
The audit committee’s assessment of the entity’s opportunity for appeal — The audit committee’s assessment of the entity’s opportunity for appeal, considered along with the assessments of internal or outside counsel and the entity’s management, may constitute additional information about the entity’s defense strategy and its chances for success on appeal.
Example 1 in ASC 450-20-55-18, Cases A through D of Example 2 in
ASC 450-20-55-22, and Example
2-11 illustrate the accounting for various litigation
scenarios.
ASC 450-20
Example 1:
Litigation Open to Considerable
Interpretation
55-18 An entity may be
litigating a dispute with another party. In preparation
for the trial, it may determine that, based on recent
developments involving one aspect of the litigation, it
is probable that it will have to pay $2 million to
settle the litigation. Another aspect of the litigation
may, however, be open to considerable interpretation,
and depending on the interpretation by the court the
entity may have to pay an additional $8 million over and
above the $2 million.
55-19 In that case, paragraph
450-20-25-2 requires accrual of the $2 million if that
is considered a reasonable estimate of the loss.
55-20 Paragraphs 450-20-50-1
through 50-2 require disclosure of the nature of the
accrual, and depending on the circumstances, may require
disclosure of the $2 million that was accrued.
55-21 Paragraphs 450-20-50-3
through 50-8 require disclosure of the additional
exposure to loss if there is a reasonable possibility
that the additional amounts will be paid.
Example 2:
Multiple Case Litigation Example
55-22 The following Cases
illustrate application of the accrual and disclosure
requirements in the following stages of litigation:
- The trial is complete but the damages are undetermined (Case A).
- The trial is incomplete but an unfavorable outcome is probable (Case B).
- The trial is incomplete and unfavorable outcome is reasonably possible (Case C).
- There is a range of loss and one amount is a better estimate than any other (Case D).
Case A: Trial Is Complete but Damages
Are Undetermined
55-23 An entity is involved
in litigation at the close of its fiscal year and
information available indicates that an unfavorable
outcome is probable. Subsequently, after a trial on the
issues, a verdict unfavorable to the entity is handed
down, but the amount of damages remains unresolved at
the time the financial statements are issued or are
available to be issued (as discussed in Section
855-10-25). Although the entity is unable to estimate
the exact amount of loss, its reasonable estimate at the
time is that the judgment will be for not less than $3
million or more than $9 million. No amount in that range
appears at the time to be a better estimate than any
other amount.
55-24 In this Case, paragraph
450-20-30-1 requires accrual of the $3 million (the
minimum of the range) at the close of the fiscal
year.
55-25 Paragraphs 450-20-50-1
through 50-2 require disclosure of the nature of the
contingency and, depending on the circumstances, may
require disclosure of the amount of the accrual.
55-26 Paragraphs 450-20-50-3
through 50-8 require disclosure of the exposure to an
additional amount of loss of up to $6 million.
Case B: Trial Is Incomplete but
Unfavorable Outcome Is Probable
55-27 Assume the same facts
as in Case A, except it is probable that a verdict will
be unfavorable and the trial has not been completed
before the financial statements are issued or are
available to be issued (as discussed in Section
855-10-25). In that situation, the condition in
paragraph 450-20-25-2(a) would be met because
information available to the entity indicates that an
unfavorable verdict is probable. An assessment that the
range of loss is between $3 million and $9 million would
meet the condition in paragraph 450-20-25-2(b).
55-28 In this Case, if no
single amount in that range is a better estimate than
any other amount, paragraph 450-20-30-1 requires accrual
of $3 million (the minimum of the range) at the close of
the fiscal year.
55-29 Paragraphs 450-20-50-1
through 50-2 require disclosure of the nature of the
contingency and, depending on the circumstances, may
require disclosure of the amount of the accrual.
55-30 Paragraphs 450-20-50-3
through 50-8 require disclosure of the exposure to an
additional amount of loss of up to $6 million.
Case C: Trial Is Incomplete and
Unfavorable Outcome Is Reasonably Possible
55-31 Assume the same facts
as in Case B, except the entity had assessed the verdict
differently (for example, that an unfavorable verdict
was not probable but was only reasonably possible). The
condition in paragraph 450-20-25-2(a) would not have
been met and no amount of loss would be accrued.
Paragraphs 450-20-50-3 through 50-8 require disclosure
of the nature of the contingency and any amount of loss
that is reasonably possible.
Case D: Range of Loss and One Amount Is
a Better Estimate Than Any Other
55-32 Assume that in Case A
and Case B the condition in paragraph 450-20-25-2(a) has
been met and a reasonable estimate of loss is a range
between $3 million and $9 million but a loss of $4
million is a better estimate than any other amount in
that range.
55-33 In this Case, paragraph
450-20-30-1 requires accrual of $4 million.
55-34
Paragraphs 450-20-50-1 through 50-2 require
disclosure of the nature of the contingency and,
depending on the circumstances, may require disclosure
of the amount of the accrual.
55-35 Paragraphs 450-20-50-3
through 50-8 require disclosure of the exposure to an
additional amount of loss of up to $5 million.
Example 2-11
Broker-Dealer
Dispute With Investors
Company A, a broker-dealer, markets and
sells investments in certain financial products. The
investments do not contain an option for investors to
put the investments back to A. Company A later faces
criticism and potential litigation for misleading
investors about the economic characteristics of the
investments. As a result, A enters into a settlement
agreement that gives each investor the right to demand
that A repurchase the investment for cash equal to its
par value on a specified future date (or range of dates)
upon physical delivery of the investment to A.
The accounting considerations depend on
whether A has entered into a legally enforceable
settlement agreement that provides each investor with
the option to require A to repurchase the
investment.
Accounting Before
Settlement Agreement
Before an enforceable settlement
agreement or the resolution of any associated
litigation, the potential that a broker-dealer has
incurred a loss in connection with its past selling or
marketing of investments is a loss contingency within
the scope of ASC 450-20 and should be evaluated as a
contingent liability for recognition and disclosure
purposes.
Under ASC 450-20-25-2, the broker-dealer
should accrue a liability for the contingency and
recognize a related charge in current-period income if
information that is available before the financial
statements are issued (or before they are available to
be issued) indicates that (1) it is probable that a
liability has been incurred as of the date of the
financial statements in connection with the
broker-dealer’s past selling or marketing of investments
and (2) the amount of the loss can be reasonably
estimated. ASC 450-20-50-3 and 50-4 specify that if it
is reasonably possible that a loss or an additional loss
in excess of the amount of the loss accrued may have
been incurred or the loss amount cannot be reasonably
estimated, the broker-dealer should disclose the “nature
of the contingency” and an “estimate of the possible
loss or range of loss or a statement that such an
estimate cannot be made.”
Accounting Once a
Settlement Agreement Becomes Legally
Enforceable
On the date A enters into an enforceable
settlement agreement, the uncertainty regarding whether
a loss has been incurred is resolved, and A must
recognize an obligation for issuing the written put
option.
If A determines that the written put
option does not meet the definition of a derivative
instrument under ASC 815-10, it would account for the
option as a guarantee contract under ASC 460-10.
Accordingly, at initial recognition of the obligation
undertaken in issuing the guarantee, A should apply ASC
460-10-30-3, which states, in part, that the amount
initially recognized in connection with the written put
option should be the greater of:
- The amount that satisfies the fair value objective as discussed in the preceding paragraph
- The contingent liability amount required to be recognized at inception of the guarantee by Section 450-20-30.
ASC 460-10-35 does not address
subsequent measurement in detail; however, A would be
expected to subsequently measure the put option in a
manner consistent with the SEC staff’s long-standing
position that written options should be marked to fair
value through current-period earnings.
2.3.2.4 Evaluating the Impact of an Adverse Legal Judgment on the Recognition and Measurement of a Loss Contingency
In some cases, an entity may receive an adverse legal judgment
for payment of a specific amount related to an event that occurred on or before
the date of the financial statements. This judgment may be determined before the
date of the financial statements, or after the date of the financial statements
but before the financial statement issuance or the date on which the financial
statements are available to be issued. The entity may not have previously
recognized a contingent liability for this matter because it did not believe
that the criteria in ASC 450-20-25-2 had been met.
The rendering of an adverse legal judgment against an entity
does not automatically trigger recognition of a liability for a loss contingency
since the entity may be successful in overturning all or part of the original
judgment on appeal. As mentioned above, ASC 450-20-25-2 requires entities to
accrue, by a charge to income, an estimated loss from a loss contingency if (1)
it is probable that a “liability had been incurred” and (2) the “amount of loss
can be reasonably estimated.” In determining the probability and the estimate of
the loss, the entity must analyze all available information.
An adverse legal judgment constitutes significant objective evidence of the
probability that an entity has incurred a liability as of the date of the
financial statements. Consequently, for an entity that intends to appeal the
judgment to conclude that no liability has been incurred as of the date of the
financial statements, evidence supporting nonrecognition must be sufficient to
counterbalance the external legal determination (i.e., the adverse legal
judgment) and any other similar evidence. That is, to support nonrecognition,
the evidence as a whole must reduce the likelihood that a liability has been
incurred as of the date of the financial statements to a level below the
probable threshold under ASC 450-20; otherwise, a liability should be recognized
as long as the amount of the liability is reasonably estimable.
After analyzing all of the available information, the entity
that received the adverse legal judgment may conclude that no loss contingency
accrual is necessary because one or both of the conditions in ASC 450-20-25-2
have not been met. However, the entity would still be required to disclose the
contingency (in accordance with ASC 450-20-50-3) if it is at least reasonably
possible that a loss has been incurred as of the date of the financial
statements. It is unlikely that an entity that has received an adverse legal
judgment will have sufficient information to conclude that the likelihood of a
loss is remote. Also, it is likely that the disclosure would need to contain
sufficient information to enable financial statement users to understand the
status of the litigation, the fact that an adverse judgment had been determined,
and the factors the entity considered to determine that the loss should not be
recognized.
If the entity is unable to or does not intend to appeal the
adverse judgment, or otherwise concludes in accordance with ASC 450-20-25-2(a)
that it is probable that a liability has been incurred, the entity should
determine whether the liability can be reasonably estimated in accordance with
ASC 450-20-25-2(b). If a reasonable estimate of the liability is a range, the
entity should apply the guidance in ASC 450-20-25-5 and ASC 450-20-30-1. That
is, when one amount within a range appears to be a better estimate than any
other amount within the range, that amount should be accrued; when no amount
within the range is a better estimate than any other amount, the minimum amount
in the range should be recorded.
2.3.2.5 Accrual of Future Legal Costs
In determining the amount to accrue for a loss contingency
involving litigation, entities must consider whether expected legal fees related
to the litigation should be accrued when the loss contingency is initially
recognized or when the legal services are actually provided at a future date.
Practice related to this issue has varied owing to the absence of definitive
guidance. As a result, the SEC staff suggested that the EITF Agenda Committee
consider the need to add an item to the EITF’s agenda to address this issue.
The EITF Agenda Committee discussed this potential issue before
the January 1997 meeting but did not reach a recommendation for the Task Force.
The Agenda Committee considered whether the Task Force should recommend that the
FASB undertake the project so that it receives adequate due process, but the
Agenda Committee did not reach a conclusion. The Agenda Committee also discussed
the existing practice related to the accrual of legal fees associated with a
loss contingency and determined that it might be helpful to ask the Task Force
for input on whether such practice is diverse. The SEC observer indicated that
the SEC staff will need to consider whether to provide interim guidance while
the EITF or the FASB decides whether to address this issue.
In addition, the minutes of the January 23, 1997, EITF meeting contain the
following discussion of this issue, which is also summarized in an SEC staff
announcement codified in ASC 450-20-S99-2:
The Task Force Chairman reported
on the meeting of the EITF Agenda Committee. The Task Force discussed a
potential new issue relating to the accounting for legal costs expected to
be incurred in connection with a FASB Statement No. 5, Accounting for
Contingencies [codified as ASC 450-20], loss contingency. Some Task Force
members observed that they believe practice typically has expensed such
costs as incurred; however, other Task Force members suggested that practice
may not be consistent in this area. The Task Force also discussed whether it
should recommend that the FASB address this potential new issue but decided
not to take any action. The Task Force declined to add this potential new
issue to its agenda. The SEC Observer indicated that the SEC staff will
attempt to better understand what practice is in this area and monitor the
issue. The SEC Observer also noted that he would expect a registrant’s
accounting policy to be applied consistently and APB Opinion No. 22,
Disclosure of Accounting Policies [codified as ASC 235], requires disclosure
of material accounting policies and the methods of applying those
policies.
In the absence of further guidance from the FASB or the SEC
staff, entities should apply the guidance above, which indicates that the
decision to accrue legal costs on the basis of an estimate of future legal costs
or expense when incurred is a matter of accounting policy that should be
consistently applied and disclosed, when material. Factors an entity needs to
consider when determining the accounting policy for legal fees include whether
the policy provides for meaningful presentation of the balance sheet and income
statement, whether the policy improves comparability among entities that may
have ongoing litigation exposure, and whether the accrual of legal fees is
representative of the way in which the entity manages its litigation exposure
(when resolution and legal defense costs are so directly interrelated that they
are inseparable from the overall liability determination). Whether expensed as
incurred or accrued in advance, litigation expense should generally be
classified as an operating expense in the statement of operations.
2.3.2.6 Measurement Date for Stock Issued in Settlement of Litigation
A company may settle a legal action by issuing shares of its
stock or other equity-classified instruments to the counterparty. ASC 450 does
not provide specific guidance on measuring equity instruments for settlement of
a contingent liability. The scope of ASC 718, as indicated in ASC 718-10-15-3,
is “all share-based payment transactions in which a grantor
acquires goods or services to be used or consumed in the grantor’s own
operations or provides consideration payable to a customer by issuing
(or offering to issue) its shares, share options, or other equity instruments or
by incurring liabilities to an employee or a nonemployee that meet either of the
following conditions” (emphasis added). The settlement of a legal action does
not represent the acquisition of goods or services to be used or consumed in the
grantor’s operations. Although such a transaction is not within the scope of ASC
718, depending on the facts and circumstances specific to the legal matter, it
may be appropriate to apply certain principles from ASC 718 by analogy.
Parties to litigation may reach a preliminary agreement, subject to court
approval, on the number of shares to be issued. Under an agreement that is
subject to court approval, the court approval date is the appropriate
measurement date for stock issued in settlement of litigation. The court’s
approval of a settlement is a substantive event rather than an administrative
matter or a formality. The approval of a legal settlement by a court that serves
as the ultimate judge of fairness (i.e., approval is not perfunctory) represents
the final “future event” that gave rise to the original characterization of the
loss as a contingency under ASC 450-20. This view is consistent with the
definition of the grant date in ASC 718-20, which indicates that for plans that
are subject to shareholder approval, a measurement date for a stock award is the
date when shareholder approval is obtained. Therefore, the total expense
recognized in connection with the final settlement of a lawsuit should be
measured on the court approval date.
When determining the share price to be used in measuring a
liability that is recognized as of a balance sheet date before final settlement
in situations in which a party offers to issue equity instruments to settle a
claim, it may be appropriate for an entity to analogize to the guidance in ASC
718 regarding the measurement of liability-classified share-based payment award
transactions and to use the period-end share price. In other arrangements,
information that becomes available after the balance sheet date but before the
financial statements are issued (or available to be issued) may be relevant to
the measurement as of the balance sheet date (e.g., a settlement offer).
Alternatively, when shares are used as “currency” to settle the liability, an
entity may measure the contingent liability on the basis of its best estimate of
the amount of loss that has been incurred. An entity should carefully evaluate
such transactions in determining the appropriate share price to use in measuring
the liability at period-end. The accounting may ultimately depend on whether the
dispute involves the issuance of shares or whether an entity is merely using its
shares as “currency” to resolve a matter.
Example 2-12
Litigation
Settlement in Shares Subject to Court
Approval
Entities A and Z are parties to ongoing
litigation that is subject to a court-mandated mediation
process. Once the mediator, A, and Z agree on a
settlement amount, final court approval is needed for
the settlement to be finalized. On March 3, 20X9, as a
result of the mediation process, A agrees to issue
200,000 shares to Z to settle the litigation, subject to
the court’s final approval.
Before March 3, 20X9, A had previously
recognized a contingent liability related to the
litigation for $1.75 million because A had concluded
that it was probable that a loss had been incurred and
$1.75 million was its estimate for the loss. On the
agreement date, March 3, 20X9, the fair value of A’s
shares was $10 per share and A adjusted its recognized
liability to $2 million ($10 per share × 200,000 shares)
by debiting expense and crediting a contingent liability
for $250,000. This adjustment is considered a change in
accounting estimate.
On March 30, 20X9, the court approves
the settlement agreement of 200,000 shares to be issued
by A to Z. On the court approval date, the fair value of
A’s shares was $11 per share. Entity A must recognize
the incremental $200,000 [($11 per share − $10 per
share) × 200,000 shares] loss in income at this time
since the court approval was a substantive part of the
litigation settlement. The measurement date for the
ultimate liability is the court approval date of March
30, 20X9. Upon issuance of its shares, A should debit
the total contingent liability recognized of $2.2
million, with a corresponding credit to equity. This
adjustment is considered a change in accounting
estimate.
2.3.2.7 Recognition of Annual Bonus Plan Liabilities
Many companies use cash bonus plans to compensate employees. Annual bonus plans
may be based on specific formulas and performance targets or may be at the
discretion of management and the compensation committee of the company’s board
of directors. In some plans, annual bonus amounts are determined after the end
of a fiscal year and may not be determined until after the financial statements
are issued. Bonuses also may be forfeited if an employee is terminated or
resigns.
The recognition criteria of ASC 450-20 should be used to
estimate the amount of a bonus whose payment is probable when the cash bonus
plan is not subject to other applicable U.S. GAAP (such as ASC 718). If the
amount of a bonus that will be achieved or granted is uncertain, a range should
be computed under ASC 450-20-30-1. If “no amount within the range is
[considered] a better estimate than any other amount,” the low end of the range
should be selected. Entities must carefully evaluate bonuses that are based on
achievement of a target to determine whether such achievement is probable.
Once an entity has determined the amount of the probable bonus,
it should recognize the amount over the service period. Recognizing compensation
expense in this manner is analogous to recognizing expense in connection with
stock-based compensation arrangements over the related service period, as
required by ASC 718. Under this model, the obligating event giving rise to the
liability is considered the employee’s performance of service. Recognition of a
bonus liability should not be delayed just because the bonus would not be paid
if an employee were to terminate employment before the end of the service
period. Rather, if a reliable estimate of employee turnover is possible, the
entity may factor this estimate into the range of estimates when determining the
probable liability. Any difference between the actual bonus paid and the amount
accrued is considered a change in accounting estimate.
Example 2-13
Employee Benefit
Arrangements
Company P is preparing its financial
statements for the fiscal year ending December 31, 20X4.
On January 2, 20X4, P initiates an incentive
compensation plan for its senior executives. Under the
plan, each executive is allocated a portion of a pool of
500 units. The value of each unit will be determined as
of the plan measurement date (December 31, 20X5) in
accordance with a plan formula that uses as its basis
the difference between P’s net income in 20X5 and P’s
net income in 20X4. On December 31, 20X6, each executive
who has remained with P in uninterrupted service during
the period from January 1, 20X4, through December 31,
20X6, will receive a cash bonus based on this
calculation of unit value.
Although P annually prepares a
projection of its net income for the year, there is
uncertainty about whether the amount will ultimately be
attained since the company has failed to achieve its
targets in recent years. Management has calculated that
if P meets its forecasted level of net income in fiscal
year 20X5, the bonus (payable at the end of 20X6 under
the plan) could be as high as $8 million.
Company P should use all available
information to reasonably estimate its liability for the
cash bonus plan and accrue in fiscal year 20X4 the
percentage of the liability that is related to the 20X4
service period. When considering its forecast of net
income for fiscal year 20X5, P should take into account
any recent trends or developments and the accuracy of
its prior projections.
The probable percentage of the liability
that is related to the expired service period, which is
estimated by management to be 33.3 percent (calculated
on the basis of one of three fiscal years for which the
executive is required to have been employed), should be
accrued as of December 31, 20X4. The remaining 66.7
percent should be accrued over the following two years.
The amount of the probable bonus should be reconsidered
in each subsequent reporting period.
In accordance with ASC 450-20-30-1, if P
determines that the range of the bonus amount could be
from $1 million to $8 million and no amount within the
range is considered a better estimate than any other
amount, it would be appropriate for P to accrue a
liability on the basis of the $1 million low end of the
range.
However, since it is reasonably possible
that a liability greater than $1 million has been
incurred, ASC 450-20-50-4 requires P to disclose in its
fiscal year 20X4 financial statements a complete
description of the plan and an estimate of the possible
bonus amount or range of bonus amount or a statement
that such an estimate cannot be made.
2.3.2.7.1 Interim Considerations
When allocating annual bonuses to interim periods, entities should consider
the guidance in ASC 270-10-45-8 through 45-10. Costs and expenses should be
allocated to interim periods so that each interim period bears a reasonable
portion of the annual expense. Each quarter, entities should determine the
amount of bonus for which achievement is probable in accordance with ASC
450-20-25-2 and recognize this amount so that each interim period bears a
reasonable portion of the annual expense. Entities must exercise judgment in
determining the appropriate allocation method, and they should apply the
selected method consistently in each reporting period.
For example, an entity may have a discretionary bonus plan
that provides for the payment of annual bonuses to certain employees on the
basis of the entity’s overall achievement of specific key financial metrics.
In accordance with ASC 450-20, in each reporting period, the entity would
estimate the amount of bonus for which payment is probable and recognize an
amount that bears a reasonable portion of the annual expense. The entity may
conclude that, as a result of recognizing the bonus on a straight-line basis
over the performance period, each interim period bears a reasonable portion
of the annual bonus expense. Alternatively, the entity may conclude that
each interim period bears a reasonable portion of the annual bonus as a
result of recognizing the annual bonus on the basis of the entity’s
proportionate achievement of specific key financial metrics. The entity
would apply the method used consistently in each reporting period.
2.3.2.8 Injury or Damage Caused by Products Sold
ASC 450-20
55-2 If it is
probable that a claim resulting from injury or damage
caused by a product defect will arise with respect to
products or services that have been sold, accrual for
losses may be appropriate. The condition in paragraph
450-20-25-2(a) would be met, for instance, with respect
to a drug product or toys that have been sold if a
health or safety hazard related to those products is
discovered and as a result it is considered probable
that liabilities have been incurred. The condition in
paragraph 450-20-25-2(b) would be met if experience or
other information enables the entity to make a
reasonable estimate of the loss with respect to the drug
product or the toys.
Entities may be subject to recalls on their products (e.g.,
pharmaceutical drugs, car engines, food products). While some product recalls
are voluntary (e.g., the manufacturer has chosen to remove the product from the
shelves or has notified consumers to cease using the product), other recalls may
be required by law or a regulator (e.g., the FDA).
If an entity is not otherwise required by law or a regulator to
initiate a product recall, the obligating event triggering liability recognition
for the costs (i.e., repurchasing inventory) associated with a voluntary product
recall would generally be the announcement of the recall. Except as provided for
in a warranty arrangement, an entity has no legal obligation or duty associated
with product design or manufacturing defects after the product is sold. Because
there is no legal obligation, there is no event that gives rise to a probable
loss until a recall is announced voluntarily. If, however, a warranty
arrangement exists, the obligating event is the identification of a problem with
the product or the need for product recall, not the voluntary recall
announcement.
Alternatively, an entity may conclude, on the basis of current
laws or regulations, that it is probable that such a law or regulation will
require the entity to initiate a product recall as a result of adverse events or
conditions associated with the product in the distribution channel (i.e.,
inventory that has been sold but has not yet been consumed). In such a
situation, the obligating event triggering liability recognition for the costs
of the recall is the existence of the current law or regulation, and liability
recognition for the estimated costs of the recall would generally be required
once the entity has concluded that it is probable that such a law or regulation
will require a recall and the associated costs can be reasonably estimated.
Further, such a conclusion could be reached before formal notification by a
regulator that a recall will be mandated.
Connecting the Dots
Entities may need to exercise significant judgment when determining
whether a product recall is mandated by current law or regulation or
should be considered voluntary. This distinction is critical since the
timing of liability recognition for the recall may vary depending on the
determination.
Given the complexity and the significant judgment that may be required,
entities are encouraged to consult with their legal and accounting
advisers when making this determination.
The above discussion regarding the obligation associated with a
product recall does not take into account situations in which a product may have
caused harm or damage that could result in potential loss against a company. In
such a situation, a loss contingency would be recorded once the loss is deemed
probable and reasonably estimable in accordance with ASC 450-20-25-2. Further,
entities should consider whether the nature of a product recall calls into
question the potential impairment of any inventory on hand.
Unless other authoritative literature requires entities to
classify costs of fulfilling product recalls in a particular manner (i.e., in
accordance with the guidance in ASC 606 on consideration for a product returned
from a customer), such costs should be classified as operating costs in the
financial statements because they result from an inherent business risk.
Example 2-14
Voluntary Recall
Initiated by an Entity
Big Pharma develops and manufactures
health care products, including medicines and vaccines
to advance wellness, prevention, treatments, and cures.
In May and June, Big Pharma distributes 25,000 bottles
of a pediatric drug to various distributors. The drug is
commonly used to reduce fever and relieve symptoms from
conditions such as the flu and a common head cold.
In August, Big Pharma discovers that
8,500 of the bottles, specifically the 3 oz. cherry
flavor, were distributed with the incorrect dosage cups.
The dosage instruction provides dosing in teaspoons,
while the dosage cups included in the packaging were
labeled in tablespoons. Since 1 tablespoon contains 3
teaspoons, Big Pharma is concerned that the usage of the
tablespoon dosage cups could result in dangerous
overdoses if the cups’ labeling was overlooked.
There is no law or regulation in place
requiring Big Pharma to recall the drugs for including
the incorrect dosage cups. In addition, no consumer
lawsuits have been brought against Big Pharma regarding
this matter. However, Big Pharma weighs the potential
overdose risks of consumers’ overlooking the measurement
metric on the dosage cup and decides to voluntarily
recall the product. On August 11, 20X9, Big Pharma
announces the recall for the 8,500 affected bottles.
Upon announcing the recall, Big Pharma recognizes a
liability for the estimated costs of removing the
bottles from distributors and retail stores, replacing
them, and notifying consumers. Because Big Pharma was
not otherwise required by law to initiate the product
recall, the obligating event triggering the liability
recognition is the announcement of the recall on August
11, 20X9. Any liability related to potential consumer
lawsuits would be accounted for in accordance with ASC
450-20. Such accounting would be separate from that for
the costs Big Pharma expects to incur in connection with
the recall.
Example 2-15
Recall Required by a Regulator
Mattress Store designs mattresses and
sells them through various online retail Web sites.
Mattress Store recently developed a new sleeper sofa
that is available in various sizes, including twin,
queen, and king, in a color choice of gray, blue, and
black. Mattress Store begins selling the sleeper sofa in
January. In March, Mattress Store discovers that the
blue sleeper sofa is not in compliance with the
mandatory federal flammability standard for mattresses
and therefore poses a fire hazard. Although there have
been no incidences reported or litigation brought
against Mattress Store, the sleeper sofa is in violation
of a federal law, and if it were reported to the U.S.
Consumer Product Safety Commission, the commission would
mandate a product recall and bar Mattress Store from
selling the sleeper sofa. Therefore, Mattress Store
announces a product recall in April to refund consumers
who bought the sleeper sofa and reacquire all sold
inventory.
Although the recall is announced in
April and the regulator has not yet provided formal
notification of a mandated recall for the sleeper sofa,
Mattress Store had determined in March that it was
probable that the U.S. Consumer Product Safety
Commission would require the company to recall the
sleeper sofa upon discovery of the violation of
flammability standards. Further, Mattress Store
concluded that sufficient information was available in
March to make a reasonable estimate for the cost of the
recall. Accordingly, Mattress Store records a liability
for the product recall in March, before the April recall
announcement or a regulator-mandated recall. Any
liability related to potential consumer lawsuits would
be accounted for in accordance with ASC 450-20. Such
accounting would be separate from that for costs
Mattress Store expects to incur in connection with the
recall.
2.3.3 Threat of Expropriation
ASC 450-20-55-9 states that “[t]he threat of expropriation of assets
is a contingency (as defined) because of the uncertainty about its outcome and
effect.” The guidance requires recognition of a loss from threat of expropriation of
assets only if (1) expropriation is imminent and (2) consideration received for the
expropriated assets will be less than the carrying amount, resulting in a loss. With
respect to (1), “[i]mminence may be indicated, for example, by public or private
declarations of intent by a government to expropriate assets of the entity or actual
expropriation of assets of other entities.” With respect to (2), an entity would
recognize a loss only when the consideration received is less than the carrying
value of the expropriated asset. The condition in ASC 450-20-25-2(b) requires that
accrual be made only if the amount of loss can be reasonably estimated. In
accordance with ASC 450-20-55-9, “[i]f the conditions for accrual are not met,” the
entity should provide appropriate disclosures “if there is at least a reasonable
possibility that an asset has been impaired” (see Section 2.8 for a discussion of disclosure
requirements and Section 3.7 for information
on the gain contingency disclosure requirements).
Footnotes
3
This position is consistent with the guidance in ASC 420
and ASC 805-20-55-50 and 55-51, which indicate that the liability for
termination benefits and curtailment losses that will be triggered by
the consummation of a business combination should be recognized only
upon completion of the business combination.
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.
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.
2.5 Consideration of Inflation
A topic closely related to the discounting of liabilities is the
consideration of inflation when liabilities are measured. Contingent
liabilities may ultimately be settled many years after the current reporting
period. It is appropriate for an entity to consider the impact of inflation
when measuring a contingent liability, irrespective of whether the liability
qualifies to be discounted and ultimately is discounted, unless it is
impracticable for the entity to do so. Although ASC 450-20 does not provide
guidance on whether an entity should consider the impact of inflation when
measuring a contingent liability, an entity should consider the guidance in
ASC 410-20 and ASC 410-30 on asset retirement obligations and environmental
obligations, respectively, which may be useful for evaluating whether the
impact of inflation should be considered when other types of contingent
liabilities are measured. Specifically, ASC 410-20-55-13(b) and ASC
410-30-30-17 require an adjustment for inflation unless it is impracticable.
See also Section
3.4 of Deloitte’s Roadmap Environmental Obligations and Asset
Retirement Obligations.
