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23.4 Contingencies
Publication date: 30 Nov 2023
us Financial statement presentation guide
US GAAP defines a contingency as follows:
Definition from ASC 450-20-20
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.
The following sections discuss the disclosure considerations for loss and gain contingencies as provided by ASC 450.
23.4.1 Loss contingencies
Loss contingencies are relatively common. As discussed in ASC 450-20-05-3, examples include product warranties and litigation exposure.
There are three separate potential recognition, presentation and disclosure outcomes with regard to loss contingencies. Depending on the facts and circumstances, loss contingencies may require a reporting entity to (1) accrue a liability and disclose the nature of the contingency (FSP 23.4.1.1), (2) disclose the loss contingency, but not accrue a liability (FSP 23.4.1.2), or (3) neither accrue nor disclose (FSP 23.4.1.3).
23.4.1.1 Accrual and disclosure required
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.
ASC 450-20-30-1 provides guidance on the amount to be accrued.
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 23.4.3.1.
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 has a highly predictable settlement pattern (e.g., workers compensation claims).
ASC 450-20-S99-1 (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.
Disclosure
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.
23.4.1.2 No accrual, but disclosure required
As discussed in ASC 450-20-50-5, disclosure is required when the loss contingency is not both probable and reasonably estimable:
- A material loss contingency is probable but not reasonably estimable.
A reporting entity is required to disclose the nature of the contingency and the fact that an estimate cannot be made.
- A material loss contingency is reasonably possible but not probable.
A reporting entity is required to disclose the nature of the contingency and an estimate of the possible loss, range of loss, or disclose the fact that an estimate cannot be made.
For material loss contingencies that are reasonably possible but not probable, the SEC frequently comments on reporting entities that have incomplete or omitted disclosures pursuant to ASC 450, specifically related to the lack of disclosures regarding the nature of the contingency and the possible range of loss amounts or the statement that an estimate cannot be made. The SEC staff also cautions reporting entities that the recording of a material accrual for a contingent liability should typically not be the first disclosure regarding the material contingency. A foreshadowing disclosure that precedes an accrual for a material contingent liability is typically expected.
ASC 450 does not provide specific guidance as to the level of disclosures required (that is, individual contingency or some other aggregate level). However, it requires that reporting entities disclose information to keep the financial statements from being misleading.
Excerpt from ASC 450-20-50-1
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.
One way to alleviate some of this tension is to aggregate losses. The SEC staff has accepted this approach, which enables users to have sufficient data, but does not provide such specific information that it could prejudice a legal matter.
As discussed in ASC 450-20-50-9, if a material loss contingency arises after the balance sheet date but before the financial statements are issued, disclosure may be necessary. Assessment of whether disclosure is necessary should be based on the principles articulated in ASC 855. If disclosure is deemed necessary, a reporting entity should describe the nature of the loss contingency and an estimate of the loss or range of possible losses. If no estimate can be made, then the reporting entity should disclose that fact. Refer to FSP 28 for further information on subsequent events disclosures.
Unasserted claims
An unasserted claim is one that has not yet been asserted either because the potential claimant is unaware of the matter or has not yet pursued it. As discussed in ASC 450-20-50 and ASC 450-20-55-14 through 55-15, if assertion of a claim is judged probable, a reporting entity should accrue and/or disclose the amount, depending on the probability of, and ability to estimate, any loss arising from the claim. ASC 450-20-50-6 indicates that disclosure is required when assertion of the claim is considered probable and there is a reasonable possibility the outcome will be unfavorable; however, we believe the reporting entity should consider disclosure even if the claim is not considered probable.
Reporting entities should also evaluate the need for accrual or disclosure of a loss contingency when broader circumstances indicate that the potential exists for claims against the company. For example, the restatement of prior annual or interim financial statements to correct an error may be indicative of an unasserted claim because of the possibility that shareholders may make claims against the company for having issued allegedly false and misleading financial statements. Any restatements to correct an error in previously-issued financial statements should be evaluated in this light. See ASC 450-20-55-14 for other examples of how unasserted claims might arise.
23.4.1.3 Neither accrual nor disclosure required
As discussed in ASC 450-20-50-6, disclosure is generally not required for a loss contingency involving an unasserted claim or assessment if it is not probable that a claim will be asserted. Additionally, ASC 450 does not require disclosure of loss contingencies when the possibility of loss is remote. However, reporting entities should consider disclosing information in the footnotes if the disclosure would keep the financial statements from being misleading. Though ASC 450 does not require disclosure of remote contingencies, ASC 460 requires certain remote loss contingencies to be disclosed. Refer to FSP 23.6.1 for further discussion related to these contingencies.
