A loss contingency should be accrued if it is both (1) probable and (2) reasonably estimable.
ASC 450-20-20 defines “probable” as “the future event or events are likely to occur,” which is generally considered a 75% threshold.
Reporting entities should evaluate any information available prior to issuance of the financial statements to determine whether a loss contingency is probable at the balance sheet date. Events giving rise to new information often occur in the period between the balance sheet date and financial statement issuance. However, it is important to distinguish between events that provide additional information with respect to conditions that existed at the balance sheet date and events that provide information with respect to conditions that did not exist at the balance sheet date. Although ASC 450-20-50-9
generally requires disclosure of these events, it is not appropriate to accrue a liability at the balance sheet date for a loss contingency related to a condition that did not exist at the balance sheet date. ASC 855
, Subsequent Events,
and FSP 28
provide further guidance on subsequent events.
Excerpt from ASC 450-20-30-1
If some amount within the 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 should be accrued.
The amount of a contingent liability should be estimated and evaluated independent from any claim for recovery. See FSP 220.127.116.11
Discounting the accrued liability
Accrued liabilities for contingencies are generally not discounted. However, as discussed in ASC 835-30-15-2
, discounting a liability is acceptable when the aggregate amount of the liability and the timing of cash payments for the liability are fixed or reliably determinable. For example, this may occur when a large volume of relatively small claims have a highly predictable settlement pattern (e.g., workers compensation claims).
(SAB Topic 5.Y
, Accounting and Disclosures Relating to Loss Contingencies
) specifies that the discount rate used should produce an amount at which the liability could be settled in an arm's length transaction with a third party.
The guidance in SAB Topic 5.Y
also indicates that the discount rate used should not exceed the interest rate on monetary assets that are essentially risk-free and have maturities comparable to that of the liability. In many instances, it is difficult in practice to determine the discount rate that would result from an insurance company or other third party settlement/transfer transaction. The insurance company or third party would expect to be compensated for the risks assumed along with a profit; therefore, the rate to assume the liability is generally less than the risk-free rate. However, because these settlement rates are often not determinable, practice has gravitated toward using the risk-free rate of monetary assets that have comparable maturities. We believe the guidance on discounting should apply to all contingent liabilities, and to private and public companies.
Conceptually, the discount rate applied to a liability should not change from period to period if the liability is not recorded at fair value. However, liabilities recorded for contingencies may consist of numerous claims that are established and settled in multiple periods.
Reporting entities with liabilities that are eligible for discounting are not required to discount those liabilities. The decision of whether to discount is a matter of accounting policy that should be consistently applied and disclosed. If a reporting entity wishes to discount liabilities related to contingencies, it should have sufficient historical information with which to reasonably estimate the amount and timing of ultimate settlement costs, as described in ASC 835-30-15-2
, Interest - Imputation of Interest
, ASC 450-20-S99-1
(SAB Topic 5.Y
), and ASC 410-30
, which addresses the discounting of environmental remediation liabilities.
Switching from not discounting liabilities to discounting liabilities should be treated as a change in the method of applying an accounting principle, subject to preferability. However, a change from discounting to not discounting because there has been a change in the facts and circumstances regarding the inherent predictability in the timing and amount of the payments is not considered a change in the method of applying an accounting principle.
Classification of the accrual
The balance sheet classification of the accrual should consider when the contingency will be settled. If the period of expected settlement is within one year of the balance sheet date, the reporting entity should classify the contingency as a short-term liability. Otherwise, it should be classified as long-term.
The income statement classification of the accretion of a discounted liability to its settlement amount is an accounting policy decision that should be consistently applied and disclosed.
As discussed in ASC 450-20-50-1
, because contingency accruals are estimates, the FASB recommends that reporting entities use terms such as “estimated liability” or “a liability of an estimated amount” in describing the nature of the accrual. The term “reserve” should not be used. A reporting entity should disclose any losses that may be incremental to what was accrued if the additional loss is reasonably possible and materially different from the amount accrued.