2.6 Remeasurement and Derecognition of a Contingent Liability
2.6.1 Remeasurement
Unlike a contractual or legal liability (discussed in Section 2.2.4), whose measurement is
established on the basis of the contract or law, the initial and subsequent
measurement of a contingent liability in accordance with ASC 450-20-30 may
involve a number of judgments, including those discussed in Section 2.4. These
uncertainties may necessitate the continual evaluation and remeasurement of the
contingent liability as new information becomes available. Such remeasurement in
accordance with ASC 450-20-30 could produce an estimated amount that is lower or
higher when compared with the amount previously recognized, thereby resulting in
a reduction or increase, respectively, of the contingent liability. If the new
information indicates a reduction of the previously recognized liability, such a
reduction should not be viewed as tantamount to derecognition of the contingent
liability. That is, the remeasurement of a previously recognized contingent
liability on the basis of new information that supports a lower estimated
probable loss should not be viewed as a partial derecognition of a loss whose
occurrence was and continues to be considered probable; rather, it should be
viewed and accounted for as a change in estimate in accordance with ASC 250.
There may also be circumstances in which sufficient and reliable
data no longer are available to support an estimate that was previously made for
a contingent liability whose occurrence remains probable. For example, an entity
may recognize a contingent liability on the basis of an actuarial analysis of
historical loss data, but the availability of settlement data during recent
periods may have declined significantly because of external factors. The
decrease in the availability of recent loss data may have diminished the
entity’s ability to reasonably estimate the amount of the previously recognized
contingent liability. However, the entity may believe that it is still probable
that one or more future events will confirm that a liability has been incurred.
Therefore, while the entity concludes that a loss associated with the contingent
liability remains probable, it will nonetheless need to assess whether the
previously accrued amount continues to represent an appropriate estimate or
whether another estimate should be made on the basis of the recent circumstances
associated with the availability of recent data, which could result in a
reduction, or even a complete reversal, of the previously recognized loss. When
the entity is evaluating whether it is appropriate to remeasure a contingent
liability in such a circumstance, it should carefully support remeasurement with
compelling and sufficiently reliable evidence that provides a reasonable basis
for concluding that there has been a change in its previous judgment regarding
the amount of the estimated loss to accrue. Further, clear disclosure of the
change in facts and circumstances should be considered.
2.6.2 Derecognition When Settlement Is No Longer Considered Probable
As noted in Section 2.3, a contingency that fails to meet one or both of the two
criteria in ASC 450-20-25-2 does not reach the threshold for recognition in the
financial statements. However, questions may arise about when it is appropriate for
an entity to derecognize a previously recognized contingent liability when
settlement is no longer considered probable.
For example, an entity may recognize a contingent liability related
to the probable incurrence of a loss because of pending litigation. Subsequently and
on the basis of the facts and circumstances related to the litigation, the entity
may conclude that such a loss is no longer considered probable, even though the
matter is not subject to legal release or the statute of limitations given the
noncontractual nature of the contingency. In such a scenario, derecognition of the
contingent liability would be reasonable given the conclusion that a loss is no
longer considered probable. However, the assessment of whether a contingency is
likely to occur often involves considerable subjectivity. In those cases, it may be
prudent to reduce or reverse an existing accrual only when there is reasonably clear
or compelling evidence that a loss is no longer considered probable. When
determining the sufficiency of evidence to support derecognition, an entity should
consider the potential that derecognition in certain circumstances could be
misleading to financial statement users because it could inappropriately communicate
that the liability has been extinguished when the contingency still exists. The
entity should clearly disclose the change in the accrual and the underlying facts
and circumstances.
The example below illustrates a scenario in which derecognition of a
contingent liability may be appropriate when settlement is no longer considered
probable.
Example 2-18
Derecognition of a Contingent Liability
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.
2.7 Balance Sheet Classification
ASC 210-10 — Glossary
Current Liabilities
Current liabilities is used
principally to designate obligations whose
liquidation is reasonably expected to require the
use of existing resources properly classifiable as
current assets, or the creation of other current
liabilities. . . .
ASC 210-10
Classification of Current Liabilities
45-5
A total of current liabilities
shall be presented in classified balance
sheets.
45-6
The concept of current
liabilities includes estimated or accrued amounts
that are expected to be required to cover
expenditures within the year for known obligations
the amount of which can be determined only
approximately (as in the case of provisions for
accruing bonus payments) or where the specific
person or persons to whom payment will be made
cannot as yet be designated (as in the case of
estimated costs to be incurred in connection with
guaranteed servicing or repair of products already
sold).
45-9
Other liabilities whose
regular and ordinary liquidation is expected to
occur within a relatively short period of time,
usually 12 months, are also generally included [in
current liabilities] . . .
The balance sheet
classification of an accrued contingent liability
should be based on the period in which the entity
expects the contingency to be settled. A liability
should be classified as short-term if it is
expected to be settled within one year or less of
the balance sheet date (or longer if the entity’s
operating cycle is greater than one year).
Otherwise, the liability should be classified as
long-term.
Entities should undertake a balanced analysis
to determine the appropriate classification
without presuming either short-term or long-term
classification by default. As part of this
analysis, entities should consider the specific
circumstances associated with the liability,
including any outstanding offers to settle the
obligation. Such offers should be viewed as akin
to due-on-demand obligations, which would
generally require short-term classification unless
the outstanding offer is based on a long-term
payment plan.
Entities should have persuasive evidence to
support the classification of a liability. The
need for persuasive evidence may increase when an
entity has concluded that long-term classification
is appropriate. This evidence should clearly
demonstrate the entity's expectation regarding the
settlement period of the liability.
The following are additional considerations
related to the classification of a contingent liability:
-
A contingent liability that is measured on the basis of the entity’s best estimate of the current amount the entity would be required to pay to another party to settle a dispute is generally recognized as a current liability.
-
If an insurance recoverable receivable is recognized, the contingent liability and insurance receivable should generally be classified consistently. The determination of whether the liability and related asset are classified as current or long-term will depend on the facts and circumstances.
2.8 Disclosures
2.8.1 Disclosure Considerations Under ASC 450-20 and ASC 275
Disclosures of loss contingencies required under ASC 450-20 are intended to
provide users of financial statements with an understanding of risks and how
they could potentially affect the financial statements.
When performing accrual accounting, an entity must make
estimates in current-period financial statements to reflect current events and
transactions, the effects of which may not be precisely determinable until some
future period. The final results may not match original expectations.
Uncertainty about the outcome of future events is inherent in economics, and an
entity should understand that fact when reading reports on economic activities,
such as published financial statements. A business, to a great extent, is a
function of the environment in which it operates. Thus, it can be affected by
changing social, political, and economic factors. In addition, every entity is
subject to uncertain future events that may affect the entity or the industry in
which it operates. These uncertainties may or may not be considered
contingencies as defined by ASC 450-10-20. As a result, the disclosures required
by ASC 275-10-50 supplement and, in many cases, overlap the disclosures required
by ASC 450-20-50.
Not all uncertainties inherent in the accounting process give
rise to contingencies as that word is used in ASC 450. Estimates are required in
financial statements for many of an entity’s ongoing and recurring activities.
The fact that an estimate is involved does not by itself constitute the type of
uncertainty referred to in the definition of a contingency in ASC 450-10-20. For
example, the fact that estimates are used to allocate the known cost of a
depreciable asset over the period of use by an entity does not make depreciation
a contingency; the eventual expiration of the use of the asset is not uncertain.
Thus, depreciation of assets is not a contingency as discussed in ASC
450-10-55-2. In addition, matters related to depreciation (e.g., recurring
repairs, maintenance, and overhauls) are similarly outside the scope of ASC 450.
Amounts owed for services received, such as advertising and utilities, are not
contingencies even though the accrued amounts may have been estimated; there is
nothing uncertain about the fact that those obligations have been incurred.
Some degree of estimation is required for nearly all financial
statement amounts. However, many lawsuits that may create a material liability
are not recorded because one or both conditions for recognizing a contingent
liability are not met; they are nonetheless disclosed to the extent that a loss
is reasonably possible.
Neither ASC 450-20 nor any other authoritative literature
contains definitive guidelines on measuring the difference between estimates
that are affected by uncertainty that can be estimated reasonably and those that
cannot be estimated reasonably. Although estimates generally include some level
of uncertainty, they are not necessarily loss contingencies. Thus, estimates
regarding events in the normal course of business have frequently been included
in the financial statements without specific disclosure since ASC 450-20-50
requires disclosure of only contingencies. ASC 275-10-50 extends disclosure
requirements to numerous risks and uncertainties, many of which are not
considered contingencies.
ASC 450-20
Accruals for Loss Contingencies
50-1 Disclosure of the nature
of an accrual made pursuant to the provisions of
paragraph 450-20-25-2, and in some circumstances the
amount accrued, may be necessary for the financial
statements not to be misleading. Terminology used shall
be descriptive of the nature of the accrual, such as
estimated liability or liability of an estimated amount.
The term reserve shall not be used for an accrual
made pursuant to paragraph 450-20-25-2; that term is
limited to an amount of unidentified or unsegregated
assets held or retained for a specific purpose. Examples
1 (see paragraph 450-20-55-18) and 2, Cases A, B, and D
(see paragraphs 450-20-55-23, 450-20-55-27, and
450-20-55-32) illustrate the application of these
disclosure standards.
Pending Content (Transition Guidance: ASC
220-40-65-1)
50-1
Disclosure of the nature of an accrual made
pursuant to the provisions of paragraph
450-20-25-2, and in some circumstances the amount
accrued, may be necessary for the financial
statements not to be misleading. Terminology used
shall be descriptive of the nature of the accrual,
such as estimated liability or liability of an
estimated amount. The term reserve shall
not be used for an accrual made pursuant to
paragraph 450-20-25-2; that term is limited to an
amount of unidentified or unsegregated assets held
or retained for a specific purpose. Examples 1
(see paragraph 450-20-55-18) and 2, Cases A, B,
and D (see paragraphs 450-20-55-23, 450-20-55-27,
and 450-20-55-32) illustrate the application of
these disclosure standards. See paragraphs
220-40-50-21 through 50-25 for additional
disclosure requirements.
50-2 If the
criteria in paragraph 275-10-50-8 are met, paragraph
275-10-50-9 requires disclosure of an indication that it
is at least reasonably possible that a change in an
entity’s estimate of its probable liability could occur
in the near term. Example 3 (see paragraph 450-20-55-36)
illustrates this disclosure for an entity involved in
litigation.
Unrecognized Contingencies
50-2A The disclosures required
by paragraphs 450-20-50-3 through 50-6 do not apply to
credit losses on instruments within the scope of Topic
326 on measurement of credit losses. (See paragraph
310-10-50-21.)
50-3
Disclosure of the contingency shall be made if there is
at least a reasonable possibility that a loss or an
additional loss may have been incurred and either of the
following conditions exists:
- An accrual is not made for a loss contingency because any of the conditions in paragraph 450-20-25-2 are not met.
- An exposure to loss exists in excess of the amount accrued pursuant to the provisions of paragraph 450-20-30-1.
Examples 1–3 (see paragraphs 450-20-55-18 through 55-37)
illustrate the application of these disclosure
standards.
50-4 The
disclosure in the preceding paragraph shall include both
of the following:
- The nature of the contingency
- An estimate of the possible loss or range of loss or a statement that such an estimate cannot be made.
50-5 Disclosure is preferable
to accrual when a reasonable estimate of loss cannot be
made. For example, disclosure shall be made of any loss
contingency that meets the condition in paragraph
450-20-25-2(a) but that is not accrued because the
amount of loss cannot be reasonably estimated (the
condition in paragraph 450-20-25-2(b)). Disclosure also
shall be made of some loss contingencies that do not
meet the condition in paragraph 450-20-25-2(a) — namely,
those contingencies for which there is a reasonable
possibility that a loss may have been incurred even
though information may not indicate that it is probable
that an asset had been impaired or a liability had been
incurred at the date of the financial statements.
50-6
Disclosure is not required of a loss contingency
involving an unasserted claim or assessment if there has
been no manifestation by a potential claimant of an
awareness of a possible claim or assessment unless both
of the following conditions are met:
- It is considered probable that a claim will be asserted.
- There is a reasonable possibility that the outcome will be unfavorable.
50-7
Disclosure of noninsured or underinsured risks is not
required by this Subtopic. However, disclosure in
appropriate circumstances is not discouraged.
ASC 275-10
50-7 Various
Topics require disclosures about uncertainties addressed
by those Topics. In particular, Subtopic 450-20
specifies disclosures to be made about contingencies
that exist at the date of the financial statements. In
addition to disclosures required by Topic 450 and other
accounting Topics, this Subtopic requires disclosures
regarding estimates used in the determination of the
carrying amounts of assets or liabilities or in
disclosure of gain or loss contingencies, as described
below.
50-8
Disclosure regarding an estimate shall be made when
known information available before the financial
statements are issued or are available to be issued (as
discussed in Section 855-10-25) indicates that both of
the following criteria are met:
- It is at least reasonably possible that the estimate of the effect on the financial statements of a condition, situation, or set of circumstances that existed at the date of the financial statements will change in the near term due to one or more future confirming events.
- The effect of the change would be material to the financial statements.
50-9 The
disclosure shall indicate the nature of the uncertainty
and include an indication that it is at least reasonably
possible that a change in the estimate will occur in the
near term. If the estimate involves a loss contingency
covered by Subtopic 450-20, the disclosure also shall
include an estimate of the possible loss or range of
loss, or state that such an estimate cannot be made.
Disclosure of the factors that cause the estimate to be
sensitive to change is encouraged but not required. The
words reasonably possible need not be used in the
disclosures required by this Subtopic.
50-11 This
Subtopic’s disclosure requirements are separate from and
do not change in any way the disclosure requirements or
criteria of Topic 450; rather, the disclosures required
under this Subtopic supplement the disclosures required
under that Topic as follows:
- If an estimate (including estimates that involve contingencies covered by Topic 450) meets the criteria for disclosure under paragraph 275-10-50-8, this Subtopic requires disclosure of an indication that it is at least reasonably possible that a change in the estimate will occur in the near term; Topic 450 does not distinguish between near-term and long-term contingencies.
- An estimate that does not involve a contingency covered by Topic 450, such as estimates associated with long-term operating assets and amounts reported under profitable long-term contracts, may meet the criteria in paragraph 275-10-50-8. This Subtopic requires disclosure of the nature of the estimate and an indication that it is at least reasonably possible that a change in the estimate will occur in the near term.
50-12 If a
loss contingency meets the criteria for disclosure under
both Topic 450 and paragraph 275-10-50-8, this Subtopic
requires disclosure that it is at least reasonably
possible that future events confirming the fact of the
loss or the change in the estimated amount of the loss
will occur in the near term.
In addition to being required to provide the primary disclosures
under ASC 450-20, an entity must provide certain additional disclosures under
ASC 275 when it is reasonably possible that a change in estimate will occur in
the near term. The disclosure requirements under ASC 450-20 and ASC 275 are
summarized in the table below.
|
Possibility That a Loss Has Been Incurred
|
Ability to Estimate a Loss
|
Disclosure Requirements of ASC 450-20 and ASC 275
|
|---|---|---|
|
Reasonably possible
|
May or may not be reasonably estimable
|
Disclose all of the following:
|
|
Probable
|
Not reasonably estimable
|
Disclose both of the following:
|
|
Probable
|
Reasonably estimable
|
Disclose all of the following:
|
|
Remote
|
Not reasonably estimable
|
No specific disclosure requirements related to remote
contingencies; however, disclosures may be provided if
their omission could cause the financial statements to
be misleading.
|
Example 3 of ASC 450-20-55-36 illustrates the determination and disclosure of a
range of estimates.
ASC 450-20
Example 3: Illustrative Disclosure
55-36 Entity
A is the defendant in litigation involving a major
competitor claiming patent infringement (Entity B). The
suit claims damages of $200 million. Discovery has been
completed, and Entity A is engaged in settlement
discussions with the plaintiff. Entity A has made an
offer of $5 million to settle the case, which offer was
rejected by the plaintiff; the plaintiff has made an
offer of $35 million to settle the case, which offer was
rejected by Entity A. Based on the expressed willingness
of the plaintiff to settle the case along with
information revealed during discovery and the likely
cost and risk to both sides of litigating, Entity A
believes that it is probable the case will not come to
trial. Accordingly, Entity A has determined that it is
probable that it has some liability. Entity A’s
reasonable estimate of this liability is a range between
$10 million and $35 million, with no amount within that
range a better estimate than any other amount;
accordingly, $10 million was accrued.
55-37 Entity
A provides the following disclosure in accordance with
Section 450-20-50.
On March 15, 19X1,
Entity B filed a suit against the company claiming
patent infringement. While the company believes it has
meritorious defenses against the suit, the ultimate
resolution of the matter, which is expected to occur
within one year, could result in a loss of up to $25
million in excess of the amount accrued.
SEC Considerations
ASC 450-20-50-4 requires disclosures about the nature of any material
contingency, including the amounts that might be paid, if a loss is at
least reasonably possible. In addition, SEC Regulation S-K, Item 303,
requires discussion of items that might affect a company’s liquidity or
financial position in the future, including contingent liabilities.
The SEC staff has consistently commented on and
challenged registrants’ compliance with the disclosure requirements in
ASC 450-20. For example, Scott Taub, deputy chief accountant in the
SEC’s Office of the Chief Accountant, noted the following in a
speech at the 2004 AICPA Conference on Current SEC
and PCAOB Developments:
Given [the requirement to
record an accrual if payment is both probable and estimable and the
requirement to disclose the nature of any material contingency,
including the amounts that might be paid, if a loss is at least
reasonably possible], the recording of a material accrual for a
contingent liability related to an event that occurred several years
before should not be the first disclosure regarding that
contingency. Rather, disclosures regarding the nature of the
contingency and the amounts at stake should, in most cases, have
already been provided. Disclosures should discuss the nature of the
contingency and the possible range of losses for any item where the
maximum reasonably possible loss is material. Vague or overly broad
disclosures that speak merely to litigation, tax, or other risks in
general, without providing any information about the specific kinds
of loss contingencies being evaluated are not sufficient.
Furthermore, I should point out that Statement 5
and Interpretation 14 [codified as ASC 450-20] require accrual for
probable losses of the most likely amount of the loss. While the low
end of a range of possible losses is the right number if no amount
within the range is more likely than any other, I find it somewhat
surprising how often “zero” is the recorded loss right up until a
large settlement is announced. [Footnote omitted]
The SEC staff made similar remarks at subsequent
conferences, including the 2010 AICPA Conference on Current SEC and
PCAOB Developments. To ensure compliance with the requirements in ASC
450-20, registrants should continually review their disclosures and
update them as additional information becomes available.
Non-SEC registrants may also consider the preceding SEC
staff remarks given that the disclosure objectives outlined by the staff
would generally be expected to apply to these entities’ financial
statements as well.
2.8.2 Disclosure of Unasserted Claims
ASC 450-20-50-6 indicates that a disclosure of a loss contingency
involving an unasserted claim is not required unless both of the following
conditions are met:
- It is considered probable that a claim will be asserted.
- There is a reasonable possibility that the outcome will be unfavorable.
This exception is specific to unasserted claims and should not be
applied by analogy to claims other than unasserted claims. An entity must evaluate
all the facts and circumstances in determining whether to disclose such a loss
contingency.
2.8.3 Disclosure of Loss Contingencies Occurring After Year-End
ASC 855-10-50-2 requires an entity to disclose a nonrecognized
subsequent event if it is “of such a nature that [it] must be disclosed to keep the
financial statements from being misleading.” Although whether to provide such a
disclosure is a matter of judgment, it would seem prudent for an entity to disclose
any matter that could materially affect its financial position, results of
operations, or trend of operations. In addition, an entity should consider
disclosing any accruals made in the subsequent reporting period as a nonrecognized
subsequent event within the current-period financial statements if the accruals (1)
are unusual or material to earnings of the current reporting period or (2)
materially affect the trend of earnings.
Disclosures about a loss or loss contingency occurring after year-end should include
(1) the nature of the loss or loss contingency and (2) an estimate of the amount or
range of loss or possible loss or a statement that such an estimate cannot be made.
If the effect on the entity’s financial position is material, it may be useful for
the entity to provide supplemental pro forma financial data reflecting the loss as
if it had occurred as of the date of the financial statements.
2.8.4 Disclosure of Firmly Committed Executory Contracts
ASC 440-10
50-2 An
unconditional purchase obligation that has all of the
following characteristics shall be disclosed in accordance
with paragraph 440-10-50-4 (if not recorded on the
purchaser’s balance sheet) or in accordance with paragraph
440-10-50-6 (if recorded on the purchaser’s balance
sheet):
- It is noncancelable, or cancelable
only in any of the following circumstances:
- Upon the occurrence of some remote contingency
- With the permission of the other party
- If a replacement agreement is signed between the same parties
- Upon payment of a penalty in an amount such that continuation of the agreement appears reasonably assured.
- It was negotiated as part of arranging financing for the facilities that will provide the contracted goods or services or for costs related to those goods or services (for example, carrying costs for contracted goods). A purchaser is not required to investigate whether a supplier used an unconditional purchase obligation to help secure financing, if the purchaser would otherwise be unaware of that fact.
- It has a remaining term in excess of one year.
Unrecognized Commitments
50-4 A
purchaser shall disclose unconditional purchase obligations
that meet the criteria of paragraph 440-10-50-2 and that
have not been recognized on its balance sheet. Disclosures
of similar or related unconditional purchase obligations may
be combined. The disclosures shall include all of the
following:
- The nature and term of the obligation(s)
- The amount of the fixed and determinable portion of the obligation(s) as of the date of the latest balance sheet presented, in the aggregate and, if determinable, for each of the five succeeding fiscal years
- The nature of any variable components of the obligation(s)
- The amounts purchased under the obligation(s) (for example, the take-or-pay or throughput contract) for each period for which an income statement is presented.
The preceding disclosures may be omitted only if the
aggregate commitment for all such obligations not disclosed
is immaterial.
50-5 Disclosure
of the amount of imputed interest necessary to reduce the
unconditional purchase obligation(s) to present value is
encouraged but not required. The discount rate shall be the
effective initial interest rate of the borrowings that
financed the facility (or facilities) that will provide the
contracted goods or services, if known by the purchaser. If
not, the discount rate shall be the purchaser’s incremental
borrowing rate at the date the obligation is entered
into.
Recognized Commitments
50-6 A
purchaser shall disclose for each of the five years
following the date of the latest balance sheet presented the
aggregate amount of payments for unconditional purchase
obligations that meet the criteria of paragraph 440-10-50-2
and that have been recognized on the purchaser’s balance
sheet.
An entity should provide the incremental disclosures required by ASC
440-10-50-2 that pertain to unconditional purchase obligations or firmly committed
executory contracts. Specifically, when an executory contract is material and has
not been recognized in the financial statements, the entity should comply with the
disclosure requirements of ASC 440-10-50-4(a)–(d). When the entity has recognized an
executory contract on the balance sheet, it should disclose total payments for each
of the five years after the date of the latest balance sheet.
SEC Considerations
In addition to providing the footnote disclosures required
by ASC 440-10-50, an entity must provide incremental disclosures within
MD&A under SEC Regulation S-K, Item 303. Because the disclosures
required by SEC Regulation S-K may be broader than those required by ASC
440-10-50-2, SEC registrants may reflect different amounts related to
purchase obligations in the notes to the financial statements than they do
in MD&A.
2.9 Subsequent-Event Considerations
Entities should have processes in place to capture and 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
current-period or subsequent-period financial statements.
The recognition, measurement, and disclosure principles related to loss
contingencies 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.
ASC 450-20 includes guidance on accounting for subsequent events.
ASC 450-20
25-2 An estimated
loss from a loss contingency shall be accrued by a charge to
income if both of the following conditions are met:
- Information available before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. Date of the financial statements means the end of the most recent accounting period for which financial statements are being presented. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
- The amount of loss can be reasonably estimated.
The purpose of those conditions is to require
accrual of losses when they are reasonably estimable and relate
to the current or a prior period. Paragraphs 450-20-55-1 through
55-17 and Examples 1–2 (see paragraphs 450-20-55-18 through
55-35) illustrate the application of the conditions. As
discussed in paragraph 450-20-50-5, disclosure is preferable to
accrual when a reasonable estimate of loss cannot be made.
Further, even losses that are reasonably estimable shall not be
accrued if it is not probable that an asset has been impaired or
a liability has been incurred at the date of an entity’s
financial statements because those losses relate to a future
period rather than the current or a prior period. Attribution of
a loss to events or activities of the current or prior periods
is an element of asset impairment or liability incurrence.
25-6 After the date
of an entity’s financial statements but before those financial
statements are issued or are available to be issued (as
discussed in Section 855-10-25), information may become
available indicating that an asset was impaired or a liability
was incurred after the date of the financial statements or that
there is at least a reasonable possibility that an asset was
impaired or a liability was incurred after that date. The
information may relate to a loss contingency that existed at the
date of the financial statements, for example, an asset that was
not insured at the date of the financial statements. On the
other hand, the information may relate to a loss contingency
that did not exist at the date of the financial statements, for
example, threat of expropriation of assets after the date of the
financial statements or the filing for bankruptcy by an entity
whose debt was guaranteed after the date of the financial
statements. In none of the cases cited in this paragraph was an
asset impaired or a liability incurred at the date of the
financial statements, and the condition for accrual in paragraph
450-20-25-2(a) is, therefore, not met.
The guidance in ASC 450 indicates that entities should consider
information available before the financial statements are issued or are available to be
issued when determining whether it is probable that an asset has been impaired or a loss
event has occurred as of the balance sheet date. ASC 450 does not specifically address
events occurring after the balance sheet date that provide additional information
related to the measurement of a loss contingency; however, entities should consider the
subsequent-event guidance that is codified in ASC 855-10.
ASC 855-10
Recognized Subsequent
Events
Evidence About Conditions
That Existed at the Date of the Balance
Sheet
25-1 An entity shall
recognize in the financial statements the effects of all
subsequent events that provide additional evidence about
conditions that existed at the date of the balance sheet,
including the estimates inherent in the process of preparing
financial statements. See paragraph 855-10-55-1 for examples of
recognized subsequent events.
55-1 The following are examples of
recognized subsequent events addressed in paragraph
855-10-25-1:
- If the events that gave rise to litigation had taken place before the balance sheet date and that litigation is settled after the balance sheet date but before the financial statements are issued or are available to be issued, for an amount different from the liability recorded in the accounts, then the settlement amount should be considered in estimating the amount of liability recognized in the financial statements at the balance sheet date.
- Subsequent events affecting the realization of assets, such as inventories, or the settlement of estimated liabilities, should be recognized in the financial statements when those events represent the culmination of conditions that existed over a relatively long period of time.
Nonrecognized Subsequent
Events
Evidence About Conditions
That Did Not Exist at the Date of the Balance
Sheet
25-3 An entity
shall not recognize subsequent events that provide evidence
about conditions that did not exist at the date of the balance
sheet but arose after the balance sheet date but before
financial statements are issued or are available to be issued.
See paragraph 855-10-55-2 for examples of nonrecognized
subsequent events.
55-2 The following are examples of
nonrecognized subsequent events addressed in paragraph
855-10-25-3:
- Sale of a bond or capital stock issued after the balance sheet date but before financial statements are issued or are available to be issued
- A business combination that occurs after the balance sheet date but before financial statements are issued or are available to be issued (Topic 805 requires specific disclosures in such cases.)
- Settlement of litigation when the event giving rise to the claim took place after the balance sheet date but before financial statements are issued or are available to be issued
- Loss of plant or inventories as a result of fire or natural disaster that occurred after the balance sheet date but before financial statements are issued or are available to be issued
- Changes in estimated credit losses on receivables arising after the balance sheet date but before financial statements are issued or are available to be issued
- Changes in the fair value of assets or liabilities (financial or nonfinancial) or foreign exchange rates after the balance sheet date but before financial statements are issued or are available to be issued
- Entering into significant commitments or contingent liabilities, for example, by issuing significant guarantees after the balance sheet date but before financial statements are issued or are available to be issued.
50-2 Some
nonrecognized subsequent events may be of such a nature that
they must be disclosed to keep the financial statements from
being misleading. For such events, an entity shall disclose the
following:
- The nature of the event
- An estimate of its financial effect, or a statement that such an estimate cannot be made.
Connecting the Dots
ASC 450 and ASC 855 provide guidance on how to evaluate events
occurring after the balance sheet date. Under ASC 855-10-25-1A, the period
through which subsequent events must be evaluated differs for (1) SEC filers and
“conduit bond obligor[s] for conduit debt securities that are traded in a public
market (a domestic or foreign stock exchange or an over-the-counter market,
including local or regional markets)” and (2) entities that are neither SEC
filers nor conduit bond obligors. SEC filers and conduit bond obligors should
evaluate events that occur through the date on which the financial statements
are issued, whereas entities that are neither SEC filers nor conduit bond
obligors should evaluate events that occur through the date on which the
financial statements are available to be issued. To determine whether an entity
is a conduit bond obligor, entities should refer to the definitions of “SEC
filer” and “conduit debt securities” in the ASC master glossary.
If an event takes place after the balance sheet date but before the
financial statements are issued or are available to be issued, and the event indicates
that it is probable that an asset has been impaired or a liability has been incurred as
of the balance sheet date, the event is considered a recognized subsequent event. The
event provides additional evidence of the loss incurred before the balance sheet date
and should be reflected in the financial statements.
Examples of events that provide additional information about conditions
that existed as of the balance sheet date and therefore should be accounted for as
recognized subsequent events include the following:
- An unfavorable court ruling in a lawsuit. The company had previously determined that the likelihood of an unfavorable outcome would be remote or reasonably possible but now considers it probable.
- A litigation settlement that indicates a loss amount different from that previously recognized in the financial statements.
- The identification of asset misappropriation that occurred on or before the balance sheet date and for which no loss had previously been recognized.
If events constitute additional information that an asset had been
impaired or a liability had been incurred as of the balance sheet date, but the amount
of the loss cannot be reasonably estimated before the financial statements are issued or
are available to be issued, the entity should consider whether disclosures are provided
in accordance with Section
2.8.1.
A loss should be recognized only when events confirm that an asset had
been impaired or a liability existed as of the balance sheet date. If a loss contingency
that did not exist as of the balance sheet date occurs after the balance sheet date but
before the financial statements are issued or are available to be issued, the entity
would not recognize the loss as of the balance sheet date but may need to disclose it as
a subsequent event to keep the financial statements from being misleading.
The enactment of a law that gives rise to a liability after the balance
sheet date but before the financial statements are issued or are available to be issued
is a nonrecognized subsequent event. The newly enacted law does not provide evidence of
conditions that existed as of the balance sheet date. However, the entity should
consider whether it is required to disclose the event to keep the financial statements
from being misleading. For additional information on the enactment of a law or
legislation, see Section
2.3.1.3.
Example 2-19
Legislation Enacted After
the Balance Sheet Date
Company A, a public entity with a December 31,
20X1, year-end, operates in the banking industry and is subject
to proposed legislation that will impose a fee on deposits that
existed as of June 30, 20X1. The legislation is expected to be
enacted after year-end but before the issuance of the financial
statements. Company A believes that because enactment of the
legislation is probable and is related to balances as of a date
before the balance sheet date, an accrual should be made.