23.4.2 Accruing legal costs
As discussed in ASC 450-20-S99-2, there is no definitive guidance on whether legal defense costs should be accrued. Some believe that the accrual of the loss contingency should factor in all costs, including legal costs if they are reasonably estimable, regardless of whether a liability can be estimated for the contingency itself. Others contend that legal fees should be recognized as incurred when the legal services are provided, and therefore should not be recognized as part of a loss contingency accrual. As specified in ASC 450-20-S99-2, how a reporting entity treats legal costs is an accounting policy choice that should be consistently applied and disclosed.
Question FSP 23-2
In a two-step income statement, where should a reporting entity classify litigation expense?
In a two-step income statement, where should a reporting entity classify litigation expense?
PwC response
Generally, litigation expense should be classified as an operating expense.
23.4.3 Recovery of a loss
A claim for loss recovery (e.g., an insurance claim) generally can be recognized when a loss event has occurred and recovery is considered probable. If the claim is subject to dispute or litigation, a rebuttable presumption exists that recoverability of the claim is not probable. If the potential recovery exceeds the loss recognized in the financial statements or relates to a loss not yet recognized in the financial statements, such recovery should be recognized under the gain contingency model discussed in FSP 23.5.
ASC 450-20-S99 (SAB Topic 5.Y) includes the SEC staff's view that there is a rebuttable presumption that an asset should not be recognized for a claim for recovery from a party that asserts that it is not liable to 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. Although discussed in the context of environmental liabilities, we believe these concepts are equally applicable to other non-environmental liabilities and related recoveries (e.g., asbestos claims and related insurance coverage).
23.4.3.1 Insurance recoverables
Reporting entities often manage risk by purchasing insurance. Although a reporting entity transfers risk through an insurance policy, it generally has the primary obligation with respect to any losses. Therefore, a reporting entity is typically required to accrue and present the gross amount of a loss even if it purchased insurance to cover the loss.
Generally, amounts receivable under an insurance contract should not be offset against the reporting entity's liability, as purchasing insurance generally does not relieve the purchaser of its primary obligation to make payments related to losses that result from risk.
Unless the conditions of ASC 210-20-45-1 are met, offsetting prepaid insurance and receivables for expected recoveries from insurers against a recognized incurred but not reported liability or the liability incurred as a result of a past insurable event would not be appropriate.
Sometimes, an insurance company may agree to pay the harmed party directly, on the insured's behalf, but this does not typically extinguish or provide a legal release from the insured's obligation prior to payment to the harmed party, as is required for liability extinguishment.
For example, most states require an employer to provide its employees with workers' compensation coverage if they are injured on the job. Accordingly, an employer has an obligation to its employees. The employer may choose to purchase insurance for some or all of its workers' compensation risk. The employer's decision in this respect generally does not change its legal obligation to its employees, although its decision could affect whether there is an asset to record when an employee is injured. In addition, an employer's legal obligation is not altered if the purchased insurance contract includes all claims handling and direct contact with employees. Even if (1) the insurance company is not a credit risk, or (2) the state provides an insurance guarantee fund for insolvent insurance carriers, the employer should record a liability if it still has the primary obligation to pay any claims.
However, laws in certain jurisdictions (especially certain state laws related to workers' compensation) may dictate that a reporting entity is relieved from being the primary obligor when it purchases insurance policies for certain claims, because the insurer has assumed that role. Reporting entities with this fact pattern may need to seek assistance from legal counsel to understand whether the primary obligor designation has been transferred to the insurance company, and whether the related liability has been extinguished by purchasing workers' compensation insurance.
23.4.3.2 Financial statement classification of recovery
Several pieces of guidance govern the presentation and disclosure of insurance recoveries:
- ASC 610-30, Gains and losses on involuntary conversions
- ASC 410-30, Environmental Obligations
- ASC 220-30, Income Statement – Business Interruption Insurance
Other income model (ASC 610-30)
ASC 610-30 provides guidance on involuntary conversions of nonmonetary assets (such as property or equipment) to monetary assets (such as insurance proceeds). It requires recognition of a gain or loss on this type of involuntary conversion, measured as the difference between the carrying amount of the nonmonetary asset and the amount of monetary assets received. As such, insurance recoveries are recorded in the same financial statement line as the related loss up to the amount of loss. If insurance proceeds are in excess of the related loss, which may occur with replacement cost insurance, the gain is typically included in other income. In a two-step income statement, it is often shown as nonoperating income.