However, the obligating event in this case is the enactment of
the legislation, before which A did not incur a liability even
though a fee was assessed on preexisting balances; thus, no
accrual should be made as of December 31, 20X1. Instead, the
impact of the new legislation is a nonrecognized subsequent
event, and A should consider whether it is required to disclose
the event in its December 31, 20X1, financial statements to keep
them from being misleading.
If a recognized contingent liability is settled after the balance sheet
date but before the financial statements are issued or are available to be issued, a
contingent liability should be reversed as of the balance sheet date to the extent that
the recognized liability exceeds the settlement amount. The settlement constitutes
additional evidence of conditions that existed as of the balance sheet date and would be
considered a recognized subsequent event.
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 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 may 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 Statement 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 it may be certain that an entity will receive proceeds from
a legal settlement because there is no possibility of additional appeals, there may
be other uncertainties indicating 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.”
Chapter 4 — Loss Recoveries
Chapter 4 — Loss Recoveries
4.1 Overview
Chapters 2 and 3 of this Roadmap address the accounting for loss
and gain contingencies. This chapter addresses the accounting for recoveries
pertaining to a previously recognized financial statement loss (e.g., an impairment
of an asset or incurrence of a liability), as well as recoveries from business
interruption insurance. Insured losses might result from partial or full destruction
of an entity’s property or equipment because of fire, earthquake, hurricane, or
other natural disasters, as well as losses that arise from asbestos exposure or
environmental matters. Insured losses can also take the form of insured director and
officer costs and result from fraudulent activities undertaken by employees. Loss
recoveries may be received from litigation settlements, insurance proceeds, or
reimbursement of an employee’s fraudulent activities through liquidation of the
employee’s assets.
An entity should consider four accounting models when determining
the recognition and measurement of expected insurance or other proceeds related to a
recovery: (1) the loss recovery model, (2) the gain contingency model, (3) a
determinable mix of the loss recovery and gain contingency models, and (4) an
indeterminable mix of the loss recovery and gain contingency models.
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Loss recovery model
|
An asset for which realization is probable
should be recognized only up to the amount of the previously
recognized loss. The analysis of whether recovery is
probable is consistent with the guidance on loss contingency
recognition in Chapter 2. See
Section 4.3 for additional information.
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Gain contingency model
|
Recovery proceeds related to a loss that has
not been recognized in the financial statements should be
accounted for as a gain contingency as described in
Chapter 3. See Section 4.3 for
additional information.
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Determinable mix of loss recovery and gain
contingency models
|
A combination of the loss recovery and gain
contingency models is applied when recovery proceeds are
expected to exceed the amount of the previously recognized
loss. The probable recovery proceeds equal to the amount of
the recognized loss should be accounted for by using the
loss recovery model. The expected proceeds in excess of the
recognized loss should be accounted for by using the gain
contingency model. For an entity to apply the determinable
mix model, there must be a direct linkage between the
recovery proceeds and the specifically identifiable
recognized loss. See Section 4.4 for
additional information.
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Indeterminable mix of loss recovery and gain
contingency models
|
An indeterminable mix of the loss recovery
and gain contingency models results from a situation in
which there is no clear evidence that the amount of the
recovery proceeds is a recovery of previously recognized
losses or costs (i.e., there is no direct linkage) or the
amount of the loss or costs previously incurred is not
objectively quantifiable (i.e., the losses or costs are not
specific, incremental, identifiable costs or losses). Under
these circumstances, the application of the gain contingency
model would be appropriate for the entire amount of the
recovery proceeds. See Section 4.4 for
additional information.
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These four models are based on the loss contingency model and the
gain contingency model, both of which are codified in ASC 450. In addition, the
accounting for recovery proceeds builds upon ASC 450, drawing from other parts of
U.S. GAAP, including guidance on involuntary conversions (ASC 610-30); how to
account for the impact of the September 11, 2001, terrorist attacks (EITF Issue
01-10); and environmental obligations (ASC 410-30). This chapter describes how these
additional sources of U.S. GAAP form the basis for the accounting for recovery
proceeds.
Connecting the Dots
This chapter does not address the specific accounting that applies to
retroactive insurance contracts subject to ASC 720-20.
4.2 Involuntary Conversions
Insurance is often maintained to mitigate losses in the event of
property damage or casualty losses. The recognized loss and the associated recovery
proceeds (through insurance proceeds or other sources of recovery) are treated as
two separate events and therefore two separate units of account. The principle
underlying this separation, which is the basis for the accounting models described
in Sections 4.3 and
4.4, is derived
from the involuntary conversion guidance codified in ASC 610-30.
ASC 610-30
25-2 An
involuntary conversion of a nonmonetary asset to monetary
assets and the subsequent reinvestment of the monetary
assets is not equivalent to an exchange transaction between
an entity and another entity. The conversion of a
nonmonetary asset to monetary assets is a monetary
transaction, whether the conversion is voluntary or
involuntary, and such a conversion differs from exchange
transactions that involve only nonmonetary assets. To the
extent the cost of a nonmonetary asset differs from the
amount of monetary assets received, the transaction results
in the realization of a gain or loss that shall be
recognized.
25-3
Involuntary conversions of nonmonetary assets to monetary
assets are monetary transactions for which gain or loss
shall be recognized even though an entity reinvests or is
obligated to reinvest the monetary assets in replacement
nonmonetary assets. However, the requirement of this
Subtopic with respect to gain recognition does not apply to
an involuntary conversion of a last-in, first-out (LIFO)
inventory for which replacement is intended but not made by
year-end and the taxpayer does not recognize gain for income
tax reporting purposes. Paragraph 270-10-45-6(b) provides an
exception for the liquidation of a LIFO inventory at an
interim date if replacement is expected by year-end.
Accordingly, that exception applies to an involuntary
conversion of a LIFO inventory if replacement is expected by
year-end.
25-4 In some
cases, a nonmonetary asset may be destroyed or damaged in
one accounting period, and the amount of monetary assets to
be received is not determinable until a subsequent
accounting period. In those cases, gain or loss shall be
recognized in accordance with Topic 450.
When a nonmonetary asset (e.g., property) is involuntarily converted
to a monetary asset (e.g., an insurance receivable), an entity must recognize the
effects of the monetary transaction even if the proceeds are reinvested (voluntarily
or by requirement) in the replacement or repair of the nonmonetary asset. The loss
of a nonmonetary asset and subsequent monetary recovery through insurance are
therefore accounted for as two separate units of account.
Example 4-1
Involuntary
Conversion
A fire destroys Company X’s operating plant.
Company X must write off the plant, recognizing a loss,
regardless of its decision or the insurance company’s
requirements to use any insurance proceeds to replace or
repair the plant. If the property or equipment is destroyed
or damaged in one period and the recovery proceeds are not
recognizable (e.g., not determinable) until a subsequent
period, X recognizes the loss when incurred without
considering possible recognition of a monetary recovery
(e.g., cash proceeds).
See Example 4-3 for another illustration of the
accounting for an involuntary conversion.
4.3 Loss Recovery and Gain Contingency Models
In determining whether an asset can be recognized for expected
proceeds (e.g., proceeds from an insurance policy), an entity must first consider
the amount of the expected proceeds in comparison to the related previously
recognized loss, if any. This comparison is illustrated below in the context of the
loss recovery and gain contingency models.
Although not codified, paragraph 16 of EITF Issue 01-10 notes that a
gain is “a recovery of a loss not yet recognized in the financial statements or an
amount recovered in excess of a loss recognized in the financial statements.”
Consequently, a loss recovery could be defined as the inverse: recovery proceeds up
to the amount of the financial statement loss incurred. The recognition threshold
for a loss recovery is that it is probable, as indicated by ASC 410-30-35-8, which
states that “an asset relating to the recovery shall be recognized only when
realization of the claim for recovery is deemed probable.”
An asset related to a recovery should be recognized for a previously
recognized financial statement loss when the recovery is probable. The amount
greater than the previously recognized loss or a recovery of a loss not yet
recognized in the financial statements should be treated as a gain contingency.
ASC 410-30 addresses the accounting for recovery proceeds related to
environmental remediation liabilities. Although that guidance is specific to
environmental matters, an entity should apply the recognition and measurement
principles in ASC 410-30-35-8 and 35-9 when determining the appropriate recognition
of other loss recoveries unrelated to environmental matters.
ASC 410-30
35-8 . . . The amount of an
environmental remediation liability should be determined
independently from any potential claim for recovery, and an
asset relating to the recovery shall be recognized only when
realization of the claim for recovery is deemed probable.
The term probable is used in this Subtopic with the
specific technical meaning in paragraph 450-20-25-1.
35-9 If the
claim is the subject of litigation, a rebuttable presumption
exists that realization of the claim is not probable.
An entity that incurs a loss attributable to impairment of an asset
or incurrence of a liability and expects to recover all or a portion of that loss by
filing a claim with an insurance carrier or a claim against other third parties
should record an asset for the amount for which the recovery from the claim (not to
exceed the amount of the total losses recognized) is considered probable. Amounts
greater than an amount for which recovery from the claim was initially considered
probable should be subsequently recognized only to the extent that they do not
exceed actual additional covered losses or direct, incremental costs incurred to
obtain the recovery. Any expected recovery that is greater than covered losses or
direct, incremental costs incurred represents a gain contingency; therefore, a
higher recognition threshold is required for such a recovery, as described
throughout Chapter
3.
Example 4-2
Determining the
Probability of a Noninsurance Recovery
Company S discovers that its CFO has
perpetrated a fraud by drawing down on a corporate line of
credit of $20 million into her personal bank account.
Company S’s outside counsel meets with the bank to discuss
the fraud and advises S that it will be obligated to repay
to the bank the money withdrawn by the CFO. A forensic
investigation of the CFO’s personal accounts and holdings
uncovers approximately $8 million in assets that could be
liquidated (subject to court approval) and applied toward
the $20 million obligation.
Company S recognizes a loss of $20 million
upon discovery of the CFO’s fraud and receipt of the bank’s
communication that S will be responsible for full payment of
the $20 million. Although the $8 million is not an insurance
policy, the considerations S needs to take into account to
determine whether to recognize the $8 million of the CFO’s
assets as a recovery asset for the previously incurred $20
million loss are similar to the considerations S would need
to take into account to determine whether to recognize
insurance proceeds as a recovery asset.
Because S has recognized the full $20
million loss in its financial statements, it should apply
the loss recovery model to the $8 million possible recovery
and determine whether recovery is probable. If S can
conclude that recovery is probable after considering all
factors, it may recognize an asset for this expected
recovery. If S cannot conclude that recovery is probable, it
should not recognize an asset related to recovery unless and
until such recovery becomes probable.
A conclusion that a potential recovery is probable may involve
significant judgment and should be based on all relevant facts and circumstances.
Claim proceeds that will result in a gain should be recognized at the earlier of
when the proceeds are realized or realizable. For example, insurance proceeds may be
considered realized when the insurance carrier settles the claim and no longer
contests payment. Payment alone does not mean that realization has occurred if such
payment is made but is being contested or is subject to refund. Recognition of the
proceeds may be appropriate after consideration of the conditions outlined in
Section 3.3.
Further, an entity should analyze proceeds accounted for as a loss recovery by
applying the “probable” criterion used to determine a loss contingency (whether an
asset has been impaired or a liability has been incurred), as outlined in Section 2.3.1.1.
When recognizing potential loss recoveries from insurance carriers or other third
parties, entities should consider both internal and external evidence related to the
claim, including:
- Direct confirmation from the insurance carrier or other third parties that they would agree with the claim.
- In the absence of direct evidence from the insurance carrier or other third
parties that they would agree with the claim, an opinion from legal counsel
that it is “probable,” as that term is used in ASC 450, that:
- The claim under the policy is enforceable.
- Any loss events are covered.
Before recognizing a potential loss recovery, entities should consider the guidance
in ASC 410-30-35-9, which indicates that “[i]f the claim is the subject of
litigation, a rebuttable presumption exists that realization of the claim is not
probable.”
SEC Considerations
The guidance in ASC 410-30-35-9 is consistent with the SEC
staff’s interpretive guidance in Question 2 of SAB Topic 5.Y
(codified in ASC 450-20-S99-1). However, additional disclosure requirements
are included in footnote 49 of that guidance, which addresses uncertainties
regarding the legal sufficiency of claims filed against insurance carriers
or other third parties and the solvency of such insurance carriers and other
third parties:
The staff believes there is a rebuttable
presumption that no asset should be recognized for a claim for recovery
from a party that is asserting that it is not liable to indemnify the
registrant. Registrants that overcome that presumption should disclose
the amount of recorded recoveries that are being contested and discuss
the reasons for concluding that the amounts are probable of
recovery.
It is likely that in determining whether it is probable that an
entity will receive a recovery, the entity will need to understand, among other
factors, the solvency of the insurance carrier or other third parties and have
sufficient dialogue and historical experience with the insurance carrier or other
third parties related to the type of claim in question to assess the likelihood of
payment.
Example 4-3
Insurance Recovery of
Replacement Cost
A fire destroys Company H’s main operating
plant. Immediately after the fire, H recognizes a loss for
the net book value of the plant and meets with the insurance
adjuster to evaluate the loss and expedite the claim. Given
a similar fire loss three years earlier, both parties are
familiar with H’s plant and the process by which the
adjuster will determine H’s claim settlement amount.
Because H is constructing a similar plant, H
and the adjuster are also familiar with the replacement cost
of the plant. Accordingly, the adjuster is able to quickly
estimate the minimum property damage claim and implement
appropriate procedures to process the claim and establish a
schedule of reimbursements. The adjuster computes and the
insurance carrier approves (settles) a minimum reimbursement
for the cost of replacement; the amount is greater than the
net book value of the old plant. Company H appropriately
recognizes a gain for the excess of the minimum
reimbursement over the net book value of the property since
the amount was considered realized when the insurance
carrier settled the claim and no longer contested the
payment to be made to H. The recognition of the excess as a
gain is consistent with the guidance in ASC 610-30 on
involuntary conversions. It would not be appropriate for H
to recognize the excess as a reduction of the cost basis of
the replacement plant.
Connecting the Dots
Some incurred losses may be related to past events spanning
multiple years or decades, such as losses that arise from asbestos exposure
or environmental matters. In these situations, the losses may span periods
covered by several insurance carriers, some of which may no longer be
solvent, or various policies. Therefore, it may be challenging for an entity
to determine whether the incurred loss is a covered event, whether because
of vague language used in prior insurance policies or the number of policies
or insurance carriers that may have existed at any given time. The entity
should consider these potential limitations and factor them into its
calculation of the probability that it will receive an insurance recovery
for losses spanning multiple years.
4.4 Determinable and Indeterminable Mix of Loss Recovery and Gain Contingency Models
Under the determinable mix model, the probable recovery proceeds
equal to the amount of the recognized loss should be accounted for by using the loss
recovery model. Any expected proceeds in excess of the recognized loss should be
accounted for as a gain contingency. When there is no clear evidence that the amount
of the proceeds is a recovery of previously recognized losses or incremental costs
(i.e., there is no direct linkage) or the amount of the loss or costs previously
incurred is not objectively quantifiable (i.e., specifically identifiable), the gain
contingency model would be applied to the entire amount of the recovery proceeds
(also referred to as the indeterminable mix model). The determinable mix model,
which encompasses both the loss recovery model and the gain contingency model, and
the indeterminable mix model, which results in the application of the gain
contingency model to probable recovery proceeds, are further illustrated below.
Application of the gain contingency model for the entire amount of
the probable proceeds is illustrated below.
The example below illustrates the application of the indeterminable
mix model, while Example
4-5 illustrates the application of the determinable mix model.
Example 4-4
Indeterminable Mix of
Loss Recovery and Gain Contingency Models
Company T joins a class action lawsuit
against Credit Card Company Y because Y has overcharged for
various credit card transactions over the past 10 years.
Credit Card Company Y and T enter into a settlement
agreement, subject to the final approval of the claims
administrator, for an estimated amount of $35 million
payable to T over the next 5 years. Company T concludes that
it is probable that it will receive at least $35 million
from the settlement. The settlement agreement includes the
recovery of actual and estimated overcharges, punitive
damages, payment to avoid further cost of litigation, and
payment to restore a collaborative business
relationship.
The recovery of the overcharges amount is
based on actual and estimated overcharges over the past 10
years. Company T is unable to determine a direct linkage
between (1) what represents cost recovery of the previously
recognized overcharges and (2) punitive damages. Further, Y
contends in all legal proceedings that the lawsuit is
without merit and that T has not previously incurred any
losses. From Y’s perspective, it is settling the lawsuit to
restore a collaborative business relationship rather than to
repay T’s incurred losses. Accordingly, the amount of the
loss previously incurred is not objectively
quantifiable.
For T to characterize an amount as a loss
recovery, the amount should represent the reimbursement of
specific, incremental, identifiable costs that were
previously incurred. Company T determines that it is unable
to objectively determine how much of the settlement
represents recovery of previously recognized overcharges.
Therefore, T applies the gain contingency model to the
entire amount of the settlement. Uncertainties remain
regarding the settlement’s approval; therefore, T should
defer recognition of the gain until sufficient information
is available for T to conclude that the gain is realized or
realizable.
4.5 Insurance Deductible
Before recognizing an asset for expected insurance proceeds, an
entity should consider the individual policy covering the loss and analyze whether
the asset should be reduced for any policy-related deductibles.
Example 4-5
Insurance Recovery of
Fair Market Value With Deductible
An earthquake destroys Company R’s corporate
headquarters. At the time of the earthquake, the net book
value of the corporate headquarters is $350,000. Company R’s
insurance policy covers the fair market value of the
property, and R has a $50,000 deductible. In accordance with
the insurance policy, the fair market value of the corporate
headquarters is based on a third-party appraisal before the
earthquake. Company R carefully analyzes the provisions of
the insurance policy regarding the deductible. Using an
external expert, R determines that the fair value of the
corporate headquarters before the earthquake was $500,000.
In the same period as the earthquake, the
insurance adjuster communicates to R that once the fair
value is determined, an amount equal to the fair market
value of the property, reduced by the deductible, will be
paid to R, and the amount will not be subject to refund.
Because this is a determinable mix of a loss recovery and a
gain contingency, in the current period in which the
earthquake occurs, R recognizes a loss of $350,000 for the
net book value of the destroyed corporate headquarters and a
corresponding insurance recovery receivable of $350,000. The
loss recovery receivable is recognized because R concludes
that it is probable that the insurance recovery will be
realized.
Because it is probable that the insurance
recovery will be realized and the fair value of the facility
was determined to be well above the net book value of the
corporate headquarters, it would be appropriate for R to
recognize the entire $350,000 loss recovery in the period in
which the loss on the property is recognized. In a scenario
in which there is sufficient evidence that the insurance
payment (in this case, $450,000, which represents the
$500,000 fair market value of the property reduced by the
$50,000 deductible) will exceed the amount of recognized
loss (in this case, $350,000), it would be appropriate for R
to recognize an insurance recovery receivable in an amount
of $350,000 and apply the deductible to the deferred gain,
which represents the excess amount of the fair market value
over the net book value of the property.
The deferred gain is the $100,000 difference
between the expected insurance proceeds of $450,000 less the
$350,000 recognized recovery receivable. Such a gain
contingency should not be recognized until all contingencies
are resolved and the insurance proceeds are realized. In
this example, R may conclude that the $100,000 is realized
once the adjuster pays or confirms the related covered
amount (the fair value of the corporate headquarters) and
the amount is no longer contested or subject to refund (see
Chapter 3 for additional considerations
related to the determination of the appropriate period in
which to recognize the gain contingency).
Evidence to Support
Probable Receipt of $350,000 Insurance Proceeds
To recognize the $350,000 recovery
receivable, R considered whether it had sufficient evidence
to support recognition of the full amount of the loss
recovery receivable. If, for example, the external expert
had determined the fair value of the corporate headquarters
to be $400,000 rather than $500,000, it may have been more
difficult for R to conclude that the full $350,000 loss
recovery asset would have been received because there would
have been no excess (i.e., cushion) of fair value over the
net book value of the property. In these situations, an
entity could consider consulting with its accounting
advisers.
4.6 Business Interruption Insurance
ASC 220-30-20 defines business interruption insurance as
“[i]nsurance that provides coverage if business operations are suspended due to the
loss of use of property and equipment resulting from a covered cause of loss.
Business interruption insurance coverage generally provides for reimbursement of
certain costs and losses incurred during the reasonable period required to rebuild,
repair, or replace the damaged property.” ASC 220-30-05-02 describes the types of
costs and losses that business interruption insurance covers.
ASC 220-30
05-2 The types
of costs and losses covered by business interruption
insurance typically include the following:
- Gross margin that was lost or not earned due to the suspension of normal operations
- A portion of fixed charges and expenses in relation to that lost gross margin
- Other expenses incurred to reduce the loss from business interruption (for example, rent of temporary facilities and equipment, use of subcontractors, and so forth).
The guidance in Section 4.3 on loss recoveries and gain contingencies applies to the
accounting for business interruption insurance. That is, certain fixed costs
incurred during the interruption period may be analogous to losses from property
damage; accordingly, it may be appropriate to recognize a receivable (not to exceed
the amount of costs incurred) for amounts whose recovery is considered probable. A
recovery receivable should be recognized into income when the direct and incremental
losses are incurred if the entity concludes that receipt of the recovery proceeds is
probable. A recovery receivable should be recognized only up to the amount of the
financial statement loss incurred (e.g., the fixed costs incurred). The possible
recovery of lost profit margin should be considered a gain contingency since the
absence of expected profit margin would not be considered a previously recognized
financial statement loss. Therefore, the recovery of lost profit margin should be
recognized in income when the gain contingency is resolved (i.e., the proceeds are
realized or realizable). Because of the usually complex and uncertain nature of the
settlement negotiations process, recognition of the lost profit margin (i.e., the
gain contingency) may occur at the time of final settlement or when nonrefundable
cash advances are made.
Because business interruption insurance may be paid in a lump-sum
amount to the insured, including reimbursement for both property damage and lost
profit margin, it may be difficult to determine whether the recovery is for losses
previously recognized in the financial statements (i.e., whether the recovery should
be considered a determinable mix or an indeterminable mix of loss recovery and gain
contingency). We encourage entities to consult with their accounting advisers when
evaluating whether a receivable may be recognized for expected insurance recoveries
associated with fixed costs incurred during the interruption period.
Connecting the Dots
There may be situations in which business interruption
insurance is paid as an advance, lump-sum, nonrefundable final settlement
amount for both future estimated fixed costs (e.g., continued labor,
utilities) and estimated future lost profit margin for a claim period that
covers future reporting periods. Under these circumstances, the amount
received in advance related to future estimated fixed costs or future
estimated lost profit margin is treated as a gain contingency. Therefore,
because the advance payment is final and nonrefundable, the gain is
considered realized even though the future fixed costs or lost profit margin
has not yet occurred. There is no remaining contingency; the gain is
therefore recognized in the financial statements given that there is no
basis for deferring and amortizing the insurance proceeds over the future
anticipated periods of continuing fixed costs or lost profit margin.
Example 4-6
Recognition of Business
Interruption Insurance Proceeds
On January 7, 20X1, a fire severely damages
Company W’s retail store, resulting in impaired operations
and lost profits. Company W maintains insurance coverage to
cover business interruption losses, including both fixed
costs incurred and profits lost during the inoperable
period. The insurance policy coverage period is from January
1, 20X1, to December 31, 20X1. Company W expects that the
retail store will be closed until at least the second
quarter of 20X2.
Company W’s insurance policy covers $100,000
of continued fixed costs and lost profits during the
inoperable period, but the policy does not bifurcate the
$100,000 between the two categories. In addition, W
estimates that for the remainder of 20X1, its continued
fixed costs will be $100,000 and its lost profits will be
$150,000.
During the period from January 7, 20X1, to
April 30, 20X1, the date W issues its first-quarter
financial statements, W and its insurer have ongoing
discussions regarding the accuracy of W’s estimates of
continuing fixed costs and lost profits expected through
December 31, 20X1. Company W believes that as of April 30,
20X1, it is probable that it will receive insurance proceeds
of the full $100,000 policy; however, the insurer has not
distinguished what portion of the probable $100,000 payment
should be allocated to the expected continuing fixed costs
(which includes certain fixed costs incurred and recognized
in the first-quarter financial statements) or to the
estimated lost profits in the period from January 7, 20X1,
to December 31, 20X1.
In its first-quarter financial statements, W
concludes that the entire probable insurance payment can be
attributed to an indeterminable mix of (1) previously
recognized fixed costs recognized during the first quarter,
(2) estimated future fixed costs to be incurred, and (3)
estimated lost profits during the first quarter and through
the end of December 31, 20X1. Therefore, W accounts for the
entire amount as a gain contingency and does not recognize
any amount as a recovery receivable asset given that payment
is not realized or realizable.
On June 30, 20X1, the insurer pays W the
entire $100,000 and communicates to W that the payment is
nonrefundable and that there are no remaining contingencies
for the policy period through December 31, 20X1 (e.g., no
remaining due diligence is to be performed by the insurer).
The insurer also communicates to W that the $100,000 is
allocated in the following manner:
- $50,000 to fixed costs incurred through June 30, 20X1.
- $25,000 to estimated fixed costs to be incurred from July 1, 20X1, to December 31, 20X1.
- $10,000 to estimated lost profits during the period from January 7, 20X1, to June 30, 20X1.
- $15,000 to estimated lost profits during the period from July 1, 20X1, to December 31, 20X1.
In its June 30, 20X1, financial statements,
W recognizes the entire $100,000 insurance payment in
income. Because all contingencies have been resolved upon
receipt of the payment, the gain contingency is considered
realized and should be recognized in the financial
statements at that time without deferral over the remaining
periods of estimated fixed costs to be incurred and future
estimated lost profits. Although W predicts that the retail
store will be inoperable until the second quarter of 20X2,
it would not be appropriate for W to recognize the proceeds
over the remaining period of inoperability or the remaining
period in the policy through December 31, 20X1, because the
final settlement received on June 30, 20X1, is no longer a
contingency.
ASC 220-30-45-1 addresses the income statement presentation related
to business interruption insurance and allows an entity to “choose how to classify
business interruption insurance recoveries in the statement of operations, as long
as that classification is not contrary to existing generally accepted accounting
principles (GAAP).” In addition, in a period in which business interruption
insurance recoveries are recognized, ASC 220-30-50-1 requires further disclosures in
the notes to financial statements.
ASC 220-30
50-1 The
following information shall be disclosed in the notes to
financial statements in the period(s) in which business
interruption insurance recoveries are recognized:
- The nature of the event resulting in business interruption losses
- The aggregate amount of business interruption insurance recoveries recognized during the period and the line item(s) in the statement of operations in which those recoveries are classified.
4.7 Balance Sheet Presentation — Offsetting
ASC 210-20-20 defines a right of setoff as “a debtor’s legal right,
by contract or otherwise, to discharge all or a portion of the debt owed to another
party by applying against the debt an amount that the other party owes to the
debtor.” A right of setoff exists when all of the criteria in ASC 210-20-45-1 are
met.
ASC 210-20
45-1 A right of
setoff exists when all of the following conditions are
met:
- Each of two parties owes the other determinable amounts.
- The reporting party has the right to set off the amount owed with the amount owed by the other party.
- The reporting party intends to set off.
- The right of setoff is enforceable at law.
An entity that purchases insurance from a third-party insurer generally remains
primarily obligated for insured liabilities; however, the entity should carefully
evaluate the insurance contract and applicable laws. Under U.S. GAAP, it is only
appropriate to offset assets and liabilities when the four above conditions in ASC
210-20-45-1 for the existence of a right of setoff are met.
It is not appropriate to offset a receivable for a probable
insurance recovery against a contingent liability unless the requirements of ASC
210-20 are met. In such circumstances, the conditions for offsetting would typically
not be met because an insurance receivable and claim liability generally would be
with different counterparties. For example, insurance proceeds received by the
reporting entity are usually from a third-party insurer, whereas the contingent
liability related to claim liabilities would be to a party other than the
third-party insurer.
4.8 Income Statement Classification of Loss Recoveries and Gain Contingencies
As discussed in Section 4.6, ASC 220-30-45-1 addresses the income statement
presentation related to business interruption insurance and allows an entity to
“choose how to classify business interruption insurance recoveries in the statement
of operations, as long as that classification is not contrary to existing generally
accepted accounting principles (GAAP).” Further, ASC 410-30 provides guidance on the
income statement presentation of environmental remediation costs and related
recoveries, such as insurance recoveries. ASC 410-30-45-4 states that “environmental
remediation-related expenses shall be reported as a component of operating income in
income statements that classify items as operating or nonoperating. Credits arising
from recoveries of environmental losses from other parties shall be reflected in the
same income statement line.”
Although authoritative income statement classification guidance does
not exist for many other types of loss recoveries, such as involuntary conversions,
in practice, entities have generally applied the guidance in ASC 410-30 by analogy
when determining the appropriate classification of other loss recoveries.
For recoveries in which the recovery proceeds exceed the incurred
loss, resulting in a gain, an entity should consider other authoritative literature,
including applicable SEC regulations (e.g., SEC Regulation S-X), when determining
whether it is appropriate to classify the gain within the related income statement
line item as the loss recovery. Depending on the nature of the gain, entities should
consider whether it is appropriate to classify it as operating or nonoperating. In
determining whether it is appropriate to classify a loss, a loss recovery, or a gain
as operating or nonoperating, entities may consider SEC Regulation S-X, Rule 5-03.
Although Rule 5-03 does not define items that should be classified as operating, it
does provide examples of items that should be classified as nonoperating.
Entities should provide sufficient disclosure, if material, to
enable financial statement users to determine in which financial statement line item
the gain has been recognized.
4.9 Classification of Insurance Proceeds in the Statement of Cash Flows
ASC 230-10-45-21B states that “[c]ash receipts resulting from the
settlement of insurance claims, excluding proceeds received from corporate-owned
life insurance policies and bank-owned life insurance policies, shall be classified
on the basis of the related insurance coverage (that is, the nature of the loss).”
In addition, for lump-sum settlements, “an entity shall determine the classification
on the basis of the nature of each loss included in the settlement.”
Entities should determine the classification of insurance receipts
that have aspects of more than one class of cash flows by first applying specific
guidance in U.S. GAAP. When such guidance is not available, financial statement
preparers should separate each identifiable source of cash flows on the basis of the
nature of the underlying cash flows. Each separately identified source of cash
receipts should then be classified on the basis of its nature. Classification based
on the activity that is most likely to be the predominant source or use of cash
flows is appropriate only when the source of insurance receipts has multiple
characteristics and is not separately identifiable. For additional information on
the determination of more than one class of cash flows, see Section 6.4 of Deloitte’s
Roadmap Statement of Cash
Flows.
For example, insurance settlement proceeds received as a result of a
claim made in connection with the destruction of productive assets should be
classified as cash inflows from investing activities because the settlement proceeds
could be analogous to proceeds received on the sale of such assets. However,
proceeds received as a result of claims related to a business interruption should be
classified as operating activities.
Example 4-7
Business Interruption
Cash Flow Classification
A flash flood destroys a fleet of RVs and a
building at the corporate headquarters of RV Company XYZ,
leaving the RV dealer inoperable for three months until it
can restock its inventory and repair the corporate
headquarters. RV Company XYZ has property and business
interruption insurance that covers lost profit margins, lost
inventory, and damaged equipment and property. Covered
losses under the insurance policy include natural disasters,
such as floods. RV Company XYZ receives a lump-sum insurance
payment of $85 for lost profit margin, lost RV inventory,
and corporate headquarters repairs. In a manner consistent
with the submitted claim, XYZ determines that $15 should be
allocated to lost profit margin, $45 to damaged inventory,
and $25 to rebuilding a portion of the corporate
headquarters.
RV Company XYZ appropriately classifies the
insurance receipt in the statement of cash flows as
follows:
- $15 lost profit margin = operating inflow.
- $45 lost inventory = operating inflow.
- $25 corporate headquarters reconstruction = investing inflow.
4.10 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 financial
statements or in the subsequent-period financial statements. The recognition,
measurement, and disclosure principles related to loss recoveries 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.
After the balance sheet date, there may be a recovery of a loss that
exceeds the amount of a loss previously recognized on or before the balance sheet
date, resulting in a gain after the balance sheet date. The recovery should be
treated as two separate units of account:
- Loss recovery — The amount of the recovery equal to the previously recognized loss.
- Gain contingency — The amount of the recovery in excess of the previously recognized loss.
The recognition of these two units of account will differ in a
manner that is consistent with the different loss recovery models described in this
chapter. A recovery asset (e.g., a receivable) for the amount of the recovery equal
to the previously recognized loss should be accounted for as a recognized or
nonrecognized subsequent event in a manner that is consistent with the recognition
threshold for loss contingencies.
If an event occurs after the balance sheet date but before the
financial statements are issued or are available to be issued, and the event
indicates that a loss recovery is probable (or the loss recovery has been received)
for a loss incurred on or before the balance sheet date, the event provides
additional evidence of the recovery and should be accounted for as a recognized
subsequent event. Examples might include (1) the probable receipt of insurance
proceeds equaling the loss incurred related to a plant that was destroyed on or
before the balance sheet date or (2) proceeds from a lawsuit settlement in the
amount of a previous loss incurred for litigation that arose on or before the
balance sheet date.
The amount of the recovery in excess of the previously recognized
loss would be accounted for as a nonrecognized subsequent event because to realize
the gain recovery would be to recognize income before it is realized, as described
in ASC 450-30-25-1. Accounting for the two units of account by using separate
recognition thresholds is consistent with the subsequent-event treatment of loss
contingencies and gain contingencies discussed earlier in this Roadmap. Further, the
treatment of the loss recovery and the gain contingency as two separate units of
account is consistent with the guidance in Section 4.2 on involuntary conversions.
Example 4-8
Accounting for Insurance
Proceeds Comprising a Loss Recovery and a Gain
Contingency
Company P is a public company with a
calendar year-end of December 31, 20X8. On December 24,
20X8, a flood severely damages P’s operating plant. Company
P determines that it has incurred a loss of $500,000 because
of the flood damage and therefore recognizes the $500,000
loss as of December 31, 20X8. On February 19, 20X9, before
the issuance of P’s financial statements, the insurance
company notifies P that it will pay insurance proceeds in
the amount of $750,000, subject to the completion of the
insurance company’s investigation process.
Company P has previously received insurance
proceeds from this insurance company in connection with
other damages and is therefore familiar with the ongoing
investigation process. Company P determines that it is
probable that the investigation will not change the
anticipated recovery of $750,000. Therefore, as of December
31, 20X8, P recognizes a loss recovery asset as a recognized
subsequent event in the amount of $500,000, which is the
amount equal to the previously recognized loss. The
remaining $250,000 is subject to the gain contingency
guidance; therefore, the notion of probability is
irrelevant. Since there are unresolved contingencies as of
the balance sheet date of December 31, 20X8 (i.e., the
ongoing investigation), the $250,000 does not reach the gain
contingency recognition threshold described in Chapter
3; therefore, the $250,000 constitutes a
nonrecognized subsequent event and should not be recorded as
of December 31, 20X8.
Chapter 5 — Guarantees
Chapter 5 — Guarantees
5.1 Overview
ASC 460 addresses the
accounting and disclosure requirements for
guarantors. The objective of the guidance in ASC
460 is to achieve transparency in a guarantor’s
financial reporting about the obligations and
risks related to issuing guarantees. This
objective is achieved by providing informative
disclosures about the nature and amount of
guarantees in the guarantor’s financial statements
as well as by helping ensure comparability between
guarantees issued with a separately identified
premium (i.e., guarantees for which the guarantor
receives consideration in exchange for the
issuance of the guarantee) and guarantees issued
without a separately identified premium. ASC 460
applies to all entities.
5.2 Scope
The guidance in ASC 460 is organized into two subsections: (1)
general and (2) product warranties. The guidance on product warranties is discussed
in Section 5.6;
accordingly, the remainder of this section addresses the scope of all guarantees
other than product warranties.
It may prove challenging to assess
the scope of ASC 460 because there are several exceptions related to applying the
recognition, measurement, or disclosure guidance therein. In some instances, the
guidance in ASC 460 results in the recognition and disclosure of a liability for a
guarantee obligation. However, other types of guarantees are outside the scope of
ASC 460’s recognition and measurement guidance (e.g., derivatives accounted for in
accordance with ASC 815) but are still subject to its disclosure requirements. The
figure below presents a framework for evaluating whether a guarantee is within the
scope of ASC 460 and indicates that there are three possible conclusions for
guarantees within the scope of ASC 460-10-15-4.
The flowchart below illustrates the
decisions made to determine whether a guarantee is within the scope of any portion
of ASC 460.
5.2.1 Transactions Within the Scope of ASC 460-10-15-4
ASC 460-10-15-4 is the starting point for determining whether a
transaction is a guarantee that may be within the scope of the recognition,
measurement, and disclosure requirements of ASC 460. ASC 460-10-15-4 lists
contract types that should be accounted for as guarantees under ASC 460 in the
absence of a specific scope exception in ASC 460-10-15-7 (as discussed in
Section 5.2.2).
The flowchart below illustrates
common types of guarantee contracts that are within the scope of ASC
460-10-15-4.
ASC 460-10
15-4 Except as provided in
paragraph 460-10-15-7, the provisions of this Topic
apply to the following types of guarantee contracts:
- Contracts that contingently require a guarantor to make payments (as described in the following paragraph) to a guaranteed party based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party. For related implementation guidance, see paragraph 460-10-55-2.
- Contracts that contingently require a guarantor to make payments (as described in the following paragraph) to a guaranteed party based on another entity’s failure to perform under an obligating agreement (performance guarantees). For related implementation guidance, see paragraph 460-10-55-12.
- Indemnification agreements (contracts) that contingently require an indemnifying party (guarantor) to make payments to an indemnified party (guaranteed party) based on changes in an underlying that is related to an asset, a liability, or an equity security of the indemnified party.
- Indirect guarantees of the indebtedness of others, even though the payment to the guaranteed party may not be based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party.
It is possible that a guarantee could result from a contractual
arrangement that represents one or more of the four types of contracts described
in ASC 460-10-15-4. In the absence of a scope exception in ASC 460-10-15-7, a
contractual arrangement only needs to be one of these four contract types to be
a guarantee within the scope of ASC 460. Accordingly, once an entity has
concluded that its guarantee is one of these four types of contracts, it does
not need to further consider whether it also represents one or more of the
remaining three types.
According to the above guidance, contracts or indemnification
agreements that could require a guarantor to make payments that are based on an
underlying (as defined below) related to an asset, liability, or equity security
of the guaranteed party are within the scope of ASC 460-10-15-4.
ASC 460-10 — Glossary
Underlying
A specified interest rate, security
price, commodity price, foreign exchange rate, index of
prices or rates, or other variable (including the
occurrence or nonoccurrence of a specified event such as
a scheduled payment under a contract). An underlying may
be a price or rate of an asset or liability but is not
the asset or liability itself. An underlying is a
variable that, along with either a notional amount or a
payment provision, determines the settlement of a
derivative instrument.
ASC 460-10-20 describes an underlying as “a variable that . . .
determines the settlement of a derivative instrument.” In the context of a
guarantee contract, the underlying will govern whether the guarantor is required
to make a payment. For example, in a guarantee of the principal balance of a
loan, the underlying is the occurrence or nonoccurrence of the debtor’s
repayment of the loan. If the debtor repays the loan on its contractual
repayment date, the guarantor will not be required to make a payment. If the
debtor fails to repay the loan on the specified date, the guarantor is obligated
to make the payment.
An important provision of ASC 460-10-15-4(a) is that the
underlying must be related to an asset, liability, or equity security of the
guaranteed party. Regarding guarantees of debt, ASC 460-10-15-6 states, in
part:
[I]t does not matter whether the guaranteed party
is the creditor or the debtor, that is, whether the guarantor is required to
pay the creditor or the debtor (who would then have the funds to pay its
debt to the creditor). The underlying (that is, the debtor’s failure to make
scheduled payments or the occurrence of other events of default) could be
related to either the creditor’s receivable or the debtor’s liability.
ASC 460-10-15-5 notes that the payment the guarantor must make,
as described in ASC 460-10-15-4, is not limited to a payment in cash; rather,
payment can take the form of cash, financial assets, nonfinancial assets, shares
of the guarantor’s stock, or the provision of services.
Connecting the Dots
While the payment a guarantor may be required to make
can take the form of the provision of a service, a contract that
requires an entity to perform a service regardless of changes in an
underlying would not represent a guarantee and therefore would be
subject to other guidance (e.g., ASC 606-10). For example, if an entity
is required to perform health care claim services for another party,
that contract would not represent a guarantee within the scope of ASC
460-10. Rather, it would constitute a contract to perform services. If,
however, an entity agrees to provide a service to a guaranteed party on
the basis of another entity’s failure to properly perform this service,
such an arrangement may be subject to the recognition, measurement, and
disclosure provisions of ASC 460-10.
5.2.1.1 Financial Guarantees
ASC 460-10-15-4(a) describes financial guarantee contracts,
and ASC 460-10-55-2 indicates that common examples of such contracts
include, but are not limited to, the following:
- A financial standby letter of credit
- A market value guarantee on either a financial asset (such as a security) or a nonfinancial asset owned by the guaranteed party [e.g., real estate or a commodity]
- A guarantee of the market price of the common stock of the guaranteed party
- A guarantee of the collection of the scheduled contractual cash flows from individual financial assets held by a special-purpose entity
- A guarantee granted to a business or its owner(s) that the revenue of the business (or a specific portion of the business) for a specified period of time will be at least a specified amount.
For each of these contracts, the guarantor could be required
to make payments to the guaranteed party for a specified financial
obligation. The requirement to make payments is an important consideration
in the evaluation of whether an arrangement is within the scope of ASC 460.
If the guarantor is able to avoid payment, such as through specific clauses
limiting the requirement to make a payment (e.g., a material adverse change
clause, as further described in Section 5.2.1.1.1), the arrangement
would not be within the scope of ASC 460.
5.2.1.1.1 Financial Guarantees — Financial Standby Letters of Credit
ASC 460-10-20 defines a
financial standby letter of credit and a commercial letter of credit as
follows:
ASC 460-10 — Glossary
Financial
Standby Letter of Credit
An irrevocable undertaking
(typically by a financial institution) to
guarantee payment of a specified financial
obligation.
Commercial
Letter of Credit
A document issued typically by a
financial institution on behalf of its customer
(the account party) authorizing a third party (the
beneficiary), or in special cases the account
party, to draw drafts on the institution up to a
stipulated amount and with specified terms and
conditions; it is a conditional commitment (except
if prepaid by the account party) on the part of
the institution to provide payment on drafts drawn
in accordance with the terms of the document.
ASC 460-10-55-16(a) states that “[c]ommercial letters of credit and other
loan commitments, which are commonly thought of as guarantees of
funding, are not included in the scope of [ASC 460-10] because those
instruments do not guarantee payment of a money obligation and do not
provide for payment in the event of default by the account party.”
Therefore, entities must distinguish between financial standby letters
of credit, which are subject to ASC 460-10, and commercial letters of
credit, which are not subject to ASC 460-10.
A financial standby letter of credit is an irrevocable undertaking by an entity (e.g., a
bank) guaranteeing to the guaranteed party (e.g., a third-party seller
of goods) the payment of a specified financial obligation of a third
entity (e.g., a customer or account party). For example, if a customer
is unable to make a payment on an obligation to a seller of goods, the
bank (i.e., the guarantor) will make that payment. Because the issuer of
a financial standby letter of credit cannot avoid making a payment upon
a default of a third party, such letters of credit are within the scope
of ASC 460.
Footnote 5 of the Basis for Conclusions of Interpretation 45 states that a commercial letter of credit “is a
document issued typically by a financial institution on behalf of its
customer (the account party) authorizing a third party (the
beneficiary), or in special cases the account party, to draw drafts on
the institution up to a stipulated amount and with specified terms and
conditions; it is a conditional commitment (except when prepaid by the
account party) on the part of the institution to provide payment on
drafts drawn in accordance with the terms of the document.” A commercial
letter of credit is similar to a loan commitment. Neither of those
instruments possesses the characteristics in ASC 460-10-15-4(a) because
they do not guarantee payment of a money obligation and do not provide
for payment in the event of default by the account party. Like loan
commitments, commercial letters of credit customarily contain material
adverse change clauses or similar provisions that allow the issuing
institution (i.e., the bank) to avoid making a loan (or other payment)
if the borrower encounters financial difficulties after the instrument
is issued.
Example 5-1
Financial
Standby Letter of Credit
Company J is a purveyor of fine
meats and cheeses and is based in the United
States. Company J wishes to purchase $1 million of
goods from Company W, which is based in Italy, for
J to resell in the United States. While J is an
established company with a history of reselling
meats and cheeses, W has had no prior business
dealings with J and requests additional assurance
that it will ultimately collect amounts owed for
selling its products to J.
Accordingly, J obtains a
financial standby letter of credit from Company L
(i.e., the guarantor) for up to $1 million, which
guarantees payment to W (i.e., the guaranteed
party) in the event that J is unable to meet its
contractual financial obligation. The guarantee is
effective for up to one year from the issuance
date. In exchange for issuing the financial
standby letter of credit, L charges J a fee
commensurate with J’s credit evaluation and
collateral provided.
Upon receipt of evidence of the
financial standby letter of credit, W provides the
goods to J on June 1, 20X1, with payment due on
July 1, 20X1. As of July 1, 20X1, J is only able
to make a payment on $600,000 of its contractual
financial obligation. Therefore, L must provide
$400,000 to W.
Example 5-2
Commercial
Letter of Credit
Assume the same facts as in the
example above except that J is a newly
incorporated entity as of January 1, 20X1. Because
J does not have an established operating history,
to provide goods to J, W demands payment for the
goods upon delivery.
To ensure payment to W upon
delivery, J obtains from Bank T a commercial
letter of credit that allows W to draw down from
the bank up to $1 million upon J’s receipt of the
goods. Bank T charges J a fee commensurate with
J’s credit evaluation and collateral provided for
issuing the commercial letter of credit.
On June 1, 20X1, J receives the
goods from W. Accordingly, T makes a direct
payment to W for $1 million. As a result, J now
owes T $1 million. This arrangement is similar to
a loan commitment.
Example 5-3
Ability of a
Guarantor to Avoid Payment
Company J and Company V form a
joint venture (JV), and V issues a financial
standby letter of credit to the JV. If the JV does
not perform (i.e., defaults), V is obligated to
make payments to the financial institution that
issued a line of credit to the JV. Company V’s
investment in the JV is appropriately accounted
for under the equity method. The JV does not need
V’s approval to draw down on the line of
credit.
Company V’s guarantee of the
line of credit is within the scope of ASC
460-10-15-4(a) because V is required to make a
payment to the institution that issued the line of
credit if the JV defaults. Company V is unable to
avoid payment. The guarantee does not qualify for
the scope exception in ASC 460-10-25-1(g) for
guarantees made by a parent on a subsidiary’s debt
to a third party since V is not the JV’s parent
(i.e., it applies the equity method to account for
its investment in the JV).
Further, at the inception of the
guarantee, V does not factor the outstanding
balance of the line of credit into its conclusion
regarding whether the guarantee is within the
scope of ASC 460. As noted in ASC 460-10-25-2 and
discussed in Section 5.3.2, a
guarantee obligation consists of two components:
(1) a noncontingent portion arising from the
guarantor’s undertaking of “an obligation to stand
ready to perform over the term of the guarantee in
the event that the specified triggering events or
conditions occur” and (2) a contingent portion
representing the guarantor’s “obligation to make
future payments if those triggering events or
conditions occur.” At a minimum, when a guarantor
enters into the guarantee arrangement, it must
record a liability for the fair value of its
noncontingent obligation to stand ready to
perform. The amount of any subsequent balance
drawn down by the JV on its line of credit would
factor into the determination of the contingent
portion of the guarantee obligation; the amounts
JV expects to draw on the line of credit could
affect the fair value ascribed to the
noncontingent portion that is recognized at
inception of the guarantee liability.
Additional Scenario
If the scenario described above
was changed to specify that the JV needs V’s
approval before drawing down on the line of
credit, V’s guarantee of the line of credit would
not be within the scope of ASC 460. If the JV
needs V’s approval before drawing down on the line
of credit, V can avoid payment under the guarantee
by not providing approval to the JV. The guidance
in ASC 460 is applicable as soon as V gives
approval since, at that point, V cannot avoid its
contingent obligation to pay.
5.2.1.1.2 Financial Guarantees — Market Value Guarantees
A market value guarantee is a type of financial
guarantee that includes a guarantee of the price of a financial asset
(such as a security), a nonfinancial asset, or the common stock of a
guaranteed party. Payments are based on changes in the underlying that
is related to an asset, liability, or equity security of the guaranteed
party. This consideration is important because payments must be based on
such changes to be within the scope of ASC 460-10-15-4(a).
Option-based contracts in which any net potential
contingent payment flows only from the guarantor to the guaranteed party
are the most common type of market value guarantees. Option-based
contracts can take the form of a put option or call option. A put option
gives the holder the right, but not the obligation, to sell a specified
amount of an underlying at a certain price and time. A call option gives
the holder the right, but not the obligation, to buy a specified amount
of an underlying at a certain price and time. For these types of
contracts, only the issuer (writer) of the option could potentially
represent the guarantor. As further described below, these contracts may
be within the scope of ASC 460.
5.2.1.1.2.1 Market Value Guarantees — Put Options
There are two main considerations that entities
should evaluate to determine whether a written put option is within
the scope of ASC 460:
- Whether the written put option is a derivative in accordance with ASC 815.
- Whether the put option represents a freestanding instrument.
5.2.1.1.2.1.1 Evaluating Whether the Written Put Option Represents a Derivative in Accordance With ASC 815
In evaluating whether a written put option is
within the recognition and measurement provisions of ASC 460, an
entity should first assess whether the option is within the
scope of ASC 815. Written put options accounted for as
derivatives in accordance with ASC 815 are not subject to the
recognition and measurement provisions of ASC 460, as noted in
Section
5.3.1. However, the disclosure requirements of
ASC 460 apply to written put options that possess the
characteristics in ASC 460-10-15-4(a) even if those options are
accounted for as derivatives under ASC 815.
ASC 815-10
15-83 A
derivative instrument is a financial instrument or
other contract with all of the following
characteristics:
- Underlying, notional amount,
payment provision. The contract has both of the
following terms, which determine the amount of the
settlement or settlements, and, in some cases,
whether or not a settlement is required:
- One or more underlyings
- One or more notional amounts or payment provisions or both.
- Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
- Net settlement. The contract
can be settled net by any of the following means:
- Its terms implicitly or explicitly require or permit net settlement.
- It can readily be settled net by a means outside the contract.
- It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
An entity’s evaluation of whether a written put
option is within the scope of ASC 460 may depend on the
settlement terms in the contract.
5.2.1.1.2.1.2 Gross-Settled Written Put Options
A written put option that must be gross-settled
is within the scope of ASC 460 since the issuer (the guarantor)
is contingently required to make payments to the option holder
on the basis of changes in an underlying asset, liability, or
equity security of the option holder (the guaranteed party). As
discussed in ASC 460-10-55-5, a written put option that must be
gross-settled by delivery of an asset related to the underlying
of the option possesses the characteristics described in ASC
460-10-15-4(a) irrespective of whether the entity knows whether
the option holder owns an asset or owes a liability related to
the underlying.
Written put options that must be gross-settled
will be accounted for as derivatives if the net settlement
characteristic in ASC 815-10-15-83(c) is present (e.g., if the
underlying asset is readily convertible to cash).
Connecting the Dots
For a contract to be considered a
derivative and accounted for under ASC 815, it must be
required or permitted to be net-settled, it “can readily
be settled net by a means outside the contract” (i.e., a
market mechanism), or it “puts the recipient in a
position not substantially different from net
settlement” (i.e., the underlying asset is readily
convertible to cash or is itself a derivative).
Therefore, an entity must carefully consider the
settlement provisions of written put options.
Written put options accounted for as derivatives
are not subject to the recognition and measurement provisions of
ASC 460 (see ASC 460-10-25-1(a)). However, as specified in ASC
460-10-50-1, the disclosure requirements of ASC 460 apply to
written put options that possess the characteristics in ASC
460-10-15-4(a) even if those options are accounted for as
derivatives under ASC 815. Accordingly, gross-settleable written
put options accounted for as derivatives (i.e., that meet the
net settlement characteristic as described above) are subject to
the disclosure requirements of ASC 460.
5.2.1.1.2.1.3 Net-Settled Written Put Options
As discussed in ASC 460-10-55-7, if a put option
is permitted or required to be net-settled, the issuer (the
guarantor) must assess whether it is probable that the option
holder (the guaranteed party), on or around the date of the put
option’s issuance, owns an asset or owes a liability related to
the underlying of the option. If it is probable that the holder
has such an asset or liability, the put option possesses the
characteristics described in ASC 460-10-15-4(a) and therefore is
within the scope of ASC 460 because the put option contractually
requires the writer of the option to purchase the asset or
liability related to the option’s underlying if the option is
exercised. In performing this assessment, the issuer must
consider its business relationship with the option holder and
other circumstances related to the issuance of the put option.
If the issuer has no basis for concluding that it is probable
that the option holder owns an asset or owes a liability related
to the underlying, the option is not a guarantee under ASC
460-10-15-4(a).
The assessment of whether the guaranteed party
owns an asset or owes a liability associated with the underlying
of the put option is performed only at inception of the option.
There is no reassessment of whether the guaranteed party owns
the underlying asset or owes the underlying liability during the
term of the option.
Generally, net-settled written put options are
(1) within the scope of ASC 815 and (2) accounted for as
derivatives. Written put options accounted for as derivatives
are not subject to the recognition and measurement provisions of
ASC 460 (see ASC 460-10-25-1(a)). However, as specified in ASC
460-10-50-1, the disclosure requirements of ASC 460 apply to
written put options that have the characteristics in ASC
460-10-15-4(a) even if those options are accounted for as
derivatives under ASC 815. Accordingly, net-settleable written
put options accounted for as derivatives are subject to the
disclosure requirements of ASC 460, provided that, as discussed
above, it is probable that the option holder owns an asset or
owes a liability related to the underlying on or around the date
of the issuance of the put option.
Example 5-4
Market
Value Guarantee — Interaction With Derivative
Accounting
Farmer enters into a put
option with the Chicago Mercantile Exchange (CME).
The put option gives Farmer the right to sell
5,000 bushels of corn at $10 per bushel. Physical
settlement is contractually required for the put
option.
The written put option is not
subject to the recognition and measurement
provisions of ASC 460 because it is accounted for
as a derivative instrument in accordance with ASC
815. Although physical settlement is contractually
required for the put option, there is a market
mechanism to facilitate net settlement (i.e., the
put option is traded on the CME); therefore, the
option meets the net settlement criterion for a
derivative.
In contrast, assume that
Supplier enters into a put option with Clothing
Market under which Supplier has the right to sell
5,000 bundles of yarn at $10 per bundle to
Clothing Market. The put option is not traded on
an exchange, the yarn is not readily convertible
to cash, and physical settlement is contractually
required for the put option. In that case, the
written put option is subject to the recognition
and measurement provisions of ASC 460 since it is
not accounted for in accordance with ASC 815
because physical settlement is contractually
required for the put option and the option does
not allow for implicit net settlement.
Example 5-5
Determining Whether an Underlying Is Related to
an Asset or Liability of the Guaranteed Party
Company W sells a
weather-based derivative contract to Company X.
Contract payouts depend on whether rainfall
exceeds 5 inches in Seattle during January 20X1.
The contract is not an exchange-traded contract
and is not within the scope of ASC 460. Weather
derivatives are typically option-based contracts
that involve a payment to the guaranteed party on
the basis of a climatic or geological variable
(e.g., whether a specified amount of rainfall
occurs). The characteristic in ASC 460-10-15-4(a)
involves payments based on changes in an
underlying that is related only to an asset,
liability, or equity security of the guaranteed
party. Since the climatic variable is not an
asset, liability, or equity security of the
guaranteed party, the weather derivative is not
within the scope of ASC 460 and is therefore
subject to the guidance in ASC 815-45.
5.2.1.1.2.1.4 Evaluating Whether the Put Option Represents a Freestanding Instrument
ASC 815-40-20 defines a freestanding contract as
one entered into either “[s]eparate and apart from any of the
entity’s other financial instruments or equity transactions” or
“[i]n conjunction with some other transaction and is legally
detachable and separately exercisable.” Section
3.2.1 of Deloitte’s Roadmap Contracts on an
Entity’s Own Equity describes the
different considerations related to identifying freestanding
contracts that should be viewed as separate units of
account.
A written put option that is embedded (i.e., not
a freestanding instrument) in its host asset, liability, or
equity security does not possess the characteristics in ASC
460-10-15-4(a) because the guaranteed party’s asset is an
investment in the entire contract (the puttable security) and
not an investment in a nonputtable security. Therefore, a
written put option embedded in its underlying security typically
would be outside the scope of ASC 460. This concept is explained
in paragraph A10 of the Basis for Conclusions of FASB Interpretation 45, which states, in part:
For example, the put option that is embedded in a puttable
bond (but is not accounted for separately as a derivative)
could be viewed by the investor (the guaranteed party) as a
guarantee against the market value of the remaining
instrument (a bond absent the put option) declining below
the put price; however, the embedded put option does not
meet characteristic (a) because the guaranteed party’s asset
is an investment in the entire contract, a puttable bond,
and not an investment in a nonputtable bond.
Example 5-6
Put Option
— Freestanding Contract
Entity X issues a structured
note that contains a written put option allowing
the holder, at maturity or upon a triggering
event, to put bonds issued by Entity Y to X in
exchange for the principal amount of the notes
issued by X plus the principal amount of the bonds
issued by Y.
In this example, the written
put option is not embedded in the structured note
but the underlying of the put option is a separate
bond issued by Y. Since the guarantee is not
considered embedded, it would be within the scope
of ASC 460, provided that it possesses the
characteristics in ASC 460-10-15-4(a).
5.2.1.1.2.2 Market Value Guarantees — Call Options
ASC Master Glossary
Call
Option
A contract that allows the
holder to buy a specified quantity of stock from
the writer of the contract at a fixed price for a
given period. See Option and Purchased Call
Option.
ASC 460 does not provide specific guidance on
written call options. Therefore, the writer of the option should
consider its business relationship with the holder and the other
circumstances related to the issuance of the option. If the writer
of the option has knowledge that the holder is purchasing the option
to cover a short position in the same asset as the underlying in the
option, the written call option is within the scope of ASC
460-10-15-4(a), since the writer of the call option is required to
transfer an asset to the option holder on the basis of the changes
in a liability of the option holder (i.e., the underlying short
position).
If the writer of the call option has no factual
basis to conclude that the holder of the call option is purchasing
the option to cover a short position in the asset, the written call
option is not within the scope of ASC 460, since the writer of the
call option does not have the information necessary to conclude that
the option holder has an underlying short position. In practice,
written call options are generally not accounted for as guarantees
because the writers of such options are typically unaware of whether
the purchaser has a short position in the same underlying asset.
Example 5-7
Evaluating
Whether a Call Option Is Within the Scope of ASC
460
A short position is created
when an entity sells a security or other asset
that it does not own. Such transactions occur
because the seller expects the price of the
security or other asset to decline. To settle the
short position, the entity must purchase the
security or other asset before the maturity of the
sale transaction so that the sale is “covered.”
For example, assume that on
April 1, 20X0, Trader A sells gold for $2,000 an
ounce to Entity B and that the settlement date is
December 15, 20X0. On July 1, 20X0, the price of
gold has declined to $1,800 an ounce. Trader A
expects that the price of gold will continue to
decline and will be lower as of the settlement
date of the short sale. However, A wants to “lock
in” a profit on the short sale. To do so, A
purchases an option to buy gold at $1,900 an ounce
from Entity C, a third party; the settlement date
is December 15, 20X0. (Note that the option
premium payable to purchase gold at $1,800 an
ounce [December 15, 20X0, settlement date] was too
expensive.)
Entity C would consider the
presence of the short position, to the extent
known, in determining whether the call option is
within the scope of ASC 460. If C is aware of A’s
short position, the call option written by C would
be within the scope of ASC 460. However, if C is
not aware of the short position and has no basis
for concluding that A is purchasing the option to
cover a short position in the asset, C’s written
call option would not be within the scope of ASC
460.
5.2.1.1.3 Financial Guarantees — Contractual Cash Flows of a Special-Purpose Entity
A guarantee of the contractual cash flows of the
financial assets or financial liabilities of a special-purpose entity
(SPE) is a type of financial guarantee. SPEs are distinct legal entities
whose permitted activities are significantly limited, as defined in the
legal documents that established the SPE, and that typically only hold
financial assets. Companies may use SPEs to sell financial assets, such
as receivables, to isolate financial risks (e.g., interest rate risk and
credit risk).
Example 5-8
Guarantee of
an SPE’s Receivables
Company X, a financial services
company, transfers certain mortgage receivables
that arose from its commercial property business
to a nonconsolidated SPE in exchange for cash
consideration. That transfer is accounted for as a
sale under ASC 860. Company X guarantees the
status of the receivables transferred at the time
of the transfer to the SPE. For example, X
guarantees that the receivables transferred will
not become overdue by more than 180 days. If the
transferred mortgage receivables become overdue by
more than 180 days, X will be obligated to make a
cash payment to the SPE.