Most insurance proceeds are typically not refundable and do not require any further action from the insured; therefore, full or partial deferral of recognition of the proceeds should be rare.
Example FSP 23-1 illustrates the recognition, measurement, and disclosure of a loss of equipment with a potential insurance recovery.
EXAMPLE FSP 23-1
Considerations for casualty loss with a potential insurance recovery
On June 1, 20X1, FSP Corp's equipment is heavily damaged while being transported from its manufacturing facility to its retail facility. Due to the nature of the damage, FSP Corp determines that there is a total loss. The equipment had a net book value of $7 million and an estimated replacement value of $6 million as of the date of loss. FSP Corp files a property and casualty claim with its insurer for recovery of $6 million. Based on its discussions with the insurer and review of the policy by in-house experts, FSP Corp concludes that it has a covered loss under the policy and that it is probable the insurer will settle the claim for at least $5 million. However, the insurer has communicated to FSP Corp that the amount of final settlement is subject to verification of the identity of the equipment damaged and the receipt of additional market data regarding its value.
How should FSP Corp recognize, measure, and disclose the loss of the equipment and the potential insurance recovery?
Analysis
FSP Corp should write off the net book value of the equipment of $7 million and recognize an asset of $5 million for the probable recovery of its loss (a loss recovery asset on the balance sheet), resulting in a net initial loss of $2 million. FSP Corp should recognize any remaining recovery (i.e., any excess over $5 million) when recovery of an additional amount is probable (e.g., when the identity of the damaged equipment has been established and additional market data confirm its value).
FSP Corp should record the insurance recovery in the same financial statement line item in the income statement as the related loss was recorded. To the extent the loss is material, FSP Corp should disclose the nature of the events leading to the loss and additional amounts that are expected to be recovered.
FSP Corp should record the insurance recovery in the same financial statement line item in the income statement as the related loss was recorded. To the extent the loss is material, FSP Corp should disclose the nature of the events leading to the loss and additional amounts that are expected to be recovered.
Insurance recoveries of environmental obligations
ASC 410-30-35-8 and ASC 410-30-35-9 address insurance recoveries related to environmental obligations. The guidance indicates that an asset related to an insurance recovery should be recognized only when realization of the claim underlying the recovery is probable. It further stipulates that there is a rebuttable presumption that realization of the claim is not probable if the claim is the subject of litigation.
Probable recoveries should be reflected separately as an asset in the balance sheet and not netted against the remediation liability, consistent with ASC 210-20, Balance Sheet—Offsetting. ASC 410-30-45-2 states that it would be rare, if ever, that the facts and circumstances surrounding environmental remediation liabilities and related receivables and potential recoveries would meet the criteria of ASC 210-20. The financial statements should also include a discussion of material uncertainties that may affect the measurement and realization of the asset and liability.
Business interruption insurance
ASC 220-30 provides guidance related to the presentation and disclosure of business interruption insurance proceeds. Business interruption insurance is insurance that a reporting entity might purchase to cover losses caused by the loss of use of property or equipment. This insurance typically provides for reimbursement of qualifying costs while a reporting entity rebuilds, repairs, or replaces the damaged property. The guidance allows a reporting entity to determine the classification of recoveries as long as the classification does not conflict with existing US GAAP.
An entity may 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).
ASC 220-30-50-1 also requires a reporting entity to disclose certain information in the footnotes for period(s) in which recoveries are recognized. These include:
The nature of the event that caused the business interruption losses
- The aggregate amount of business interruption insurance recoveries recognized each period and the income statement line item in which the recoveries were included
23.4.4 Lawsuits covered by insurance
SEC staff comment letters have questioned the completeness of disclosures related to pending settlements regarding lawsuits that are covered by insurance. Specifically, reporting entities have been asked to disclose how insurance arrangements have affected conclusions concerning settlements and the likely effect that litigation and future settlements will have on the financial statements. Accordingly, it is important for reporting entities to ensure that any liabilities that are covered by insurance are properly disclosed in accordance with ASC 450.
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