This contract meets the
definition of a guarantee in accordance with ASC
460-10-15-4(a) as follows:
- It requires the guarantor (X) to make contingent payments to a guaranteed party (SPE) — Company X is required to make cash payments to the SPE in the event that the transferred receivables fail to perform in a manner as guaranteed at the time of transfer.
- It is related to an underlying — The occurrence or nonoccurrence of a specified event (such as a scheduled payment under a contract) is a variable that is considered an underlying. In X’s case, a specified event, such as an event that brings to light the fact that a receivable becomes overdue would be considered a change related to an underlying.
- It is related to an asset, liability, or equity security of the guaranteed party — The underlying is related to the transferred mortgage receivables, which are assets of the SPE.
5.2.1.1.4 Financial Guarantees — Minimum Revenue Guarantees
Minimum revenue guarantees are a type of financial
guarantee. The ASC master glossary defines a minimum revenue guarantee
as a “guarantee granted to a business or its owners that the revenue of
the business (or a specific portion of the business) for a specified
period of time will be at least a specified minimum amount.” As noted
above, ASC 460-10-15-4(a) includes “[c]ontracts that contingently
require a guarantor to make payments (as described in the following
paragraph) to a guaranteed party based on changes in an underlying that
is related to an asset, a liability, or an equity security of the
guaranteed party.”
Connecting the Dots
A minimum revenue guarantee is within the scope of ASC 460-10
because the guarantee’s underlying (the business’s gross
revenue) is considered related to an asset or equity security of
the guaranteed party. For example, if the guaranteed party is
the owner of the business, the business’s gross revenues are
considered related to changes in the owner’s investment in the
business (i.e., an equity security of the guaranteed party). If,
however, the guaranteed party is the business itself, the
business’s gross revenues are considered related to changes in
the net assets of the business because of transactions with
customers.
ASC 460-10-55-10 gives an example of a minimum revenue
guarantee.
ASC 460-10
55-10
An example of the type of guarantee described in
paragraph 460-10-55-2(e) is a minimum revenue
guarantee granted to a new day-care center by a
corporation as an incentive for the center to
locate near the corporation’s main plant. The
corporation, as the guarantor, has agreed to make
monthly payments to the day-care center (the
guaranteed party) over a specified term for any
shortfall from the guaranteed minimum amount of
revenue for each month.
The example below
further illustrates a minimum revenue guarantee contract.
Example 5-9
Minimum Revenue Guarantee
A regional hospital recruits nonemployee
physicians to establish independent practices in
nearby communities. As part of an incentive
package, the regional hospital guarantees a
physician’s practice a minimum level of revenue
over a predetermined period (e.g., one year).
Thus, during this period, the physician will be
able to bill (or collect) a minimum amount of
monthly revenue from the private practice. If
actual monthly billings are below this minimum
amount, the regional hospital will pay the
physician for the difference. In exchange for this
guarantee, the physician agrees to offer services
for a specified period (e.g., three years). The
physician also agrees to provide on-call coverage
at the regional hospital in her area of
specialization.
According to the guarantee agreement, if the
physician fails to provide services for the
agreed-upon service period, the physician is
required to pay the regional hospital back for any
payments made under the guarantee (the clawback
feature). The terms of the agreement reduce the
amount due under the clawback feature on a pro
rata basis over the required service period. That
is, for each month the physician works, a portion
of the regional hospital’s clawback potential is
reduced.
This minimum revenue guarantee is within the
scope of ASC 460. Specifically, the scope of ASC
460-10-55-2(e) includes a “guarantee granted to a
business or its owner(s) that the revenue of the
business (or a specific portion of the business)
for a specified period of time will be at least a
specified amount.”
Further, ASC 460-10-55-11 gives an example of a
guarantee that is within the scope of ASC
460-10-55-2(e) and states the following:
Another example is a guarantee granted to a
nonemployee physician by a not-for-profit health
care facility that has recruited the physician to
move to the facility’s geographical area to
establish a practice. The health care facility, as
the guarantor, has agreed to make payments to the
newly arrived physician (the guaranteed party) at
the end of specific periods of time if the gross
revenues (gross receipts) generated by the
physician’s new practice during that period of
time do not equal or exceed a specific dollar
amount. This Topic applies to minimum revenue
guarantees granted to physicians regardless of
whether the physician’s practice qualifies as a
business.
The regional hospital concludes that its
guarantee to the nonemployee physician meets the
criterion in ASC 460-10-15-4(a) and that it does
not qualify for one of the scope exceptions in ASC
460-10-15-7, as discussed in Section 5.2.2.
Initial Measurement
Section 5.3.2
discusses the recognition and measurement of a
guarantee liability. The regional hospital should
apply the guidance in ASC 460-10-30-2(b) and ASC
460-10-30-3 and 30-4, which require, at the
inception of the guarantee, recognition of a
liability that is equal to the greater of (1) the
estimated contingent loss (if probable) under ASC
450-20-25-2 or (2) the amount that satisfies the
fair value objective discussed in ASC
460-10-30-2(b). In estimating the liability, the
regional hospital should not rely solely on simple
averages of historical payouts under similar
arrangements. Rather, the estimate should be
refined on a contract-by-contract basis. For
example, if past patterns of revenue guarantees
varied because of discernible factors such as
geographic location, type of physician practice,
experience level of the physician, or amount of
the revenue guarantee or other commitments, the
regional hospital should consider such factors in
estimating the fair value of the stand-ready
obligation or the ASC 450 contingent minimum
revenue guarantee obligation.
Offsetting
Entry
Section 5.3.2.4
discusses the offsetting entry upon the initial
recognition of a guarantee liability. ASC
460-10-55-23 describes four situations involving
offsetting entries, none of which accurately
reflect the regional hospital’s circumstances.
However, ASC 460-10-55-23(a) indicates that “[i]f
the guarantee were issued in a standalone
transaction for a premium, the offsetting entry
would be consideration received (such as cash or a
receivable).”
Although the regional hospital
did not issue a guarantee for a premium, the
regional hospital concludes that ASC
460-10-55-23(a) would apply by analogy. The
regional hospital has received a commitment from
the physician to locate her practice to the region
for a specified number of years. If the physician
leaves before fulfilling her obligation, she must
repay the regional hospital a pro rata portion of
the payments received under the guarantee. These
commitments are a form of consideration. The
physician’s presence in the community has a
positive impact on the hospital’s financial
performance, since patients are more likely to
stay in the community to receive treatment and,
therefore, to use the hospital’s facilities. The
regional hospital is not providing a guarantee for
no consideration on a stand-alone basis, as
described in ASC 460-10-55-23(e) (i.e., the
guarantee is not within the scope of the guidance
on contributions in ASC 720-25).
The regional hospital can conclude that its guarantee meets the definition of an asset in FASB Concepts Statement 8, Chapter
4. The physician’s obligation to operate a
practice in the regional hospital’s area (or pay
back certain amounts if the obligation is not
fulfilled) represents a probable future economic
benefit that the regional hospital has obtained as
a result of the contractual relationship with the
physician. Accordingly, the offsetting entry
should be an asset.
Subsequent
Accounting
Section 5.4
discusses the (1) subsequent accounting for a
guarantee liability and (2) offsetting entry, if
applicable. In determining the appropriate
subsequent accounting for the minimum revenue
guarantee liability and offsetting entry (i.e.,
the asset), the regional hospital considers that
the overriding principle of ASC 460 is the
recognition of a liability at the inception of a
guarantee and the derecognition of the remaining
carrying amount of that guarantee liability at the
end of the guarantee period.
In accordance with ASC
460-10-35-1 and 35-2, amortization should occur in
a systematic and rational manner over the period
of the guarantee (three years in the example
presented). At the end of the minimum revenue
guarantee period, no stand-ready obligation should
remain. That is, the only remaining liability
should be any unpaid guarantee benefits.
The offsetting entry (i.e., the
asset) should be amortized over the useful life of
the asset — generally the period the physician is
contractually required to stay in the community
(three years in the example). The regional
hospital should periodically assess the asset for
impairment.
ASC 460 does not permit
subsequent adjustments to the guarantee liability
or to the related asset on the basis of actual
cash payments under the guarantee. The stand-ready
obligation is separate from the ASC 450 contingent
liability for probable cash payments under the
guarantee. During the guarantee period, the
regional hospital will need to continually monitor
whether it should remeasure its contingent
liability in accordance with ASC 450.
As discussed above,
revenues are changes in a business’s net assets because of transactions
with customers. Expenses and net income also represent changes in a
business’s net assets. In addition, the form of an arrangement should
not override its substance in the determination of whether the
arrangement is a guarantee under ASC 460-10-55-2. Accordingly, certain
net income reimbursement arrangements and expense reimbursement
arrangements are within the scope of ASC 460-10-15-4(a), as illustrated
in the example below.
Example 5-10
Minimum
Revenue Guarantee — Expense Reimbursement
Assume the same facts as in
Example 5-9,
except that the hospital agrees to reimburse the
physician for allowable expenses that exceed a
stated amount up to a maximum reimbursable amount
(e.g., a reimbursement of expenses in excess of
$400,000 up to a maximum amount of $1 million).
Examples of allowable expenses include office
rent, equipment rental, and other similar expenses
associated with establishing and maintaining a
medical practice.
Although the guarantee is not
based on the level of the physician’s revenue, it
is within the scope of ASC 460-10-55-2(e). The
medical practice assistance agreement is similar
in substance to a minimum revenue guarantee. That
is, the substance of the medical practice
assistance is a guarantee of the performance (net
assets) of the physician’s practice.
Like a traditional minimum
revenue guarantee, a medical practice assistance
arrangement creates an obligation for the hospital
providing the protection. The substance of an
agreement to reimburse expenses of a physician’s
practice is a guarantee of the performance of the
physician’s practice. Accordingly, the medical
practice assistance is within the scope of the
recognition, measurement, and disclosure
provisions of ASC 460.
5.2.1.2 Performance Guarantees
ASC 460-10-15-4(b) defines a performance guarantee as a
contractual arrangement that “contingently require[s] a guarantor to make
payments . . . to a guaranteed party based on another entity’s failure to
perform under an obligating agreement.” An important item to note, as
highlighted in ASC 460-10-15-7(i), is that an entity’s guarantee of its own
performance is only within the scope of ASC 460 if it is related to the
entity’s past performance. Conversely, a guarantee of a third party’s
performance is subject to ASC 460 regardless of whether it is related to
future or past performance. This concept is illustrated in the example
below.
Example 5-11
Performance
Guarantees on an Entity’s Future
Performance
Company A engages Contractor C to
construct a building in accordance with certain
specifications outlined in the contract. In exchange
for a premium from C, Company B issues a guarantee
to A such that A is guaranteed compensation from B
if C fails to follow the contractual specifications
for the building.
The guarantee provided by B is
within the scope of ASC 460. Company B is providing
a guarantee to A for a third party’s future
performance in constructing the building.
ASC 460-10-55-12 lists common examples of performance
guarantees such as performance standby letters of credit, bid bonds, and
performance bonds. The ASC master glossary defines a performance standby
letter of credit as “[a]n irrevocable undertaking by a guarantor to make
payments in the event a specified third party fails to perform under a
nonfinancial contractual obligation.” This guarantee is within the scope of
ASC 460 because it contingently requires the guarantor to make payments to
the guaranteed party on the basis of another entity’s failure to perform
under an agreement.
Connecting the Dots
A financial standby letter of credit is a guarantee
within the scope of ASC 460-10-15-4(a), while a performance standby
letter of credit is within the scope of ASC 460-10-15-4(b). A
financial standby letter of credit requires the guarantor to make a
payment in the event of a third party’s default (i.e., failure to
pay a financial obligation), while a performance standby letter of
credit requires the guarantor to make a payment in the event that a
third party fails to perform a nonfinancial obligation.
5.2.1.3 Indemnifications
ASC 460-10-15-4(c) describes
indemnification agreements. Further, ASC 460-10-55-13 gives examples of
common types of indemnification arrangements that are within the scope of
ASC 460.
ASC 460-10
55-13 The following are
examples of contracts of the type described in
paragraph 460-10-15-4(c):
- An indemnification agreement (contract) that contingently requires the indemnifying party (guarantor) to make payments to the indemnified party (guaranteed party) based on an adverse judgment in a lawsuit or the imposition of additional taxes due to either a change in the tax law or an adverse interpretation of the tax law.
- A lessee’s indemnification of the lessor for any adverse tax consequences that may arise from a change in the tax laws, because only a legislative body can change the tax laws, and the lessee therefore has no control over whether payments will be required under that indemnification. In contrast, as discussed in paragraph 460-10-55-18(a), when a lessee indemnifies a lessor against adverse tax consequences that may arise from acts, omissions, and misrepresentations of the lessee, that indemnification is outside the scope of this Topic because the lessee is, in effect, guaranteeing its own future performance.
- A seller’s indemnification against additional income taxes due for years before a business combination, because the indemnification relates to the seller-guarantor’s past performance, not its future performance.
Indemnification agreements require the issuer (i.e., the
guarantor) to compensate the guaranteed party upon the occurrence of certain
conditional events. The examples in ASC 460-10-55-13 illustrate that for an
indemnification agreement to be within the scope of ASC 460, it can be
related to either (1) the future or past performance of another entity or
(2) the past performance of the issuing entity. In a manner similar to that
discussed in Section
5.2.1.2, when an entity issues an indemnification related to
its own performance, the indemnification is only within the scope of ASC 460
if it is related to the entity’s past performance.
The examples below
illustrate scenarios in which an entity indemnifies a third party.
Example 5-12
Indemnifications
for Losses by a Contracting Party
Company A engages Company B to
perform certain duties on behalf of A. Company A
indemnifies B for third-party damage claims and
lawsuits that could be filed against B in performing
the contracted services.
The indemnification provided by A is
within the scope of ASC 460. The indemnification
contingently requires A to make a payment to B on
the basis of changes in B’s contingent liability.
This indemnification possesses the characteristics
defined in ASC 460-10-15-4(c) and is within the
scope of ASC 460.
Example 5-13
Indemnification of Taxes in a Business Combination
Company C enters into an agreement to sell 100
percent of the outstanding stock in its wholly owned
subsidiary, Company Y, to Company D. Before the
sale, Y files a separate tax return in which a tax
position is taken that requires the recognition of a
liability for an unrecognized tax benefit. Because Y
filed a separate tax return, C is not directly
liable for any of Y’s tax obligations after the
sale. As part of the purchase agreement, C
indemnifies D for any future settlement with the tax
authority in connection with the uncertain tax
position taken by Y in its prior tax return.
Company C would not account for the tax
indemnification related to Y’s previously taken tax
position after the sale under ASC 740. Rather, by
indemnifying D for any loss related to Y’s prior tax
position, C has entered into a guarantee contract
that is within the scope of ASC 460-10-15-4(c) and
ASC 460-10-55-13(c). Therefore, C would recognize a
guarantee liability on the sale date and on each
reporting date thereafter in accordance with the
recognition and measurement provisions of ASC
460-10.
Company C makes the following
assumptions in recording journal entries as of the
date on which Y is sold:
-
The amount of Y’s uncertain tax benefit is $100 (i.e., Y recognizes this amount as a liability under ASC 740-10 before and after the sale).
-
Settlement of the indemnification liability would result in a tax deduction for C.
-
The initial guarantee liability determined under ASC 460-10 is $40.
-
Company C has an effective tax rate of 25 percent.
The journal entries recorded would be as follows:
The deferred tax entry is recognized because there is
a deductible temporary difference related to the
difference between the reported amount and the tax
basis of the indemnification liability (i.e., 25
percent of $40).
It is common for a party to issue indemnification agreements
(i.e., the guarantor) to a third party (i.e., the guaranteed party) in
connection with a contingent liability of the third party. The underlying’s
relationship to an unrecognized liability is irrelevant to the assessment of
whether the indemnification is within the scope of ASC 460. Therefore, such
an indemnification would be within the scope of ASC 460 even if the
guaranteed party has not recognized a liability. This conclusion is
consistent with the example in ASC 460-10-55-13(c) (see above).
The examples below
illustrate the analysis an entity must perform for such
indemnifications.
Example 5-14
Indemnifications
— Underlying Analysis
Company Z enters into an alliance
agreement with Company Y, an unrelated party, under
which Z and Y plan to jointly launch a generic
version of Product A. Product A is currently
patent-protected; thus, any launch of a generic
version would be an at-risk launch (i.e., at risk
for litigation). The following outcomes are possible
according to the terms of the alliance agreement:
- Scenario 1 — Companies Z and Y mutually agree to jointly launch a generic version of Product A. All profits and costs will be shared equally, and each company has agreed to indemnify the other for litigation costs in such a way that any costs incurred by either party will be shared equally.
- Scenario 2 — Either Z or Y can compel the other party to go forward with an at-risk launch of the generic version of Product A. The compelling party would receive 90 percent of the profits and cover 90 percent of the costs from the sale of the generic product. In addition, the compelling party agrees to indemnify the other party for 100 percent of any litigation costs that may be incurred.
- Scenario 3 — Companies Z and Y agree not to launch a generic version of Product A and effectively terminate the alliance agreement. Upon termination, Z and Y will share in any inventory losses equally.
In Scenarios 1 and 2, both Z and Y
can avoid placing themselves in a guarantor
capacity, since both parties have control over
whether they proceed with a particular scenario. The
analysis of these scenarios is discussed below.
Scenario 3 does not address an indemnification
arrangement.
Underlying
Analysis
The litigation indemnification in
the alliance agreement is within the scope of ASC
460. Indemnification agreements that contingently
require payments to be made on the basis of changes
in an underlying related to an asset, liability, or
equity security of the indemnified party are within
the scope of ASC 460, as stated in ASC
460-10-15-4(c). Scenarios 1 and 2 both include this
type of indemnification. From Z’s perspective, if
the terms of the litigation indemnification included
in the alliance agreement become effective, these
terms will contingently require Z to make payments
to Y on the basis of changes in Y’s contingent
liability associated with potential litigation — the
underlying. Although the underlying is not related
to a recognized asset, liability, or equity security
of the indemnified party, the change in an
underlying related to an unrecognized contingent
liability is within the scope of ASC 460. Since the
indemnification possesses the characteristics
defined in ASC 460-10-15-4(c), it is within the
scope of ASC 460.
Recognition
of a Stand-Ready Obligation
Company Z should not recognize a
stand-ready obligation under ASC 460 until it places
itself in a guarantor capacity. At the inception of
the alliance agreement, Z had not yet obligated
itself to contingently make payments to Y. The
decision that would place Z in a stand-ready
capacity to indemnify future litigation costs to Y
is currently within Z’s control; that event had not
yet occurred as of inception and may never occur.
Under Scenario 1, Z would control the decision to
mutually agree to go forward with an at-risk launch
because mutual agreement requires the consent of
both parties and would obligate Z to stand ready to
perform under the indemnification. Under Scenario 2,
Z would control the decision about whether to compel
Y to go forward with an at-risk launch. Upon
compelling Y in this scenario, Z would become
obligated to stand ready to perform under the
indemnification. Company Z should record a
stand-ready obligation under ASC 460 when the
litigation indemnifications under either Scenario 1
or Scenario 2 become effective.
Example 5-15
Indemnifications
— Underlying Analysis for Contingent
Liabilities
Company A has in the past issued
certain indemnifications to underwriters and is
likely to issue similar indemnifications in the
future. The terms of these indemnifications are as
follows:
The Company agrees
to indemnify and hold harmless each underwriter,
the directors, officers, employees, and agents of
each underwriter and each person who controls any
underwriter, within the meaning of either the Act
or the Exchange Act, against any and all losses,
claims, damages, or liabilities, joint or several,
to which they or any of them may become subject
under the Act, the Exchange Act, or other federal
or state statutory law or regulation, at common
law or otherwise, insofar as such losses, claims,
damages, or liabilities (or actions in respect
thereof) (1) arise out of or are based on any
untrue statement or alleged untrue statement of a
material fact contained in the registration
statement as originally filed or in any amendment
thereof, or in the basic prospectus, any
preliminary final prospectus or the final
prospectus, or in any amendment thereof or
supplement thereto, or (2) arise out of or are
based on the omission or alleged omission to state
therein a material fact required to be stated
therein or necessary to make the statements
therein not misleading.
The above indemnification is subject
to the recognition and measurement provisions of ASC
460. Under ASC 460-10-15-4(c), an indemnification is
within the scope of ASC 460 if contingent payments
are “based on changes in an underlying that is
related to an asset, a liability, or an equity
security of the indemnified party.” Since A would be
required to make payments to the underwriter in the
event that the underwriter is held liable for
losses, damages, or claims resulting from any untrue
statement contained in a registration statement, A
has satisfied the contingent payment condition.
A specified event, such as a
requirement by a court of law requiring an
underwriter to make a payment to a third party
because of an untrue statement in a registration
statement, would be considered an underlying. Thus,
A has also satisfied the “underlying” condition in
ASC 460-10-15-4(c).
ASC 460-10-15-4(c) also requires
entities to assess whether the underlying is related
to an asset, liability, or equity security of the
underwriter. In A’s case, the underlying is related
to a contingent liability of the underwriter that
may arise if the future specified event occurs. As
noted above in this section, an indemnification in
which the underlying is an unrecognized contingent
liability of the indemnified party is within the
scope of ASC 460.
Example 5-16
Indemnification
— Environmental Liability
Company A sells a building to
Company B. As part of the sale, A indemnifies B from
future claims resulting from environmental
liabilities existing on or before the date of sale.
Assume that on the date of purchase, B is not
required to recognize an environmental liability
under GAAP.
The indemnification provided by A to
B is within the scope of ASC 460. The
indemnification applies to environmental
contamination that occurred before the date of sale
and may result in a liability to B because of
changes in environmental laws or subsequent
discovery of contamination. ASC 460-10-15-4(c)
states that “[i]ndemnification agreements
(contracts) that contingently require an
indemnifying party (guarantor) to make payments to
an indemnified party (guaranteed party) based on
changes in an underlying that is related to an
asset, a liability, or an equity security of the
indemnified party” are within the scope of ASC
460.
Company A’s indemnification of B
from changes in B’s contingent liability related to
the discovery of contamination that occurred on or
before the date of sale is within the scope of ASC
460 because it meets the definition of a guarantee
(A is assuming the risk of the environmental
liabilities resulting from the condition of the
building at the time of sale). It does not matter
that the liability has not been recognized in the
financial statements of the guaranteed party.
5.2.1.4 Indirect Guarantees of the Indebtedness of Others
ASC 460-10-15-4(d) describes indirect guarantees of the indebtedness of others. Indirect guarantees were originally within the scope of FASB Interpretation 34, which was later incorporated into FASB Interpretation 45 (codified in ASC 460). Paragraph 9 of FASB Interpretation
34 clarifies the difference between a direct guarantee and an indirect
guarantee and states:
Some respondents requested
clarification of the definition of an indirect guarantee and the
difference between direct and indirect guarantees of indebtedness of
others. Both direct and indirect guarantees of indebtedness involve
three parties: a debtor, a creditor, and a guarantor. In a direct
guarantee, the guarantor states that if the debtor fails to make payment
to the creditor when due, the guarantor will pay the creditor. If the
debtor defaults, the creditor has a direct claim on the guarantor. Under
an indirect guarantee, there is an agreement between the debtor and the
guarantor requiring the guarantor to transfer funds to the debtor upon
the occurrence of specified events. The creditor has only an indirect
claim on the guarantor by enforcing the debtor’s claim against the
guarantor. After funds are transferred from the guarantor to the debtor,
the funds become available to the creditor through its claim against the
debtor.
The ASC master glossary
defines both direct and indirect guarantees of indebtedness.
ASC Master Glossary
Direct Guarantee
of Indebtedness
An agreement in which a guarantor
states that if the debtor fails to make payment to
the creditor when due, the guarantor will pay the
creditor. If the debtor defaults, the creditor has a
direct claim on the guarantor.
Indirect
Guarantee of Indebtedness
An agreement that obligates the
guarantor to transfer funds to a debtor upon the
occurrence of specified events, under conditions
whereby:
- After funds are transferred from the guarantor to the debtor, the funds become legally available to creditors through their claims against the debtor
- Those creditors may enforce the debtor’s claims against the guarantor under the agreement.
In contrast, with a direct guarantee
of indebtedness, if the debtor defaults, the
creditor has a direct claim on the guarantor.
Examples of indirect guarantees include agreements
to advance funds if a debtor’s net income, coverage
of fixed charges, or working capital falls below a
specified minimum.
As demonstrated in the
graphic below, a creditor has a direct claim on a guarantor in a direct
guarantee of indebtedness. Conversely, a creditor may enforce the debtor’s
claim against a guarantor in an indirect guarantee of indebtedness rather
than making a claim against the guarantor itself.
The example in ASC
460-10-55-15 illustrates an indirect guarantee of the indebtedness of
others, as that term is addressed in ASC 460-10-15-4(d).
ASC 460-10
55-15 A community foundation
has a loan guarantee program to assist
not-for-profit entities (NFPs) in obtaining bank
financing at a reasonable cost. Under that program,
the community foundation issues a guarantee of an
NFP’s bank debt. That guarantee is within the scope
of this Topic, and on the issuance of the guarantee,
the community foundation would recognize a liability
for the fair value of that guarantee. The issuance
of that guarantee would not be considered merely a
conditional promise to give under paragraphs
958-605-25-11 through 25-13 because, upon the
issuance of the guarantee, the NFP will have
received the gift of the community foundation’s
credit support. That credit support enables the NFP
to obtain a lower interest rate on its
borrowing.
The example below further
illustrates an indirect guarantee of the indebtedness of others.
Example 5-17
Indirect
Guarantee of the Indebtedness of Others
Company A is a distributor of mobile
devices. Company B provides wireless communication
services to consumers and often leases mobile
devices to its customers. Company B leases its
mobile devices from Company L (the “head lease”),
which B then uses to lease to its customers (the
“sublease”). Assume that B has not applied ASC 842
and therefore has not recognized any assets or
liabilities related to these leases (i.e., they are
operating leases).
Companies A and B enter into a
program (the “Program”) under which B will offer its
customers the right to upgrade or replace their
mobile devices at any time. The customer will pay B
$5 a month for this right in addition to an
incremental fee upon upgrade. This incremental fee
is determined on the basis of the quality of the
device as well as the date on which the upgrade
occurs throughout its sublease term.
Under the Program, A assumes B’s
obligations in exchange for a portion of the monthly
fee from the customer and the incremental upgrade
fee. Upon an upgrade, A will pay B an amount that
represents the purchase price of the device, less an
amount that reflects the lease payments previously
received by B from its customer. Company B will then
use these proceeds to repay its head lease payment
to L. Company A cannot cancel this agreement with B
and is obligated to perform under the Program.
Company A concludes that the Program
represents an obligation to B rather than to L.
Company L and its creditors must look solely to B
for consideration related to early termination of
the head lease. Company B has a direct claim for
payment from A regardless of whether B satisfies its
obligation to L. If B did not make the payment to L
for an early termination of the head lease, L could
pursue a claim against A to make its payment under
the Program to B, which L could then recover. The
Program represents an obligation of A that is based
on changes in an underlying related to an
unrecognized asset and unrecognized liability of
B.
5.2.2 Transactions Outside the Scope of ASC 460
Guarantee arrangements that qualify as one of the four types of
arrangements discussed in ASC 460-10-15-4, but that are subject to a scope
exception in ASC 460-10-15-7, are outside the scope of ASC 460. Such
arrangements should be accounted for under other applicable authoritative
literature such as that on revenue recognition, derivative accounting, leasing,
or industry-specific topics. The scope exceptions in ASC 460-10-15-7 are
included because other Codification topics already address the relevant
accounting considerations.
ASC 460-10
15-7 The guidance in this
Topic does not apply to the following types of guarantee
contracts:
- A guarantee or an indemnification that is excluded from the scope of Topic 450 (see paragraph 450-20-15-2 — primarily employment-related guarantees)
- A lessee’s guarantee of the residual value of the underlying asset at the expiration of the lease term under Topic 842
- A contract that meets the characteristics in paragraph 460-10-15-4(a) but is accounted for as variable lease payments under Topic 842
- A guarantee (or an indemnification) that is issued by either an insurance entity or a reinsurance entity and accounted for under Topic 944 (including guarantees embedded in either insurance contracts or investment contracts)
- A contract that meets the characteristics in paragraph 460-10-15-4(a) but provides for payments that constitute a vendor rebate (by the guarantor) based on either the sales revenues of, or the number of units sold by, the guaranteed party
- A contract that provides for payments that constitute a vendor rebate (by the guarantor) based on the volume of purchases by the buyer (because the underlying relates to an asset of the seller, not the buyer who receives the rebates)
- A guarantee or an indemnification whose existence prevents the guarantor from being able to either account for a transaction as the sale of an asset that is related to the guarantee’s underlying or recognize in earnings the profit from that sale transaction
- A registration payment arrangement within the scope of Subtopic 825-20 (see Section 825-20-15)
- A guarantee or an indemnification of an entity’s own future performance (for example, a guarantee that the guarantor will not take a certain future action)
- A guarantee that is accounted for as a credit derivative at fair value under Topic 815.
- A sales incentive program in which a manufacturer contractually guarantees to reacquire the equipment at a guaranteed price or guaranteed prices at a specified time, or at specified time periods (for example, the entity is obligated to reacquire the equipment or the entity is obligated at the customer’s request to reacquire the equipment). That program shall be evaluated in accordance with Topic 606 on revenue from contracts with customers, specifically the implementation guidance on repurchase agreements in paragraphs 606-10-55-66 through 55-78.
For related implementation guidance, see
Section 460-10-55.
5.2.2.1 Scope Exceptions That Are Outside the Scope of ASC 450
Section
2.2 discusses the scope exceptions in ASC 450-20-15-2, which
include (1) stock issued to employees (addressed in ASC 718), (2) certain
employment-related costs (addressed in ASC 710, ASC 712, and ASC 715),1 (3) uncertainty in income taxes (addressed in ASC 740-10-25), and (4) accounting and reporting by insurance entities (addressed in ASC 944). Because FASB Interpretation 45 (codified in ASC 460) was originally issued as an interpretation of FASB Statement 5 (ASC 450), the scope of ASC 460
does not include contingencies and uncertainties that are outside the scope
of ASC 450.
Connecting the Dots
A company’s indemnification of its employees against
litigation that arises in connection with their employment is
outside the scope of ASC 460 because it is considered an
employment-related cost that is outside the scope of ASC 450.
Similarly, a company’s indemnification of its nonemployee directors,
such as board members, is also outside the scope of ASC 460 since
nonemployee directors are considered employees as defined by ASC
718-10-20.
5.2.2.2 Guarantee or Indemnification of an Entity’s Own Future Performance
As discussed in Section 5.2.1.3, to
be within the scope of ASC 460, an indemnification can be related to either
(1) the future or past performance of another entity or (2) the past
performance of the issuing entity. That is, the scope exception in ASC
460-10-15-7(i) specifically excludes guarantees or indemnifications of an
entity’s own future performance, which is illustrated in the example
below.
Example 5-18
Guarantees of an
Entity’s Own Performance — Employment-Related
Arrangements
Company A has many employees who are
paid in accordance with a union contract. The
contract stipulates that, in the event that a
facility is idled, employees will continue to
receive payments throughout the contract period in
amounts equaling approximately 95 percent of their
base pay.
This provision of the union contract
is not a guarantee within the scope of ASC 460 both
in circumstances in which the idling of the facility
is within A’s control and in circumstances outside
A’s control. ASC 460-10-15-7(i) excludes guarantees
of an entity’s own future performance from the scope
of ASC 460 (see further discussion below).
However, although the guarantee is
not within the scope of ASC 460, A is still required
to apply the recognition and disclosure requirements
of ASC 450 and ASC 712 for its postemployment
obligations under the union contract, as described
in Section 2.2.2.
ASC 712 establishes the accounting
for benefits provided to former or inactive
employees, their beneficiaries, and covered
dependents. ASC 712-10-20 defines inactive employees
as “[e]mployees who are not currently rendering
service to the employer and who have not been
terminated. They include those who have been laid
off and those on disability leave, regardless of
whether they are expected to return to active
status.”
In addition, ASC 712-10-05-5 gives
the following examples of other postemployment
benefits:
“Other
postemployment benefits include, but are not
limited to, the following:
- Salary continuation
- Supplemental unemployment benefits
- Severance benefits
- Disability-related benefits (including workers’ compensation)
- Job training and counseling
- Continuation of benefits such as health care benefits and life insurance coverage.”
As described in Section
2.2.2, an entity accounts for certain
postemployment contracts in accordance with ASC 450
by applying ASC 712; therefore, such contracts could
be within the scope of ASC 460 (i.e., the scope
exception in ASC 460-10-15-7(a) does not apply).
Accordingly, A must determine whether the scope
provisions of ASC 460-10-15-4 apply to the
guarantee. The table below summarizes whether the
guarantee is within the scope of ASC 460.
|
Scope
|
Within Scope?
|
|---|---|
|
ASC 460-10-15-4(a) —
“Contracts that contingently require a guarantor
to make payments (as described in [ASC
460-10-15-5]) to a guaranteed party based on
changes in an underlying that is related to an
asset, a liability, or an equity security of the
guaranteed party.”
|
No — The guaranteed party
would not record a related asset, liability, or
equity security in connection with the
contract.
|
|
ASC 460-10-15-4(b) —
“Contracts that contingently require a guarantor
to make payments (as described in [ASC
460-10-15-5]) to a guaranteed party based on
another entity’s failure to perform under an
obligating agreement (performance
guarantees).”
|
No — There is no third-party
performance guarantee.
|
|
ASC 460-10-15-4(c) —
“Indemnification agreements (contracts) that
contingently require an indemnifying party
(guarantor) to make payments to an indemnified
party (guaranteed party) based on changes in an
underlying that is related to an asset, a
liability, or an equity security of the
indemnified party.”
|
No — There is no
indemnification agreement. Furthermore, the entity
is guaranteeing its own future performance.
|
|
ASC 460-10-15-4(d) —
“Indirect guarantees of the indebtedness of
others, even though the payment to the guaranteed
party may not be based on changes in an underlying
that is related to an asset, a liability, or an
equity security of the guaranteed party.”
|
No — There is no indirect
guarantee of the indebtedness of others.
|
As outlined in the table, the
guarantee does not meet the scope requirements in
ASC 460-10-15-4 and is therefore outside the scope
of ASC 460. This conclusion is appropriate because
the guarantee is considered related to the entity’s
own future performance.
5.2.2.3 Transactions Accounted for Under Other Applicable GAAP
ASC 460-10-15-7 lists scope exceptions (in addition to those
described in Sections
5.2.2.1 and 5.2.2.2) under which an entity would not apply ASC 460 to
certain transactions that are addressed in other Codification topics.
5.2.2.3.1 Lease Accounting
Under ASC 460-10-15-7(c), the scope of ASC 460 excludes
a contract that has the characteristics in ASC 460-10-15-4(a) but is
accounted for as variable lease payment under ASC 842.
5.2.2.3.2 Insurance Accounting
ASC 460-10-15-7(d) excludes from the scope of ASC 460 a
“guarantee (or an indemnification) that is issued by either an insurance
entity or a reinsurance entity and accounted for under Topic 944
(including guarantees embedded in either insurance contracts or
investment contracts).”
5.2.2.3.3 Revenue Recognition
ASC 460-10-15-7(e), (f), and (k) contain certain scope
exceptions from ASC 460 for items within the scope of ASC 606 related to
revenue from contracts with customers. As noted in ASC 460-10-15-7(e)
and (f), “payments that constitute a vendor rebate” are generally
outside the scope of ASC 460 since the accounting for such payments is
addressed by ASC 606, specifically with respect to consideration payable
to a customer as described in Chapter 6 of Deloitte’s Roadmap
Revenue
Recognition. Furthermore, as described in ASC
460-10-15-7(k), sales incentive programs in which a manufacturer
contractually guarantees to reacquire the equipment at a guaranteed
price are outside the scope of ASC 460 and are accounted for under ASC
606, as described in Section 8.7 of Deloitte’s Roadmap Revenue
Recognition.
5.2.2.3.4 Guarantees That Prevent a Sale or Recognition of Profits From That Sale
ASC 460-10-15-7(g) excludes from the scope of ASC 460
guarantee arrangements whose existence prevents the guarantor from being
able to either account for a transaction as the sale of an asset that is
related to the guarantee’s underlying or recognize in earnings the
profit from that sale transaction. The FASB’s rationale for including
this scope exception was that if the guarantee serves as an impediment
to sale accounting (under ASC 860) or to recognizing the profit from a
sale, the guarantor and guaranteed party will both have the asset on
their books. The FASB considered that other GAAP adequately addressed
the accounting for such situations and therefore did not want to include
guidance in ASC 460.
5.2.2.3.5 Registration Payment Arrangements
ASC 460-10-15-7(h) excludes from the scope of ASC 460 a
registration payment arrangement within the scope of ASC 825-20 (see ASC
825-20-15).
5.2.2.3.6 Credit Derivatives
ASC 460-10-15-7(j) excludes from the scope of ASC 460
credit derivatives accounted for in accordance with ASC 815. Although
credit derivatives that are within the scope of ASC 815 would
nevertheless be outside the scope of ASC 460’s recognition and
measurement provisions under ASC 460-10-25-1(a), this exception
clarifies that the disclosure provisions of ASC 460 do not apply to
credit derivatives. Rather, the disclosures that apply to these
instruments are addressed in ASC 815-10-50-4H and ASC 815-10-50-4J
through 50-4L.
The ASC master glossary
defines a credit derivative as follows:
ASC Master Glossary
Credit
Derivative
A derivative instrument that has
both of the following characteristics:
- One or more of its
underlyings are related to any of the following:
- The credit risk of a specified entity (or a group of entities)
- An index based on the credit risk of a group of entities.
- It exposes the seller to potential loss from credit-risk-related events specified in the contract.
Examples of credit derivatives
include, but are not limited to, credit default
swaps, credit spread options, and credit index
products.
The example below
illustrates a credit derivative that is not subject to the provisions of
ASC 460.
Example 5-19
Credit
Derivatives
Bank A makes a loan to Customer
B. To hedge its credit risk related to the loan, A
enters into a credit derivative with Bank C. Under
the credit derivative, C agrees to pay A if B’s
credit rating declines below investment-grade, B
defaults on the loan, or B defaults on any other
debt obligation.
For C, the credit derivative is
accounted for under ASC 815. Therefore, it
qualifies for the scope exception from ASC 460
under ASC 460-10-15-7(j). Moreover, all
derivatives accounted for under ASC 815 qualify
for the scope exception applicable to recognition
and measurement under ASC 460-10-25-1(a) and ASC
460-10-30-1.
For C, the credit derivative is
also not subject to the disclosure provisions of
ASC 460. Rather, the disclosure requirements in
ASC 815-10-50 apply.
Footnotes
1
As discussed in Section 2.2.2, certain
postemployment benefits are within the scope of ASC 450.
5.3 Initial Recognition and Measurement Provisions of ASC 460
5.3.1 Guarantees Not Subject to Recognition and Measurement Provisions of ASC 460
For certain types of guarantees, the guarantor
is exempt from the recognition of such a liability but is still subject to the
financial statement disclosure requirements in ASC 460-10-50 (see Section 5.5).
ASC 460-10
25-1 The following types of
guarantees are not subject to the recognition provisions
of this Subsection:
- A guarantee that is accounted for as a derivative instrument at fair value under Topic 815.
- A product warranty or other guarantee for which the underlying is related to the performance (regarding function, not price) of nonfinancial assets that are owned by the guaranteed party (see paragraph 460-10-15-9 for related guidance).
- A guarantee issued in a business combination or an acquisition by a not-for-profit entity that represents contingent consideration (as addressed in Subtopics 805-30 and 958-805).
- A guarantee for which the guarantor’s obligation would be reported as an equity item rather than a liability under generally accepted accounting principles (GAAP) (see Topics 480 and 505).
- A guarantee by an original lessee that has become secondarily liable under a new lease that relieved the original lessee from being the primary obligor (that is, principal debtor) under the original lease, as discussed in paragraph 842-20-40-3. This exception shall not be applied by analogy to other secondary obligations.
- A guarantee issued either between parents and their subsidiaries or between corporations under common control.
- A parent’s guarantee of its subsidiary’s debt to a third party (whether the parent is a corporation or an individual).
- A subsidiary’s guarantee of the debt owed to a third party by either its parent or another subsidiary of that parent.
30-1 The
types of guarantees identified in paragraph 460-10-25-1
are not subject to the initial measurement provisions of
this Subsection.
5.3.1.1 Transactions Accounted for Under Other Applicable GAAP
Certain arrangements, such as those described in ASC
460-10-25-1(a) and ASC 460-10-25-1(c)–(e), are outside the scope of the
recognition and measurement provisions of ASC 460 because the accounting
treatment is prescribed by other U.S. GAAP. Product warranties and other
guarantee contracts for which the underlying is related to the functional
performance of nonfinancial assets that are owned by the guaranteed party
are addressed separately in ASC 460. See Section 5.6 for more information.
5.3.1.2 Guarantees Between Commonly Controlled Entities
Guarantees that are issued between a parent and its
subsidiary or among entities under common control are subject to an
exception from the recognition and measurement guidance in ASC 460 (see ASC
460-10-25-1(f)–(h)). These exceptions are written in the context of the
entity’s preparation of financial statements (i.e., consolidated financial
statements or stand-alone financial statements of either the parent or the
subsidiary).
With respect to the consolidated financial statements, the following
guarantees are not subject to ASC 460’s recognition and measurement
guidance:
- Any guarantee issued by any entity in the consolidated group to another entity in the consolidated group (i.e., both the guarantor and the guaranteed party are included in the consolidated financial statements).
- Any guarantee of debt recognized in the consolidated financial statements, regardless of the entity within the consolidated group that (1) is the obligor of the debt and (2) issues the guarantee.
Guarantees that are issued by an investor directly or indirectly to an equity
method investee (e.g., guarantees of the investee’s debt) are not subject to
the scope exception discussed above. Furthermore, while the investor that
issues such a guarantee must perform in the event that the underlying event
for which payment is required occurs, it is not appropriate for the investor
to conclude that such a guarantee represents a guarantee of its future
performance.
Connecting the Dots
ASC 460-10-25-1(f)–(h) and ASC 460-10-50-1 imply
that guarantees between entities under common control are subject to
the disclosure provisions in ASC 460 but are outside the scope of
ASC 460’s recognition and measurement guidance. However, paragraph A23 of the Basis for Conclusions of FASB Interpretation 45 indicates
that in consolidated financial statements,
the parent’s guarantee of a subsidiary’s debt to a third party is
not “subject to the recognition, measurement, and disclosure
provisions of the Interpretation.”
In the consolidated financial statements that
include both the guarantor (e.g., parent) and the obligor (e.g.,
subsidiary) of debt that is recognized in the consolidated financial
statements, the guarantee is outside the scope of ASC 460’s
disclosure provisions because the debt obligation is included and
fully disclosed in the consolidated financial statements. The
guarantee is akin to a guarantee of the consolidated entity’s own
future performance, as described in ASC 460-10-15-7(i).
SEC Considerations
While certain guarantees involving entities within a
consolidated group are outside the scope of the recognition,
measurement, and disclosure provisions of ASC 460, SEC regulations
include specific disclosure requirements for registered guaranteed
securities. Debt or preferred stock registered under the Securities
Act may be guaranteed by one or more affiliates of the issuer.
Guarantees of registered securities are considered securities
themselves under the Securities Act. As a result, registration of
guaranteed securities under the Securities Act can result in a
requirement for both the issuer of the guaranteed security and the
guarantor(s) of the security to file Exchange Act periodic reports
(i.e., Form 10-K and Form 10-Q). However, in most circumstances, the
SEC has provided relief from this requirement for each issuer and
guarantor. Under Regulation S-X, Rules 3-10 and 13-01, entities can
provide alternative financial disclosures or qualitative disclosures
in lieu of such separate financial statements when certain criteria
have been met. For more information, see Deloitte’s Roadmap
SEC
Reporting Considerations for Guarantees and
Collateralizations.
Example 5-20
Consolidated Financial Statements — Guarantees
Outside the Scope of ASC 460
In accordance with ASC 810, Parent A is preparing
consolidated financial statements that include both
Subsidiary B and Subsidiary C. Parent A concludes
that each of the guarantees discussed below are
outside the scope of ASC 460’s recognition,
measurement, and disclosure provisions.
Parent’s
Direct Guarantee of Subsidiary’s
Indebtedness
Bank D, a third party, issues $100
million of debt to B. In conjunction with this
issuance, A issues a guarantee directly to D, on
behalf of B, stating that in the event of B’s
default on the debt, A will make all remaining
scheduled payments to D.
Parent A presents the $100 million
debt obligation in its consolidated financial
statements and concludes that this guarantee
represents a direct guarantee of indebtedness.
Because A presents the underlying obligation (i.e.,
the $100 million debt) in its consolidated financial
statements, this guarantee represents a guarantee of
A’s own performance; accordingly, A would not
account for the guarantee in accordance with the
recognition and measurement provisions of ASC 460,
nor would it provide the disclosures required by ASC
460.
Parent A further observes that, with
respect to its consolidated financial statements,
disclosures related to this guarantee would not
provide any incremental information relevant to
users of its financial statements, since A has
properly disclosed all relevant information about
the debt obligation. Further, A observes that if it
had recognized a guarantee obligation related to B’s
debt, this obligation would need to be eliminated in
consolidation.
Parent A’s conclusion would be
similar if this debt arrangement was reversed. If D
had issued $100 million in debt proceeds to A, and B
had guaranteed payment to D upon A’s default, the
analysis described above would be equally
applicable.
Parent’s
Indirect Guarantee of Subsidiary’s
Indebtedness
In a separate transaction, B borrows
$50 million from Bank E, a third party. As part of
B’s agreement with E, A agrees to guarantee B’s
obligation to Bank E. If B defaults, A will transfer
funds to B so that B can pay E. Parent A presents
the $50 million obligation in its consolidated
financial statements and concludes that this
represents an indirect guarantee of the indebtedness
of others. For the same reasons described above
related to the direct guarantee of the indebtedness
of others, A concludes that this guarantee is
outside the scope of the recognition, measurement,
and disclosure provisions of ASC 460.
Subsidiary’s
Direct Guarantee of Another Subsidiary’s
Indebtedness
Subsidiary C borrows $20 million
from Bank F, a third party. Subsidiary B provides a
direct guarantee to F that it will make all
remaining scheduled payments to F in the event of
C’s default. Parent A presents this $20 million
obligation in its consolidated financial statements.
With respect to its consolidated financial
statements, A concludes that this guarantee between
entities under common control is outside the scope
of ASC 460’s recognition, measurement, and
disclosure provisions because A already presents
this obligation in its consolidated financial
statements; therefore, this guarantee is a guarantee
of A’s own performance.
In the stand-alone financial statements of a guarantor that does not
consolidate the financial statements of a commonly controlled entity that is
the obligor of debt, the guarantor is subject to ASC 460’s disclosure
provisions even though the recognition and measurement guidance in ASC 460
does not apply. For example, if Subsidiary A guarantees the debt of its
sister company, Subsidiary B, to a third party, A must disclose this fact in
its stand-alone financial statements since the affiliate’s debt is not
included in the guarantor’s stand-alone financial statements. However, in
that case, the guarantee would be outside the scope of the recognition and
measurement provisions in accordance with ASC 460-10-25-1(h).
Upon the deconsolidation of
a subsidiary, the parent entity and subsidiary should account for such
guarantee arrangements in accordance with ASC 460 since they no longer would
qualify for the recognition and measurement scope exception in ASC
460-10-25-1(f)–(h). This conclusion is illustrated in the examples
below.
Example 5-21
Impact of Deconsolidation of a Subsidiary
Company A, a calendar-year-end entity, owns 100
percent of Company B, another calendar-year-end
entity, and includes B in its consolidated financial
statements. Company A guarantees B’s debt to a
third-party bank. Both the debt agreement and the
guarantee were entered into on July 1, 20X2; no
provisions of the debt agreement or the guarantee
have since been modified. With respect to its
consolidated financial statements for the year ended
December 31, 20X2, A concludes that the guarantee is
outside the scope of ASC 460 because of the scope
exception in ASC 460-10-25-1(g).
Subsequently, on December 15, 20X3,
A reduces its ownership interest in B to 49 percent.
Because B is not a variable interest entity under
ASC 810, A deconsolidates B in accordance with ASC
810. Upon its deconsolidation of B, A should
recognize its guarantee of B’s debt to the
third-party bank at its then fair value.
Although the terms of the guarantee have not changed,
the relationship between the guarantor, A, and the
subject of the guarantee, B, has been modified upon
the reduction in ownership, which occurred after
December 31, 20X2. Company A’s reduced ownership
interest in B and deconsolidation of B eliminates
the relationship between the parent and subsidiary.
Accordingly, A may no longer apply the scope
exception in ASC 460-10-25-1(g).
The example above
specifically applies to the deconsolidation of a subsidiary; however, the
same logic applies to a spin-off transaction, as highlighted in the example
below.
Example 5-22
Impact of a Spin-Off
Assume that Entity A is spinning off one of its
subsidiaries (Entity B) as an independent, publicly
traded company by distributing its equity interests
in B to A’s shareholders on a pro rata basis (i.e.,
B will no longer be a subsidiary of A). The
separation is accounted for as a spin-off
transaction at historically recorded amounts in
accordance with ASC 845-10-05-4 and ASC
845-10-30-10.
Further assume that before the
spin-off, various guarantee obligations are
established between the two entities. One example is
a guarantee to a landlord by A on behalf of B in
connection with a lease. Another example is a lease
obligation that cannot be legally assigned from A to
B but for which B will be responsible. For such
guarantees, B agrees to indemnify A for payments
made by A in accordance with such obligations.
Before the spin-off, the guarantees qualify for the
scope exception in ASC 460-10-25-1(g) and (h). (Note
that such guarantees would also represent guarantees
of an entity’s own future performance, since A
consolidated B.)
Both A and B would be required to
recognize their respective guarantee obligations
upon spin-off at fair value in accordance with the
recognition and measurement provisions of ASC 460.
Once the spin-off occurs, those guarantee
obligations no longer qualify for the scope
exceptions in ASC 460-10-25-1(g) or (h). Although
the terms of the guarantees have not changed, the
relationships between the guarantors and the
guaranteed parties have changed. That is, once the
spin-off occurs, the former parent entity, A, no
longer controls the resources of the spinnee, B, and
the entities operate as independent entities.
Although spin-off transactions are recorded at
historically recorded amounts, guarantee obligations
between the formerly related entities should be
recognized at fair value upon the spin-off in
accordance with ASC 460 given that the guarantee is
essentially created contemporaneously with the
spin-off and that the fair value can be reliably
determined.
These views are consistent with
those expressed in a speech by Eric West, associate chief accountant in the SEC’s Office of the Chief Accountant, at the 2007 AICPA Conference on Current SEC and PCAOB Developments. Specifically, Mr. West stated that the SEC staff believes that “the FIN 45
[codified as ASC 460] parent-subsidiary scope
exception applies only during the parent-subsidiary
relationship since the guarantee is not relevant to
the consolidated financial statements.”
Offsetting
Entry
Section 5.3.2.4
discusses the accounting for the offsetting entry
upon initial recognition of a guarantee liability.
Both guarantors conclude that the offsetting entry
(i.e., the debit) should be in equity.
ASC 460-10-25-4 specifies that the
“offsetting entry depends on the circumstances in
which the guarantee was issued.” As discussed in ASC
845-10-05-4, spin-off transactions are recorded as
nonreciprocal transfers between an enterprise and
its owners (i.e., as equity transactions). Both
guarantors consider that, given the facts and
circumstances of a spin-off accounted for at
historical cost (i.e., as an equity transaction),
the offsetting entry should be within equity.
Economically, the guarantees are
similar to other adjustments to the net assets
(either via adjustments to current assets or the
debt levels) included in the spin-off of B.
Therefore, recording the debit side of the entry for
the guarantee in equity is consistent with recording
what the entry would have been if the net assets
included in the spin-off were adjusted.
Subsequent
Accounting
Section 5.4
discusses the subsequent accounting for guarantee
liabilities. In this example, both guarantors
conclude that it would not be appropriate to release
the guarantee liability related to the noncontingent
liability to equity (i.e., where the offsetting
entry was recognized). ASC 460-10-35-1 specifies
that the liability that the guarantor initially
recognized would typically be reduced (by a credit
to earnings) since the guarantor is released from
risk under the guarantee. For example, both
guarantors might derecognize the liability ratably
over the remaining life of the lease, with a credit
to earnings. ASC 450-20 addresses the recognition
and subsequent accounting for any liability related
to the contingent loss for the guarantee.
As noted above (and further
described in Section
5.3.2), a parent company is required to consider the guidance
in ASC 450-20 in determining whether it needs to record in its stand-alone,
parent-only financial statements an estimated loss from a loss contingency
for its guarantee of its subsidiary’s debt under ASC 450-20-25. The example
below illustrates application of ASC 450-20-25.
Example 5-23
Determining When to Recognize a Liability for the
Guarantee of a Subsidiary’s Debt
On October 15, 20X4, Entity A purchases a controlling
interest in Investee B and consolidates B in A’s
consolidated financial statements. Entity A also
guarantees B’s third-party debt of $1 million. The
entire $1 million of debt is recognized in A’s
consolidated financial statements owing to A’s
controlling interest in B.
In preparing its stand-alone, parent-only financial
statements, A continually reassesses the guidance in
ASC 450 in each reporting period. On December 31,
20X5, A determines that (1) it is probable that B
will default on its debt in the future and (2) the
amount of the loss can be reasonably estimated. In
accordance with ASC 450-20-25-2, A should recognize
a liability in its stand-alone, parent-only
financial statements for its probable payment of B’s
debt. The amount of the liability is determined by
identifying the best estimate, or minimum amount
within a range, as indicated in ASC 450-20-30-1.
In a scenario in which an investment fund, in accordance with ASC 946-810,
does not consolidate a noninvestment company investee in which it has a
controlling interest, the fund nonetheless would apply the scope exception
in ASC 460-10-25-1(g) related to “[a] parent’s guarantee of its subsidiary’s
debt to a third party” with respect to a guarantee issued by the investment
fund for a debt that the noninvestment company investee owes to a third
party. This is because, even though the investment fund has not consolidated
the noninvestment company investee, the nature of their relationship is that
between a parent and its subsidiary. In this case, the investment fund
should consider the guidance in ASC 450-20-25 when determining whether a
loss contingency should be recorded for the guarantee of its investee’s
debt.
If an investment fund provides a guarantee in conjunction
with initially investing in a noninvestment company investee, it should
consider whether the unit of account represented by the transaction price
paid differs from the unit of account for the investment as subsequently
measured at fair value. Generally, it would be inappropriate to recognize a
gain in earnings as a result of (1) including the impact of the guarantee
when the investment is initially measured and (2) excluding the guarantee’s
impact when the investment is subsequently measured at fair value.
Note that the scope exception in ASC 460-10-25-1(g) applies
only to the recognition and measurement provisions of ASC 460. The
investment fund is still required to adhere to the disclosure requirements
in ASC 460 and the guidance on subsequent recognition and measurement in ASC
450.
5.3.1.3 Guarantees in Which the Obligation Is Not a Liability
ASC 480 requires (1) issuers to classify certain shares and share-settled
contracts as liabilities or, in some circumstances, as assets, and (2) SEC
registrants to classify certain redeemable equity instruments as temporary
equity. Certain contracts that an entity is not required to classify as a
liability (or asset) under ASC 480 are evaluated for classification within
equity in accordance with ASC 815-40. If a guarantee meets the indexation
and classification conditions in ASC 815-40 in such a way that it is
recognized within equity (e.g., a requirement to deliver a fixed number of
equity shares upon the occurrence of a specified event), the transaction is
not subject to the recognition and measurement requirements of ASC 460.
5.3.2 Guarantees Subject to the Recognition and Measurement Provisions of ASC 460
ASC 460-10
25-2 The issuance of a
guarantee obligates the guarantor (the issuer) in two
respects:
- The guarantor undertakes an obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur (the noncontingent aspect).
- The guarantor undertakes a contingent obligation to make future payments if those triggering events or conditions occur (the contingent aspect).
For guarantees that are not within the
scope of Subtopic 326-20 on financial instruments
measured at amortized cost, no bifurcation and no
separate accounting for the contingent and noncontingent
aspects of the guarantee are required by this Topic. For
guarantees that are within the scope of Subtopic 326-20,
the expected credit losses (the contingent aspect) shall
be measured and accounted for in addition to and
separately from the fair value of the guarantee (the
noncontingent aspect) in accordance with paragraph
460-10-30-5.
25-3 Because the issuance of
a guarantee imposes a noncontingent obligation to stand
ready to perform in the event that the specified
triggering events or conditions occur, the provisions of
Section 450-20-25 regarding a guarantor’s contingent
obligation under a guarantee should not be interpreted
as prohibiting a guarantor from initially recognizing a
liability for a guarantee even though it is not probable
that payments will be required under that guarantee.
Similarly, for guarantees within the scope of Subtopic
326-20, the requirement to measure a guarantor’s
expected credit loss on the guarantee should not be
interpreted as prohibiting a guarantor from initially
recognizing a liability for the noncontingent aspect of
a guarantee.
25-4 At the
inception of a guarantee, a guarantor shall recognize in
its statement of financial position a liability for that
guarantee. This Subsection does not prescribe a specific
account for the guarantor’s offsetting entry when it
recognizes a liability at the inception of a guarantee.
That offsetting entry depends on the circumstances in
which the guarantee was issued. See paragraph
460-10-55-23 for implementation guidance.
30-2 Except as indicated in
paragraphs 460-10-30-3 through 30-5, the objective of
the initial measurement of a guarantee liability is the
fair value of the guarantee at its inception. For
example:
- If a guarantee is issued in a standalone arm’s-length transaction with an unrelated party, the liability recognized at the inception of the guarantee shall be the premium received or receivable by the guarantor as a practical expedient.
- If a guarantee is issued as part of a transaction with multiple elements with an unrelated party (such as in conjunction with selling an asset), the liability recognized at the inception of the guarantee should be an estimate of the guarantee’s fair value. In that circumstance, a guarantor shall consider what premium would be required by the guarantor to issue the same guarantee in a standalone arm’s-length transaction with an unrelated party as a practical expedient.
- If a guarantee is issued as a contribution to an unrelated party, the liability recognized at the inception of the guarantee shall be measured at its fair value, consistent with the requirement to measure the contribution made at fair value, as prescribed in Section 720-25-30. For related implementation guidance, see paragraph 460-10-55-14.
Guarantees Not
Within the Scope of Subtopic 326-20
30-3 In the event that, at
the inception of the guarantee, the guarantor is
required to recognize a liability under Section
450-20-25 for the related contingent loss, the liability
to be initially recognized for that guarantee shall be
the greater of the following:
- The amount that satisfies the fair value objective as discussed in the preceding paragraph
- The contingent liability amount required to be recognized at inception of the guarantee by Section 450-20-30.
30-4 For many
guarantors, it would be unusual at the inception of the
guarantee for the contingent liability amount under (b)
in the preceding paragraph to exceed the amount that
satisfies the fair value objective under (a) in the
preceding paragraph. An example of that unusual
circumstance is a guarantee for which, at inception,
there is a high (probable) likelihood that the guarantor
will be required to pay the maximum potential settlement
at the end of the six-month term and a low likelihood
that the guarantor will not be required to make any
payment at the end of the six-month term. The amount
that satisfies the fair value objective would include
consideration of the low likelihood that no payment will
be required, but the accrual of the contingent loss
under Section 450-20-30 would be based solely on the
best estimate of the settlement amount whose payment is
probable (the maximum potential settlement amount in
this case). This example is considered to be an unusual
circumstance because of the high likelihood at inception
that the maximum potential settlement amount will be
paid, resulting in a substantial initial fair value for
that guarantee. Another example in which the contingent
liability amount required to be recognized under (b) in
the preceding paragraph exceeds the fair value at
inception under (a) in the preceding paragraph would
involve an undiscounted accrual under Subtopic 450-20
for a guarantee payment that is expected to occur many
years in the future.
Guarantees Within
the Scope of Subtopic 326-20
30-5 At the inception of a
guarantee within the scope of Subtopic 326-20 on
financial instruments measured at amortized cost, the
guarantor is required to recognize both of the following
as liabilities:
- The amount that satisfies the fair value objective in accordance with paragraph 460-10-30-2
- The contingent liability related to the expected credit loss for the guarantee measured under Subtopic 326-20.
An entity that issues a guarantee obligates itself to the
guaranteed party in two ways: (1) a noncontingent stand-ready obligation and (2)
a contingent obligation. The noncontingent liability represents the guarantor’s
obligation to stand ready to perform under the guarantee in the event of the
occurrence of the event or condition specified in the terms of the guarantee.
The contingent obligation represents the liability for the future payments if
the event or condition specified in the terms of the guarantee occurs.
ASC 460 explains the distinction between the contingent and
noncontingent aspects of a guarantee obligation to clarify that a guarantor is
required to recognize a liability at the inception of a guarantee within the
scope of ASC 460’s recognition and measurement guidance even if a loss on the
contract is not probable. If a guarantee is not a freestanding transaction with
a separate premium (i.e., it is embedded in a sales contract or other
agreement), the failure to recognize a liability may result in an overstatement
of the related income statement impact of the transaction. ASC 460 addresses
this issue by requiring an entity to record a liability for the stand-ready
obligation component of a guarantee.
5.3.2.1 Noncontingent Liability
For guarantee arrangements that are within the scope of ASC 460’s recognition
and measurement guidance, the guarantor is required to record a liability
for the stand-ready component of the guarantee at the inception of the
guarantee arrangement. The overall principle in ASC 460 is that the
guarantee liability should be initially recognized at fair value.
As noted in Section 5.1, one of the objectives in
ASC 460 is to achieve comparability of financial reporting for guarantees
irrespective of whether they are issued in return for a separately
identified premium. Even if there is no explicit payment or premium
receivable at the inception of a guarantee arrangement, the guarantor is
still required to stand ready to perform over the term of the arrangement
and, therefore, a liability should be recognized. The guarantee liability
recognized at inception generally represents unearned income for standing
ready to perform, which, as discussed in Section 5.4, will be reduced by a
credit to earnings as the guarantor is released from risk under the
guarantee.2
The liability that a guarantor incurs upon issuing a
guarantee should be initially recognized at fair value regardless of the
probability that the guarantor will be required to transfer assets or
provide services to satisfy its guarantee obligation. A stand-ready
obligation is a type of liability even though it may not result in the
eventual transfer of cash or other assets. For example, assume that Entity A
issues a guarantee to pay Entity C upon Entity B’s default on an obligation
that B has to C. Upon issuing the guarantee, A does not believe that B’s
default is probable; thus, it is not probable that the event that would
trigger payment will occur. Regardless of whether A received a separately
identified premium at the inception of the guarantee as consideration for
entering into this obligation, A has a contractual obligation to stand ready
to make payments to C upon B’s default. For A to extinguish its contractual
obligation, it would have to make a payment to another party to step into
its legal obligation to stand ready to perform in the event that B defaults.
Accordingly, upon issuing the guarantee, A has a liability to stand ready to
perform or to make a payment to a third party to exit this obligation. The
fact that A would have to pay another party to exit the obligation serves as
evidence of the liability’s existence.
ASC 460 describes the two aspects of a guarantee,
emphasizing that the guidance in ASC 450-20 on loss contingencies does not
prohibit the recognition of a liability arising from the issuance of a
guarantee. If entities considered guarantees as representing only contingent
liabilities, there often would be no recognition at issuance because it
would not be probable that the event or condition that triggers the
guarantor’s performance would occur.
ASC 460 contains additional discussion of the initial recognition of a
guarantee obligation.
ASC 460-10
55-21 In many
cases, the one-time premium received by a guarantor
for issuing a guarantee will be an appropriate
practical expedient for the initial measurement of
the guarantee obligation (see paragraph
460-10-30-2[a]). However, if a one-time premium is
specified for a guarantee that is issued in
conjunction with another transaction (such as the
sale of assets by the guarantor), the specified
premium may not be an appropriate initial
measurement of the guarantor’s liability because the
amount specified as being applicable to the
guarantee may or may not be its fair value (see
paragraph 460-10-30-2[b]).
55-22 In accordance with
paragraph 460-10-30-2, a liability shall be
recognized at the inception of the guarantee even if
the guarantor does not receive a separately
identified premium when it issues the guarantee. For
example, in conjunction with the cash sale of
equipment to a customer, a manufacturer may issue to
its customer’s bank a guarantee of the customer’s
loan for which the proceeds are used to pay for the
equipment. There is no separately identified premium
for the guarantee, although the sales arrangement
may impound an implicit premium. The manufacturer
may simply view the guarantee as an accommodation to
its customer. The seller-guarantor has incurred an
obligation identical to the obligation it would
incur if it required its customer to pay an explicit
premium for the guarantee. Thus, the
seller-guarantor shall immediately recognize a
liability for its obligations under a newly issued
guarantee, even if a separately identified premium
was not received. If an entity guaranteed a
customer’s bank loan purely as an accommodation to
an important longstanding customer, unrelated to a
specific transaction, the liability for the entity’s
obligations under the guarantee should be
recognized.
The general principle in ASC 460 is that a guarantee obligation should be
initially recognized at fair value. ASC 820 defines fair value as “[t]he
price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date.” Under ASC 820, fair value represents a measurement based
on an exit price — that is, the price that would be received to sell an
asset or paid to transfer a liability. Initially measuring a guarantee at
fair value in accordance with ASC 820’s exit price notion is consistent with
the objective in ASC 460 to determine the amount of consideration a
guarantor would have to pay another party to step into the guarantor’s
stand-ready obligation to perform under the terms of a guarantee.
Connecting the Dots
The fair value of a guarantee obligation will be affected by the
nonperformance risk (e.g., credit risk) of the guarantor. However,
this does not mean that the guarantor qualifies for the recognition
exception that applies to guarantees of an entity’s own
performance.
Although the initial measurement objective for guarantees
recognized under ASC 460 is fair value, ASC 460-10-30-2(a) contains a
practical expedient that allows a guarantor to use the premium received or
receivable as its initial measurement for a guarantee issued in a
stand-alone, arm’s-length transaction. Such measurement represents an entry
price rather than an exit price. As discussed in Section 9.1 of Deloitte’s Roadmap
Fair Value
Measurements and Disclosures (Including the Fair Value
Option), an entry price (i.e., the transaction price) and
an exit price are not always the same. Nevertheless, ASC 460 contains a
practical expedient that allows for initial measurement on the basis of an
entry price.
A guarantee issued as part of a multiple-element arrangement
may be more difficult to measure than one in which a separate premium is
received, but the guidance in ASC 460-10-30-2(b) indicates that a guarantor
should consider the premium that would have been received for the same
guarantee if it were issued in a stand-alone transaction. While the
measurement examples in both ASC 460-10-30-2(a) and (b) represent an entry
price rather than an exit price (which is required for fair value
measurements), the guidance indicates that an entry price may be used as a
practical expedient to achieve the fair value measurement objective. For
further discussion of the interaction of this practical expedient and fair
value under ASC 820, see Section 2.3.4 of Deloitte’s Roadmap Fair Value Measurements and
Disclosures (Including the Fair Value Option).
5.3.2.2 Contingent Liability — Guarantees Within the Scope of ASC 326-20
Some financial guarantees are also within the scope of ASC
326-20.3 For a guarantee that is within the scope of ASC 326-20, the guarantor
must recognize the amount that meets the fair value objective of the
guarantee (as described in Section 5.3.2.1) as well as a liability related to the
expected credit losses on the guarantee.
Example 5-24
Guarantee Within
the Scope of ASC 326-20
Company A sells medical equipment to Hospital H for
$100 million. Hospital H pays for the medical
equipment by taking out a loan with Bank B. As part
of the sale transaction, A provides a guarantee of
the repayment of H’s loan to B. Company A determines
that the initial fair value of the guarantee is $5
million. Company A should record the following entry
related to the sale and the stand-ready obligation
associated with the guarantee:
In addition, A must separately record a liability for
the expected credit losses on the guarantee. Company
A determines that the current expected credit loss
in accordance with ASC 326-20 is $2 million.
Therefore, A will recognize the following additional
entry:
5.3.2.3 Contingent Liability — Guarantees Not Within the Scope of ASC 326-20
A guarantor assumes the risk
that it will need to perform under a guarantee. In an arm’s-length
transaction between unrelated parties, a guarantor would be expected to
charge a premium, either separately or embedded within the purchase price of
a multiple-element contract. That premium is expected to be commensurate
with the amount of risk incurred. It would be unusual for a guarantor to
charge a premium that is less than the amount that is probable to be paid
under the contract as of its inception date. Accordingly, for guarantees
that are not within the scope of ASC 326-20, entities often only recognize
the fair value of the obligation at the inception of a guarantee; they
generally do not recognize an amount for the contingent liability component
as of that date. If, however, an entity does consider that, at the inception
of a guarantee, it is probable (according to ASC 450-20-25-2) that it will
have to perform in accordance with the contingent aspect of the guarantee,
the entity should recognize the larger of (1) the fair value of the
guarantee or (2) the contingent liability.
ASC 460-10-30-4 acknowledges
that it would be unusual at the inception of the guarantee for the
contingent liability measured in accordance with the principles of ASC 450
to be greater than the fair value estimate.
ASC 460-10
30-4 For many
guarantors, it would be unusual at the inception of
the guarantee for the contingent liability amount
under (b) in the preceding paragraph to exceed the
amount that satisfies the fair value objective under
(a) in the preceding paragraph. An example of that
unusual circumstance is a guarantee for which, at
inception, there is a high (probable) likelihood
that the guarantor will be required to pay the
maximum potential settlement at the end of the
six-month term and a low likelihood that the
guarantor will not be required to make any payment
at the end of the six-month term. The amount that
satisfies the fair value objective would include
consideration of the low likelihood that no payment
will be required, but the accrual of the contingent
loss under Section 450-20-30 would be based solely
on the best estimate of the settlement amount whose
payment is probable (the maximum potential
settlement amount in this case). This example is
considered to be an unusual circumstance because of
the high likelihood at inception that the maximum
potential settlement amount will be paid, resulting
in a substantial initial fair value for that
guarantee. Another example in which the contingent
liability amount required to be recognized under (b)
in the preceding paragraph exceeds the fair value at
inception under (a) in the preceding paragraph would
involve an undiscounted accrual under Subtopic
450-20 for a guarantee payment that is expected to
occur many years in the future.
Example 5-25
Contingent
Liability Exceeds Fair Value at Inception
Company A engages Company B to perform certain duties
on behalf of A as part of a 10-year contract.
Company A indemnifies B for third-party damage
claims and lawsuits that could be filed against B in
performing the contracted services over the course
of the long-term contract.
The indemnification contingently
requires A to make a payment to B on the basis of
changes in a contingent liability of B. This
indemnification possesses the characteristics in ASC
460-10-15-4(c) and therefore is within the scope of
ASC 460.
Company A determines that the
probable loss is $10 million, which is payable after
the end of the contract. As discussed in Section
2.4.3.1, contingent liabilities are
rarely discounted; thus, the liability under ASC
450-20 is $10 million. Company A may calculate the
fair value of the guarantee by using the same
projected cash flows, discounted back to present
value. Because the fair value measurement reflects
the time value of money but the contingent liability
does not, the liability calculated in accordance
with ASC 450-20 is greater than the amount of the
guarantee determined by using fair value.
5.3.2.4 Offsetting Entry
As noted in ASC 460-10-25-4,
ASC 460 does not prescribe a specific offsetting entry upon the initial
recognition of a guarantee obligation; the offsetting entry will depend on
the facts and circumstances. ASC 460-10-55-23 gives examples of a
guarantor’s offsetting entries for different guarantee arrangements:
|
Transaction Type
|
Offsetting Entry
|
|---|---|
|
Guarantee is issued in a stand-alone transaction for
a premium (i.e., for separate consideration
received) (ASC 460-10-55-23(a))
|
Consideration received (e.g., cash or a
receivable).
|
|
Guarantee is issued in conjunction with the sale of
assets, a product, or a business (ASC
460-10-55-23(b))
|
The overall proceeds (such as the
cash received or receivable) would be allocated
between the consideration being remitted to the
guarantor for issuing the guarantee and the proceeds
from the sale.
|
|
Guarantee is issued in conjunction with the formation
of a partially owned business or a venture accounted
for under the equity method (ASC
460-10-55-23(c))
|
Recognition of the liability for the guarantee would
result in an increase to the carrying amount of the
investment.
|
|
Guarantee is issued to an unrelated party for no
consideration on a stand-alone basis (ASC
460-10-55-23(e))
|
Expense.
|
SAB Topic 5.E provides interpretive guidance on the
accounting for divestiture of a subsidiary or other business operation when
a guarantee is issued in conjunction with such a transaction. This guidance
further expands on the ASC 460 implementation guidance related to guarantees
issued in conjunction with the sale of assets, a product, or a business and
would also apply to entities that are not SEC registrants. SAB Topic 5.E
states the following:
Facts: Company X transferred
certain operations (including several subsidiaries) to a group of
former employees who had been responsible for managing those
operations. Assets and liabilities with a net book value of
approximately $8 million were transferred to a newly formed entity —
Company Y — wholly owned by the former employees. The consideration
received consisted of $1,000 in cash and interest bearing promissory
notes for $10 million, payable in equal annual installments of $1
million each, plus interest, beginning two years from the date of
the transaction. The former employees possessed insufficient assets
to pay the notes and Company X expected the funds for payments to
come exclusively from future operations of the transferred business.
Company X remained contingently liable for performance on existing
contracts transferred and agreed to guarantee, at its discretion,
performance on future contracts entered into by the newly formed
entity. Company X also acted as guarantor under a line of credit
established by Company Y.
The nature of Company Y’s business was such that
Company X’s guarantees were considered a necessary predicate to
obtaining future contracts until such time as Company Y achieved
profitable operations and substantial financial independence from
Company X.
Question: If deconsolidation of the
subsidiaries and business operations is appropriate, can Company X
recognize a gain?
Interpretive Response:
Before recognizing any gain, Company X should identify all of the
elements of the divesture arrangement and allocate the consideration
exchanged to each of those elements. In this regard, we believe that
Company X would recognize the guarantees at fair value in accordance
with FASB ASC Topic 460, Guarantees; the contingent liability for
performance on existing contracts in accordance with FASB ASC Topic
450, Contingencies; and the promissory notes in accordance with FASB
ASC Topic 310, Receivables, and FASB ASC Topic 835, Interest.
ASC 460-10-55-23(b) does not
explicitly distinguish between the sale of services and the sale of assets;
therefore, the concepts are considered the same, as illustrated in the
example below.
Example 5-26
Guarantee Issued
in Connection With a Service Contract
A company provides management
services for a group of hotels to be constructed and
owned by an unrelated master limited partnership
(MLP). The management contract is exclusive for a
five-year term and specifies the company’s annual
fixed fee as well as an annual contingent fee that
is based on operating cash flows at the hotels. In
connection with obtaining the contract, the company
agrees to provide a guarantee of mezzanine debt to
be issued by the MLP for the funding of the hotel
construction. The debt has scheduled principal
repayment on a straight-line basis over five
years.
The company has determined that it should recognize a
liability for the guarantee separately and apart
from the management agreement at inception of the
arrangement (see ASC 460-10-30-2(b)). The amount of
the liability recognized is an estimate of the fair
value of the guarantee.
ASC 460-10-55-23 gives examples of
various circumstances and the appropriate offsetting
entries. ASC 460-10-55-23(b) states:
If the guarantee were issued in
conjunction with the sale of assets, a product, or
a business, the overall proceeds (such as the cash
received or receivable) would be allocated between
the consideration being remitted to the guarantor
for issuing the guarantee and the proceeds from
the sale. That allocation would affect the
calculation of the gain or loss on the sale
transaction.
The company should allocate the
total expected fees during the five-year service
agreement between collection of the premium for
issuing the guarantee and the future services to be
provided. The offset to the guarantee liability at
inception is a receivable equal to the fair value of
the expected fees to be received for issuing the
guarantee. When the company receives payments from
the MLP in connection with the contract, the cash
flow allocated to the guarantee premium should be
credited to the asset previously recognized upon
inception of the guarantee. The asset would be
accreted up to the amount of cash to be received,
resulting in recognition of interest income. The
amount of service revenue the company would record
over the course of the agreement would be reduced by
the amount of the proceeds initially allocated to
the premium for the debt guarantee and by the
related accretion of interest.
Additional
Fact
At the end of the third year, the
debt is retired early because of
better-than-expected cash flows at the MLP.
Subsequent
Accounting at the End of Year 3
At the time of the debt’s
extinguishment, the remaining balance of the
guarantee liability should be recognized immediately
in income because the specific guarantee no longer
exists. The accounting for the receivable should not
change because of the extinguishment of the debt as
long as the management agreement itself is not
terminated. The receivable should not be written off
as an offset to the extinguishment of the guarantee
liability since the receivable is still collectible.
The company has essentially financed its receipt of
the premium for writing the guarantee over a period
longer than the actual life of the guarantee.
Certain guarantee transactions may not be addressed by the
examples in ASC 460-10-55-3. In these situations, the guarantor will need to
use judgment to determine the offsetting entry. Just because a guarantor
does not receive a separately identified payment for entering into a
guarantee does not mean that the guarantee was issued for no consideration.
In some transactions, it may be appropriate to recognize an asset other than
cash or a receivable. Example 5-9 illustrates an entity’s determination that the
offsetting entry upon initial recognition should be an asset. Although not a
specific example in ASC 460-10-55-23, the recognition of the offsetting
entry in equity may be appropriate in certain transactions. See Example 5-22 for an
illustration.
ASC 460-10-55-23(c) provides guidance on the offsetting
entry that a guarantor would record when a guarantee is issued in
conjunction with the formation of a partially owned business or a venture
accounted for under the equity method. See Section 4.2.1 of Deloitte’s Roadmap
Equity Method
Investments and Joint Ventures for additional
discussion and examples. In addition, Section 5.2.1 of that same Roadmap
discusses the offsetting entry that would be recorded when a guarantee is
issued in connection with an entity’s investment in a joint venture but that
guarantee was not contemplated or required by the formation documents.
Footnotes
2
Under ASC 606-10-15-2(d), guarantees (other than
product or service warranties) that are within the scope of ASC 460
are outside the scope of ASC 606.
3
See Chapter 2 of Deloitte’s
Roadmap Current
Expected Credit Losses for additional
discussion of the scope of ASC 326-20.
5.4 Subsequent Measurement
ASC 460 does not provide specific guidance on how to account for the guarantees after
issuance. Rather, if an entity does not elect the fair value option for the
guarantee, the entity would apply an overarching principle in the guidance under
which it would release the initial liability to income (by a credit to earnings) as
the guarantor is released from risk under the guarantee; the remaining contingent
aspect should be accounted for in accordance with ASC 450-20.
ASC 460-10
35-1
This Subsection does not describe in detail how the
guarantor’s liability for its obligations under the
guarantee would be measured after its initial recognition.
The liability that the guarantor initially recognized under
paragraph 460-10-25-4 would typically be reduced (by a
credit to earnings) as the guarantor is released from risk
under the guarantee.
35-2
Depending on the nature of the guarantee, the guarantor’s
release from risk has typically been recognized over the
term of the guarantee using one of the following three
methods:
- Only upon either expiration or settlement of the guarantee
- By a systematic and rational amortization method
- As the fair value of the guarantee changes.
Although those three methods are currently being used in
practice for subsequent accounting, this Subsection does not
provide comprehensive guidance regarding the circumstances
in which each of those methods would be appropriate. A
guarantor is not free to choose any of the three methods in
deciding how the liability for its obligations under the
guarantee is measured subsequent to the initial recognition
of that liability. A guarantor shall not use fair value in
subsequently accounting for the liability for its
obligations under a previously issued guarantee unless the
use of that method can be justified under generally accepted
accounting principles (GAAP). For example, fair value is
used to subsequently measure guarantees accounted for as
derivative instruments under Topic 815.
35-3 Paragraph
superseded by Accounting Standards Update No. 2016-13.
35-4 The discussion in
paragraph 460-10-35-2 about how a guarantor typically
reduces the liability that it initially recognized does not
encompass the recognition and subsequent adjustment of the
contingent liability related to the contingent loss for the
guarantee. The contingent aspect of the guarantee shall be
accounted for in accordance with Subtopic 450-20 unless the
guarantee is accounted for as a derivative instrument under
Topic 815 or the guarantee is within the scope of Subtopic
326-20 on financial instruments measured at amortized cost.
For guarantees within the scope of Subtopic 326-20, the
expected credit losses (the contingent aspect) of the
guarantee shall be accounted for in accordance with that
Subtopic in addition to and separately from the fair value
of the guarantee liability (the noncontingent aspect)
accounted for in accordance with paragraph 460-10-30-5.
5.4.1 Subsequent Accounting for Noncontingent Aspect of Guarantee
An entity cannot freely choose to elect one of the three methods in ASC
460-10-35-2 to subsequently account for the liability recognized upon issuance
of a guarantee. Instead, a guarantor should choose the method that is
appropriate given the particular facts and circumstances related to each
individual guarantee. Irrespective of the method it chooses, the entity should
document and consistently apply the method for similar guarantees throughout the
term of each guarantee. Often, a systematic and rational amortization method is
appropriate. At the 2003 AICPA Conference on Current SEC Developments, the SEC
staff stated the following:
So what do we believe the appropriate “day two” accounting for the
obligation to stand ready would be? . . . It would seem a systematic and
rational amortization method would most likely be the appropriate
accounting.
Examples 5-9, 5-22, and 5-27 illustrate how an entity might account for the guarantee
liability in periods after initial measurement.
For some guarantees, an entity is required or permitted to use fair value as the
subsequent-measurement attribute:
- Subsequent measurement at fair value is required for a guarantee that meets the definition of a derivative and is within the scope of ASC 815-10.
- For a guarantee that meets the definition of a financial instrument or that is otherwise within the scope of the guidance in ASC 825-10 on the fair value option, an entity is permitted to elect fair value as the subsequent-measurement attribute. However, an entity cannot justify fair value as the subsequent-measurement attribute solely on the basis of ASC 460-10-35-2, which indicates that for some guarantees, the release from risk changes as the fair value of the guarantee changes. ASC 460-10-35-2 specifies that a “guarantor shall not use fair value in subsequently accounting for the liability for its obligations under a previously issued guarantee unless the use of that method can be justified under [GAAP].” Therefore, a fair value election is appropriate only if it conforms to the guidance in ASC 825-10. See Chapter 12 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option) for additional discussion of the eligibility and application of the fair value option.
5.4.2 Subsequent Accounting for the Contingent Aspect of a Guarantee
The discussion in ASC 460-10-35-2 about how a guarantor
typically reduces the liability that it initially recognized does not encompass
the recognition and subsequent adjustment of the liability related to the
contingent loss on the guarantee. The subsequent measurement of the contingent
liability, if any, is measured in accordance with ASC 450-20 unless the
guarantee is subsequently measured at fair value through earnings (or is within
the scope of ASC 326-20). The ASC 450-20 liability is subsequently measured on
the basis of facts and circumstances specific to the contingency, and the
related loss is recognized in earnings.
5.4.2.1 Subsequent Accounting for Guarantees Within the Scope of ASC 326-20
The contingent aspect of a
guarantee that is within the scope of ASC 326-20 is accounted for separately
from the initial recognized liability in accordance with the expected credit
loss model.
Example 5-27
Guarantee Within the Scope of ASC
326-20
Assume the same facts as in
Example 5-24. Further assume that the
guaranteed loan has a term of three years and that
A’s systematic and rational method for subsequent
measurement of the initial obligation is to amortize
the liability over the life of the loan, given that
H makes monthly payments of principal and interest.
Company A’s expected credit losses as of the end
date of each reporting period are as follows:
- End of year 1 — $3 million.
- End of year 2 — $1 million.
- End of year 3 — $0 million.
Company A will record the following
subsequent-accounting entries:
End of year
1
End of year
2
End of year
3
In this example, since no amount was
ultimately paid on the guarantee, the expected loss
reverts to zero as of the end of the term of the
guarantee.
5.4.2.2 Subsequent Accounting for Guarantees Not Within Scope of ASC 326-20
Neither ASC 460-10 nor ASC 450-20 provides explicit guidance
on the interaction between those subtopics after initial recognition.
Accordingly, entities should establish a systematic and rational method that
is supportable for the subsequent accounting. In establishing that method,
entities may look to analogous guidance, such as ASC 605-20-25-6, ASC
606-10, ASC 942-825-50-2, and ASC 944. Irrespective of the method it
chooses, the entity should document and consistently apply the method for
similar guarantees throughout the term of each guarantee. Further, the
entity should consider the nature of its operations and the specific terms
of the guarantee to ensure that the method is appropriate on the basis of
the facts and circumstances of the guarantee. Two possible methods of
determining the amount of an ASC 450-20 liability to record are discussed
below.
5.4.2.2.1 Method 1 — Incremental Recognition of the ASC 450-20 Contingent Liability
After the initial recognition, an entity would record a separate ASC
450-20 liability only when the entire estimated ASC 450-20 amount
exceeds the unamortized ASC 460 liability. The ASC 450-20 liability
equals the excess of the entire estimated probable obligation over (1)
the unamortized ASC 460 liability or (2) the expected unamortized ASC
460 liability at the time of the expected payment. In subsequent
periods, the ASC 450-20 liability may need to be adjusted so that it
continues to equal the excess of the entire estimated probable
obligation over the unamortized ASC 460 liability.
5.4.2.2.2 Method 2 — Gross Recognition of the ASC 450-20 Liability
Under this method, after the initial recognition and measurement of the
guarantee, an entity would record a separate ASC 450-20 liability for
the entire amount of the estimated probable obligation. The entity would
continue to amortize the ASC 460 liability in accordance with its
established policy until it is released from its obligation to stand
ready. This approach is similar to the approach required for guarantees
within the scope of ASC 326-20 although the contingent loss is measured
in accordance with ASC 450-20 rather than under the expected credit loss
model.
Note that this guidance does not apply to guarantees that meet the
definition of a derivative or are otherwise recognized at fair value. If
a guarantee meets the definition of a derivative or is otherwise
subsequently accounted for at fair value, both the stand-ready
obligation and contingent obligation of the guarantee should be treated
as a single unit of account, with subsequent changes in fair value of
the guarantee recorded in earnings for the period in which the changes
occur.
The example below
illustrates the two different methods discussed above.
Example 5-28
Contingent
Liability — Incremental Versus Gross
Recognition
Entity B is seeking to borrow $20 million for a
term of five years from Bank C; however, C will
not issue such proceeds to B without a third-party
guarantee. On January 1, 20X1, B pays Entity A $1
million as a separately identified premium in
exchange for A’s issuance to C of a guarantee
stating that, in the event of B’s default, A will
step in and make all remaining scheduled payments.
Also, on January 1, 20X1, C loans Entity B $20
million. The loan calls for equal monthly payments
of principal and interest during the five-year
term.
Upon initial recognition of the guarantee
obligation, A applies ASC 460-10-30-2(a) and
recognizes the $1 million cash received with a
corresponding guarantee liability.
As of each reporting period through September 30,
20X3, A assesses the probability of B’s default
(i.e., the event that would require A to make some
or all of B’s remaining payments to C) and
concludes that it is not probable that B will
default. However, during the fourth quarter of
20X3, a severe decrease in demand for B’s main
product occurred, as a result of which A concluded
that it is probable that it will be required to
pay C for B’s payments due in 20X4 and 20X5.
Entity B can make the contractually required
payments through December 31, 20X3. Assume that
the total amount of the remaining payments after
December 31, 20X3, is $10 million.
The two examples below illustrate how A’s
accounting would differ depending on which method
is applied to the subsequent accounting for the
contingent aspect of the guarantee.
Subsequent
Entries:
December
31, 20X1
No entry is required for the ASC
450 contingent liability because a loss is not
probable.
December
31, 20X2
No entry is required for the ASC
450 contingent liability because a loss is not
probable.
December
31, 20X3
Incremental
Recognition
Gross Recognition
Note that after these two
entries, there remains $400,000 of the guarantee
liability for the unamortized portion of the
stand-ready obligation. It would be acceptable for
that amount to also be recognized immediately into
income since the full amount of the guarantee has
been recognized as a contingent liability.
5.5 Disclosure Requirements
This section discusses the disclosure
requirements in ASC 460.
The requirements in ASC 460-10-50-2 through 50-4 apply to guarantees,
including guarantees that are outside the scope of ASC 460-10-15-4; however, they do not
apply to the guarantees described in ASC 460-10-15-7.
ASC 460-10
50-1 The requirements in paragraphs
460-10-50-2 through 50-4 apply to guarantees, including
guarantees that are outside the scope of paragraph 460-10-15-4;
however, they do not apply to guarantees described in paragraph
460-10-15-7.
50-2 An entity
shall disclose certain loss contingencies even though the
possibility of loss may be remote. The common characteristic of
those contingencies is a guarantee that provides a right to
proceed against an outside party in the event that the guarantor
is called on to satisfy the guarantee. Examples include the
following:
- Guarantees of indebtedness of others, including indirect guarantees of indebtedness of others
- Obligations of commercial banks under standby letters of credit
- Guarantees to repurchase receivables (or, in some cases, to repurchase the related property) that have been sold or otherwise assigned
- Other agreements that in substance have the same guarantee characteristic.
50-3 The disclosure
shall include the nature and amount of the guarantee.
Consideration should be given to disclosing, if estimable, the
value of any recovery that could be expected to result, such as
from the guarantor’s right to proceed against an outside
party.
50-4 A guarantor shall disclose all
of the following information about each guarantee, or each group
of similar guarantees, even if the likelihood of the guarantor’s
having to make any payments under the guarantee is remote:
- The nature of the guarantee, including
all of the following:
- The approximate term of the guarantee
- How the guarantee arose
- The events or circumstances that would require the guarantor to perform under the guarantee
- The current status (that is, as of the date of the statement of financial position) of the payment/performance risk of the guarantee (for example, the current status of the payment/performance risk of a credit-risk-related guarantee could be based on either recently issued external credit ratings or current internal groupings used by the guarantor to manage its risk)
- If the entity uses internal groupings for purposes of item (a)(4), how those groupings are determined and used for managing risk.
- All of the following information about
the maximum potential amount of future payments under
the guarantee:
- The maximum potential amount of future payments (undiscounted) that the guarantor could be required to make under the guarantee, which shall not be reduced by the effect of any amounts that may possibly be recovered under recourse or collateralization provisions in the guarantee (which are addressed under (d) and (e))
- If the terms of the guarantee provide for no limitation to the maximum potential future payments under the guarantee, that fact
- If the guarantor is unable to develop an estimate of the maximum potential amount of future payments under its guarantee, the reasons why it cannot estimate the maximum potential amount.
- The current carrying amount of the liability, if any, for the guarantor’s obligations under the guarantee (including the amount, if any, recognized under Section 450-20-30 or Subtopic 326-20 on financial instruments measured at amortized cost), regardless of whether the guarantee is freestanding or embedded in another contract
- The nature of any recourse provisions that would enable the guarantor to recover from third parties any of the amounts paid under the guarantee
- The nature of any assets held either as collateral or by third parties that, upon the occurrence of any triggering event or condition under the guarantee, the guarantor can obtain and liquidate to recover all or a portion of the amounts paid under the guarantee
- If estimable, the approximate extent to which the proceeds from liquidation of assets held either as collateral or by third parties would be expected to cover the maximum potential amount of future payments under the guarantee.
See the Product Warranties Subsection of Section
460-10-50 for an exception to the requirements of (b).
50-5 The disclosures required by
this Subsection do not eliminate or affect the following
disclosure requirements:
- The requirements in the General Subsection of Section 825-10-50 that certain entities disclose the fair value of their financial guarantees issued
- The requirements in paragraphs 450-20-50-3 through 50-4 that an entity disclose a contingent loss that has a reasonable possibility of occurring
- The requirements in the Disclosure Sections of Topic 815, which apply to guarantees that are accounted for as derivatives
- The requirements in Section 275-10-50 that an entity disclose information about risks and uncertainties that could significantly affect the amounts reported in the financial statements in the near term. See Example 1 (paragraph 460-10-55-25) for an illustration of the required disclosure.
- The requirements in Section 326-20-50 that an entity disclose information on the measurement of credit loss.
In addition to the disclosure requirements for contingencies and
uncertainties in ASC 275 that are discussed in Section 2.8, ASC 275-10-50-15(j) contains
incremental guarantee-related disclosure requirements related to estimates that are
particularly sensitive to changes in the near term. These requirements are illustrated
in ASC 460-10-55-25 through 55-27.
ASC 460-10
55-25 This Example
illustrates the disclosure required by paragraph 275-10-50-15(j)
of the potential near-term effect of a change in estimate of a
contingent liability resulting from the guarantee of the debt of
another entity. Entity A’s loss of customers causes the
potential for a near-term material change in that estimate
within the next fiscal year. Although disclosure of Entity A’s
ongoing efforts to replace those customers is not required, this
additional information may be presented.
55-26 Entity
A operates a shipping center in Local City. In 19X0, Entity A
decided to raise money for modernization of facilities through a
debt offering. In order for the offering to take place, Entity
B, a local manufacturer, agreed to guarantee the bonds if Entity
A’s revenues were insufficient to pay debt service. In May 19X4
(four years later when the bonds had an outstanding balance of
$55 million), Entity A lost two of its major shipping customers,
constituting 35 percent of its prior-year revenues, to a
competitor in a neighboring port. At Entity B’s June 30, 19X4,
year end, Entity A was directing substantial efforts toward
finding new customers. It is reasonably possible, however, that
Entity A will not replace the lost revenue in time to pay debt
service installments at December 30, 19X4, and June 30, 19X5,
totaling $6 million.
55-27 Entity B
would make the following disclosure.
In 19X0, Entity B guaranteed the Series AA
debt of Entity A, which operates a shipping center within Local
City. Entity B continues as guarantor of such debt totaling $55
million. In May 19X4, Entity A lost two of its major customers.
Although Entity A is directing substantial efforts toward
obtaining new customers, it is at least reasonably possible that
Entity A will not replace lost revenues sufficient to make its
December 19X4 and June 19X5 debt service payments totaling $6
million. If so, Entity B will become responsible for repayment
of at least a portion of that amount and possibly additional
amounts over the debt term. A liability of $XX has been reported
in Entity B’s financial statements pending the outcome of Entity
A’s efforts during the next fiscal year.
5.5.1 Guarantees Issued by Related Parties
ASC 460 requires disclosures that are incremental to
those in ASC 850.
ASC 460-10
50-6 Some
guarantees are issued to benefit entities that are related
parties such as joint ventures, equity method investees, and
certain entities for which the controlling financial
interest cannot be assessed by analyzing voting interests.
In those cases, the disclosures required by this Topic are
incremental to the disclosures required by Topic 850.
ASC 850-10
50-1 Financial
statements shall include disclosures of material related
party transactions, other than compensation arrangements,
expense allowances, and other similar items in the ordinary
course of business. However, disclosure of transactions that
are eliminated in the preparation of consolidated or
combined financial statements is not required in those
statements. The disclosures shall include:
- The nature of the relationship(s) involved
- A description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements
- The dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period
- Amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement
- The information required by paragraph 740-10-50-17.
50-6 If the
reporting entity and one or more other entities are under
common ownership or management control and the existence of
that control could result in operating results or financial
position of the reporting entity significantly different
from those that would have been obtained if the entities
were autonomous, the nature of the control relationship
shall be disclosed even though there are no transactions
between the entities.
If a principal shareholder or another related party issues a guarantee that benefits
the reporting entity, the guarantee should be disclosed in the entity’s financial
statements.
5.5.2 Guarantees Obtained by a Reporting Entity Related to Its Own Assets, Liabilities, or Equity Securities
In addition to providing the disclosures required by ASC 460 for
entities that issue guarantees, an entity should disclose instances in which it
purchases or otherwise receives guarantees related to its own assets, liabilities,
or equity securities. Financial statement users may find that information useful in
assessing the entity’s access to liquidity or its ability to obtain financing.
5.5.3 Subsequent Events
ASC 855-10
25-3 An entity
shall not recognize subsequent events that provide evidence
about conditions that did not exist at the date of the
balance sheet but arose after the balance sheet date but
before financial statements are issued or are available to
be issued. See paragraph 855-10-55-2 for examples of
nonrecognized subsequent events.
55-2 The following are examples
of nonrecognized subsequent events addressed in paragraph
855-10-25-3:
- Sale of a bond or capital stock issued after the balance sheet date but before financial statements are issued or are available to be issued
- A business combination that occurs after the balance sheet date but before financial statements are issued or are available to be issued (Topic 805 requires specific disclosures in such cases.)
- Settlement of litigation when the event giving rise to the claim took place after the balance sheet date but before financial statements are issued or are available to be issued
- Loss of plant or inventories as a result of fire or natural disaster that occurred after the balance sheet date but before financial statements are issued or are available to be issued
- Changes in estimated credit losses on receivables arising after the balance sheet date but before financial statements are issued or are available to be issued
- Changes in the fair value of assets or liabilities (financial or nonfinancial) or foreign exchange rates after the balance sheet date but before financial statements are issued or are available to be issued
- Entering into significant commitments or contingent liabilities, for example, by issuing significant guarantees after the balance sheet date but before financial statements are issued or are available to be issued.
A significant commitment or contingent liability, such as a
guarantee contract, entered into after the balance sheet date but before the
financial statements are issued (or available to be issued) is an example of a
nonrecognized subsequent event. In accordance with ASC 855-10-50-2, an entity should
consider whether such a contract should be disclosed to prevent the financial
statements from being misleading. In that case, the entity should disclose (1) the
nature of the guarantee and (2) an estimate of its financial effect or a statement
that the financial effect cannot be estimated.
5.6 Product Warranties
ASC 460 includes guidance on warranty
obligations incurred in connection with the sale of goods or services (i.e., product
warranties). The ASC master glossary defines a warranty as follows:
ASC Master Glossary
Warranty
A guarantee for which the underlying is related to the
performance (regarding function, not price) of nonfinancial
assets that are owned by the guaranteed party. The obligation
may be incurred in connection with the sale of goods or
services; if so, it may require further performance by the
seller after the sale has taken place.
5.6.1 Scope of Guidance on Product Warranties
Section 5.2 discusses the application of the
scope guidance in ASC 460 that is relevant to all guarantees other than product
warranties. All product warranties are within the scope of the disclosure
requirements of ASC 460; however, certain product warranties may be outside the
scope of ASC 460’s recognition and measurement guidance and may instead be accounted
for in accordance with ASC 606.
ASC 460-10
15-9 The
guidance in the Product Warranties Subsections applies only
to product warranties, which include all of the
following:
- Product warranties issued by the guarantor, regardless of whether the guarantor is required to make payment in services or cash
- Separately priced extended warranty or product maintenance contracts and warranties that provide a customer with a service in addition to the assurance that the product complies with agreed-upon specifications (see paragraphs 606-10-55-30 through 55-35 for guidance on determining whether a warranty provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications)
- Warranty obligations that are incurred in connection with the sale of the product, that is, obligations in which the customer does not have the option to purchase the warranty separately and that do not provide the customer with a service in addition to the assurance that the product complies with agreed-upon specifications.
Connecting the Dots
Because the general recognition and measurement requirements that apply to
guarantees in ASC 460-10 differ significantly from the recognition and
measurement requirements for product warranties, it is important for
entities to appropriately determine whether an arrangement is subject to the
guidance that applies to product warranties. On the basis of informal
discussions, we understand that the SEC’s Office of the Chief Accountant
recently objected to a transaction in which a registrant accounted for an
arrangement as a product warranty that involved the guarantee of the
functionality of a security service provided to the entity’s customer by
another customer of the entity. While this guarantee was part of a
multiple-element revenue arrangement, the SEC staff objected to the
registrant’s conclusion that this arrangement was a product warranty. We
understand that the SEC staff believed that a guarantee of a service
provided to a customer by another entity cannot be a product warranty
because the guarantor was not the entity that provided the service. The SEC
staff believed that the arrangement should be accounted for in accordance
with the general recognition and measurement guidance that applies to
guarantee obligations.
As noted in ASC 460-10-15-9(b),
certain warranties may be accounted for as separate performance obligations under
ASC 606. Section 5.5 of
Deloitte’s Roadmap Revenue
Recognition discusses the determination of whether a warranty
is an assurance-type warranty (and therefore outside the scope of ASC 606) or a
service-type warranty (and is therefore accounted for as a performance obligation in
accordance with ASC 606). The following decision tree illustrates this
determination:
See Section
5.5 of Deloitte’s Roadmap Revenue Recognition for additional
guidance on each step in the determination of whether a warranty is within the scope
of ASC 606 or is instead within the scope of ASC 460.
5.6.2 Recognition and Measurement of Warranty Obligations
Once an entity determines that its warranty is an assurance-type warranty that is
within the scope of ASC 460’s recognition and measurement guidance, it should
account for its warranty obligation in a manner consistent with its accounting for
other loss contingencies.
ASC 460-10
25-5 Because of
the uncertainty surrounding claims that may be made under
warranties, warranty obligations fall within the definition
of a contingency. Losses from warranty obligations shall be
accrued when the conditions in paragraph 450-20-25-2 are
met.
25-6 The
condition in paragraph 450-20-25-2(a) is met at the date of
an entity’s financial statements if, based on available
information, it is probable that customers will make claims
under warranties relating to goods or services that have
been sold. Satisfaction of the condition in paragraph
450-20-25-2(b) will normally depend on the experience of an
entity or other information. In the case of an entity that
has no experience of its own, reference to the experience of
other entities in the same business may be appropriate.
Inability to make a reasonable estimate of the amount of a
warranty obligation at the time of sale because of
significant uncertainty about possible claims (that is,
failure to satisfy condition [b] in that paragraph)
precludes accrual and, if the range of possible loss is
wide, may raise a question about whether a sale should be
recorded before expiration of the warranty period or until
sufficient experience has been gained to permit a reasonable
estimate of the obligation.
25-7 The
conditions in paragraph 450-20-25-2 may be considered in
relation to individual sales made with warranties or in
relation to groups of similar types of sales made with
warranties. If those conditions are met, accrual shall be
made even though the particular parties that will make
claims under warranties may not be identifiable.
The recognition requirements of ASC 450 apply to warranty obligations, which meet the
definition of a contingency given the uncertainty associated with the volume,
amount, and timing of any future claims that may be made. Because the recognition
requirements of ASC 450 apply to the warranty obligations, there is no initial fair
value guarantee to record in accordance with ASC 460. Therefore, estimates are
required for accruals related to warranty claims; such accruals should be recorded
when the loss is both probable and reasonably estimable in accordance with ASC
450-20-25-2. (See Chapter 2 for further discussion of the application of the
recognition guidance in ASC 450.)
ASC 450-20
25-2 An
estimated loss from a loss contingency shall be accrued by a
charge to income if both of the following conditions are
met:
- Information available before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. Date of the financial statements means the end of the most recent accounting period for which financial statements are being presented. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
- The amount of loss can be reasonably estimated.
The purpose of those conditions is to require accrual of
losses when they are reasonably estimable and relate to the
current or a prior period. Paragraphs 450-20-55-1 through
55-17 and Examples 1–2 (see paragraphs 450-20-55-18 through
55-35) illustrate the application of the conditions. As
discussed in paragraph 450-20-50-5, disclosure is preferable
to accrual when a reasonable estimate of loss cannot be
made. Further, even losses that are reasonably estimable
shall not be accrued if it is not probable that an asset has
been impaired or a liability has been incurred at the date
of an entity’s financial statements because those losses
relate to a future period rather than the current or a prior
period. Attribution of a loss to events or activities of the
current or prior periods is an element of asset impairment
or liability incurrence.
The criteria in ASC 450-20-25-2 are met if (1) it is probable, as of the date of an
entity’s financial statements, that customers will make claims under warranties
related to goods or services that have been sold and (2) the amount of such claims
is reasonably estimable. Generally, an entity may use its own historical information
and experiences to assess the probability of warranty claims related to sales in the
current period. If an entity has no prior experience, it may be appropriate to
consider the experiences of similar entities in the same industry if such
information is known. If an entity cannot reasonably estimate possible claims (and
therefore does not meet the criterion in ASC 450-20-25-2(b)), ASC 450 precludes that
entity from recording a loss accrual.
An assurance-type warranty guarantees to the customer that the goods
or services are free from defects and function in accordance with the entity’s
performance obligation. Therefore, ASC 460-10-25-6 notes that if an entity concludes
that it is unable to estimate its warranty obligation in accordance with ASC
450-20-25-2(b), or “if the range of possible loss is wide,” questions may arise
about whether the associated sale should be recognized before either (1) the
warranty period expires or (2) the entity has enough experience to reasonably
estimate the obligation. Because assurance-type warranties guarantee the performance
of an underlying good or service, if a customer is dissatisfied with the good’s or
service’s ability to function in accordance with the revenue contract, the guarantee
provides for remediation to the customer in the form of further vendor performance.
If an entity is unable to estimate its warranty obligation at the time of delivery,
or the range of loss is wide, the entity should consider whether it is appropriate
to recognize revenue for the sale of the product. For example, ASC 606-10-55-85
through 55-88 discuss whether a customer’s acceptance of a product indicates that
the customer has obtained control of the product. ASC 606-10-55-87 states:
[I]f an entity cannot objectively determine that the good or
service provided to the customer is in accordance with the agreed-upon
specifications in the contract, then the entity would not be able to conclude
that the customer has obtained control until the entity receives the customer’s
acceptance. That is because, in that circumstance the entity cannot determine
that the customer has the ability to direct the use of, and obtain substantially
all of the remaining benefits from, the good or service.
See Chapter
8 of Deloitte’s Roadmap Revenue Recognition for a discussion of
customer acceptance clauses.
An entity does not need to identify the particular customer who will make a warranty
claim in determining whether it is probable that a claim will be made and the amount
is reasonably estimable. A warranty accrual may be recognized for either (1) an
individual sale with a warranty or (2) groups of similar types of sales with
warranties. Using a group of similar types of sales with warranties as the basis for
the reasonable estimate differs from a general reserve, which an entity would be
prohibited from recognizing. (See Section 2.3.1.5 for more information about general reserves.)
Recognition of general reserves is prohibited because it is not probable that the
uncertain future event or events will confirm that a loss occurred on or before the
date of the financial statements. In contrast, a recognized product warranty reserve
is akin to unasserted claims (as discussed in Section 2.3.2.1) related to a loss that, as of the date of the
financial statements, is both probable and reasonably estimable. An entity may need
to draw upon historical experience with similar types of sales with warranties to
conclude that the loss is both probable and reasonably estimable.
5.6.3 Constructive Product Warranties
Even in the absence of a written contractual arrangement with a
customer, a constructive obligation may arise from a historical practice or a stated
intention to perform repairs even if there is no legal requirement to do so.
Section 5.5.3 of
Deloitte’s Roadmap Revenue
Recognition gives an example of a constructive obligation
that is within the scope of ASC 460.
5.6.4 Product Warranty Disclosures
As discussed in Section 5.6.2, if the condition in ASC 450-20-25-2(b) is not met,
ASC 450 precludes accrual of a warranty obligation. In those instances, an entity
must apply the disclosure requirements for loss contingencies in ASC 450-20-50-3
through 50-6. When a warranty obligation is accrued, in addition to applying the
disclosure guidance in Section 5.5 on
guarantees and in Section 2.8 on loss contingencies, an entity should consider the
disclosure requirements below for product warranties. In addition, product
warranties to which the recognition and measurement guidance in ASC 606 applies are
subject to the disclosure requirements in ASC 460-10-50-1 through 50-8.
ASC 460-10
50-8 A
guarantor shall disclose all of the following information
for product warranties and other guarantee contracts
described in paragraph 460-10-15-9:
- The information required to be disclosed by paragraph 460-10-50-4 except that a guarantor is not required to disclose the maximum potential amount of future payments specified in paragraph 460-10-50-4(b)
- The guarantor’s accounting policy and methodology used in determining its liability for product warranties
- A tabular reconciliation of the
changes in the guarantor’s aggregate product
warranty liability for the reporting period. That
reconciliation shall include all of the following
amounts:
- The beginning balance of the aggregate product warranty liability
- The aggregate reductions in that liability for payments made (in cash or in kind) under the warranty
- The aggregate changes in the liability for accruals related to product warranties issued during the reporting period
- The aggregate changes in the liability for accruals related to preexisting warranties (including adjustments related to changes in estimates)
- The ending balance of the aggregate product warranty liability.
Pending Content (Transition Guidance: ASC
220-40-65-1)
50-8 A guarantor shall disclose all of
the following information for product warranties
and other guarantee contracts described in
paragraph 460-10-15-9:
-
The information required to be disclosed by paragraph 460-10-50-4 except that a guarantor is not required to disclose the maximum potential amount of future payments specified in paragraph 460-10-50-4(b)
-
The guarantor's accounting policy and methodology used in determining its liability for product warranties
-
A tabular reconciliation of the changes in the guarantor's aggregate product warranty liability for the reporting period. That reconciliation shall include all of the following amounts:
-
The beginning balance of the aggregate product warranty liability
-
The aggregate reductions in that liability for payments made (in cash or in kind) under the warranty
-
The aggregate changes in the liability for accruals related to product warranties issued during the reporting period
-
The aggregate changes in the liability for accruals related to preexisting warranties (including adjustments related to changes in estimates)
-
The ending balance of the aggregate product warranty liability.
-
See paragraphs 220-40-50-21 through 50-25 for
additional disclosure requirements.
Appendix A — Differences Between U.S. GAAP and IFRS Accounting Standards
Appendix A — Differences Between U.S. GAAP and IFRS Accounting Standards
The primary sources of guidance on the accounting for contingencies
are ASC 450 under U.S. GAAP and IAS 37 under IFRS Accounting Standards. Throughout
this appendix, terminology applicable to both U.S. GAAP and IFRS Accounting
Standards is used, depending on the applicable guidance (e.g., “contingent gain” in
U.S. GAAP versus “contingent asset” in IFRS Accounting Standards).
The table below summarizes commonly encountered differences between
the accounting for contingencies under U.S. GAAP and that under IFRS Accounting
Standards. For detailed interpretive guidance on IAS 37, see Chapter A12,
“Provisions, Contingent Liabilities and Contingent Assets,” of Deloitte’s
iGAAP publication.
Connecting the Dots
In November 2024, the IASB issued an exposure draft that would amend IAS 37 to (1) clarify
how companies assess when to record provisions and how to measure them and
(2) require entities to provide additional disclosures regarding
measurement. Comments on the exposure draft were due by March 12, 2025.
|
Subject
|
U.S. GAAP
|
IFRS Accounting Standards
|
|---|---|---|
|
Terminology
|
The three categories of contingencies
are:
|
The three categories of contingencies are:
|
|
U.S. GAAP and IFRS Accounting Standards use
different terminology to describe contingencies. Under U.S.
GAAP, this terminology is related to financial statements’
elements of performance (two key terms are “gain
contingency” and “loss contingency”), whereas under IFRS
Accounting Standards, the terminology used is related to
financial statements’ elements of financial position (the
three key terms are “contingent asset,” “contingent
liability,” and “provision”). However, the two sets of terms
may be applied similarly so that no difference between them
arises in practice.
| ||
|
Recognition of loss
contingencies/provisions
|
One of the conditions for loss accrual is
that it must be probable that (1) an asset has been impaired
or (2) a liability has been incurred. “Probable” is defined
as “likely to occur” (i.e., generally 70 percent or more),
which is a higher threshold than “more likely than not”
(i.e., greater than 50 percent).
|
One of the conditions for recognizing a
provision (as a liability) is that it must be probable that
an outflow of resources will be required to settle the
obligation. “Probable” is defined as “more likely than not”
(i.e., greater than 50 percent).
More contingencies may qualify for
recognition as liabilities under IFRS Accounting Standards
than under U.S. GAAP.
|
|
Initial measurement — range of estimates
|
When there is a range of possible outcomes
and each point is as likely as the other points, the minimum aamount in the range is
used to measure the contingency.
|
When there is a range of possible outcomes
and each point is as likely as the other points, the
midpoint of the range should be used for initial
measurement.
|
|
Discounting
|
In general, an entity is not required to
discount loss contingencies. However, for certain
obligations for which the timing and amounts of outflows are
fixed or reliably determinable, discounting is
permitted.
|
The provision for a loss contingency should
be the present value of the cost required to settle the
obligation, discounted by using a pretax discount rate that
reflects both (1) the time value of money and (2) the risks
related to the liability. Discounting is required even if
the timing of the outflows is not fixed or determinable.
|
|
Onerous contracts
|
Unless there is specific U.S. GAAP guidance
on recognizing a contingent liability related to a firmly
committed executory contract, recognition of a contingent
liability when the fair value of remaining contractual
rights declines below the remaining costs to be incurred is
not supported by U.S. GAAP. See Section 2.2.1 for
additional discussion.
|
Under IFRS Accounting Standards, an entity
is required to recognize and measure the present obligation
under an onerous contract as a provision. An onerous
contract is one “in which the unavoidable costs of meeting
the obligations under the contract exceed the economic
benefits expected to be received under it.”
|
|
Levies
|
There is no specific guidance on levies. Therefore, an entity
generally applies the guidance in ASC 450 to account for
levies as well as the related fines and penalties.
|
Levies are transfers of resources that governments impose on
entities in accordance with laws or regulations. This
definition excludes transfers of resources that are (1)
within the scope of other IFRS Accounting Standards and (2)
fines or other penalties for breaches of laws or
regulations. IFRIC 21 addresses the accounting for levies
that are within the scope of IAS 37.
|
|
Constructive obligations
|
According to the doctrine of promissory estoppel, a
constructive obligation may arise when, as a result of an
entity’s actions, a third party reasonably expects that the
entity will accept and discharge certain responsibilities.
This concept is narrower than the definition of a
constructive obligation under IFRS Accounting Standards.
Constructive obligations are recognized only if specific
Codification topics require such recognition.
|
A constructive obligation arises when, as a result of an
entity’s actions, a third party has a valid expectation that
the entity will accept or discharge certain
responsibilities.
A provision is recognized for a constructive obligation that
arises from a past event if it is probable that an outflow
of resources will be required and the amount can be reliably
estimated.
|
|
Disclosure of prejudicial information
|
There are no exemptions from the requirement
to disclose information that may be prejudicial to an
entity.
|
In extremely rare cases, if disclosure of
certain information could prejudice the position of the
entity in a dispute with other parties, that information
does not need to be disclosed. However, an entity must
disclose the nature of the dispute, along with the reason
why the information has not been disclosed.
|
|
Gain contingencies/contingent assets
|
A gain contingency is recognized at the
earlier of when it is realized or becomes realizable. An
entity is not permitted to recognize a gain contingency
before it is realized or becomes realizable.
|
When realization of a contingent asset is
virtually certain, recognition is appropriate. Because the
thresholds in U.S. GAAP are very similar to those in IFRS
Accounting Standards, no differences are expected to arise
in practice.
|
Appendix B — Titles of Standards and Other Literature
Appendix B — Titles of Standards and Other Literature
AICPA Literature
Clarified Statements on Auditing Standards
AU-C Section 501, “Audit
Evidence — Specific Considerations for Selected Items”
AU-C Section 620, “Using the
Work of an Auditor’s Specialist”
Issues Paper
The Use of Discounting in
Financial Reporting for Monetary Items With Uncertain Terms Other Than
Those Covered by Existing Authoritative Literature
FASB Literature
ASC Topics
ASC 210, Balance
Sheet
ASC 220, Income Statement
— Reporting Comprehensive Income
ASC 230, Statement of
Cash Flows
ASC 235, Notes to
Financial Statements
ASC 250, Accounting
Changes and Error Corrections
ASC 270, Interim
Reporting
ASC 275, Risks and
Uncertainties
ASC 310,
Receivables
ASC 326, Financial
Instruments — Credit Losses
ASC 330,
Inventory
ASC 340, Other Assets and
Deferred Costs
ASC 405,
Liabilities
ASC 410, Asset Retirement
and Environmental Obligations
ASC 420, Exit or Disposal
Cost Obligations
ASC 440,
Commitments
ASC 450,
Contingencies
ASC 460,
Guarantees
ASC 470, Debt
ASC 480, Distinguishing
Liabilities From Equity
ASC 505, Equity
ASC 605, Revenue
Recognition
ASC 606, Revenue From
Contracts With Customers
ASC 610, Other
Income
ASC 705, Cost of Sales
and Services
ASC 710, Compensation —
General
ASC 712, Compensation —
Nonretirement Postemployment Benefits
ASC 715, Compensation —
Retirement Benefits
ASC 718, Compensation —
Stock Compensation
ASC 720, Other
Expenses
ASC 740, Income
Taxes
ASC 805, Business
Combinations
ASC 815, Derivatives and
Hedging
ASC 820, Fair Value
Measurement
ASC 825, Financial
Instruments
ASC 835, Interest
ASC 842, Leases
ASC 850, Related Party
Disclosures
ASC 855, Subsequent
Events
ASC 860, Transfers and
Servicing
ASC 930, Extractive
Activities — Mining
ASC 942, Financial Services — Depository
and Lending
ASC 944, Financial
Services — Insurance
ASC 946, Financial
Services — Investment Companies
ASC 954, Health Care
Entities
ASC 958, Not-for-Profit
Entities
ASU
ASU 2014-15, Presentation
of Financial Statements — Going Concern (Subtopic 205-40): Disclosure of
Uncertainties About an Entity’s Ability to Continue as a Going
Concern
Concepts Statements
No. 5, Recognition and
Measurement in Financial Statements of Business Enterprises
No. 7, Using Cash Flow
Information and Present Value in Accounting Measurements
No. 8, Conceptual
Framework for Financial Reporting — Chapter 4, Elements of Financial
Statements
Proposed ASU
No. 1840-100,
Contingencies (Topic 450): Disclosure of Certain Loss
Contingencies
IFRS Literature
IAS 37, Provisions, Contingent Liabilities and Contingent
Assets
IFRIC Interpretation 21, Levies
Exposure Draft IASB/ED/2024/8,
Provisions — Targeted Improvements — proposed amendments to IAS 37
SEC Literature
Regulation S-K
Item 303, “Management’s
Discussion and Analysis of Financial Condition and Results of
Operations”
Regulation S-X
Rule 3-10, “Financial
Statements of Guarantors and Issuers of Guaranteed Securities Registered or
Being Registered”
Rule 5-03, “Statements of
Comprehensive Income”
Rule 13-01, “Guarantors and
Issuers of Guaranteed Securities Registered or Being Registered”
SAB Topics
No. 5.E, “Miscellaneous
Accounting; Accounting for Divestiture of a Subsidiary or Other Business
Operation”
No. 5.N, “Miscellaneous
Accounting; Discounting by Property-Casualty Insurance Companies”
No. 5.Y, “Miscellaneous
Accounting; Accounting and Disclosures Relating to Loss Contingencies”
Staff Paper
Work Plan for the
Consideration of Incorporating International Financial Reporting
Standards Into the Financial Reporting System for U.S. Issuers — A
Comparison of U.S. GAAP and IFRS
Superseded Literature
AICPA Accounting Research Bulletin (ARB)
ARB 50,
Contingencies
AICPA Accounting Statement of Position
96-1, Environmental
Remediation Liabilities
EITF Abstracts
Issue No. 00-21, “Revenue
Arrangements With Multiple Deliverables”
Issue No. 01-9, “Accounting
for Consideration Given by a Vendor to a Customer (Including a Reseller of
the Vendor’s Products)”
Issue No. 01-10, “Accounting
for the Impact of the Terrorist Attacks of September 11, 2001”
Issue No. 03-17, “Subsequent
Accounting for Executory Contracts That Have Been Recognized on an Entity’s
Balance Sheet”
FASB Interpretations
No. 14, Reasonable
Estimation of the Amount of a Loss — an interpretation of FASB
Statement No. 5
No. 34, Disclosure of
Indirect Guarantees of Indebtedness of Others — an interpretation of
FASB Statement No. 5
No. 45, Guarantor’s
Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others — an interpretation of
FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No.
34
FASB Statements
No. 5, Accounting for
Contingencies
No. 114, Accounting by
Creditors for Impairment of a Loan
No. 143, Accounting for
Asset Retirement Obligations
Appendix C — Abbreviations
Appendix C — Abbreviations
| Abbreviation |
Description
|
|---|---|
|
AICPA
|
American Institute of Certified Public
Accountants
|
|
ARB
|
Accounting Research Bulletin
|
|
ASC
|
FASB Accounting Standards Codification
|
|
ASU
|
FASB Accounting Standards Update
|
|
CECL
|
current expected credit loss
|
|
CFO
|
chief financial officer
|
|
CME
|
Chicago Mercantile Exchange
|
|
DOJ
|
U.S. Department of Justice
|
|
EITF
|
Emerging Issues Task Force
|
|
FASB
|
Financial Accounting Standards Board
|
|
FDA
|
U.S. Food and Drug Administration
|
|
FIN
|
FASB Interpretation
|
|
GAAP
|
generally accepted accounting principles
|
|
IAS
|
International Accounting Standard
|
|
IBNR
|
incurred but not reported
|
|
ICFR
|
internal control over financial
reporting
|
|
IFRIC
|
IFRS Interpretations Committee
|
|
IFRS
|
International Financial Reporting
Standard
|
|
IPO
|
initial public offering
|
|
JV
|
joint venture
|
|
MD&A
|
Management’s Discussion and Analysis
|
|
MLP
|
master limited partnership
|
|
PCAOB
|
Public Company Accounting Oversight
Board
|
|
SAB
|
SEC Staff Accounting Bulletin
|
|
SEC
|
U.S. Securities and Exchange Commission
|
|
SPE
|
special-purpose entity
|
Appendix D — Roadmap Updates for 2025
Appendix D — Roadmap Updates for 2025
The table below summarizes the
substantive changes made in the 2025 edition of this Roadmap.
|
Section
|
Title
|
Description
|
|---|---|---|
|
Balance Sheet Classification
|
Amended guidance on classification of
contingent liabilities as current or noncurrent.
|