Understanding the accounting for loss contingencies

FASB Accounting Standards Codification (ASC) 450, Contingencies, details the proper accounting treatment for loss contingencies and gain contingencies. If the conditions for recording a loss contingency are initially not met, but then are met during a later accounting period, the loss should be accrued in the later period. Do not make a retroactive adjustment to an earlier period to record a loss contingency.

1. Furthermore, even if there was no overt attempt to deceive, restatement is still required if officials should have known that a reported figure was materially wrong.
2. The accounting for loss contingencies specifically involves potential losses that might come as a result of certain kinds of events.
3. In some cases, it may be determined that a loss was incurred because an unfavorable outcome of the litigation, claim, or assessment is probable (thus satisfying the condition in paragraph 8(a)), but the range of possible loss is wide.
4. Based in part on Cuccia et al. (The Accounting Rev. 70 (1995) 227), we develop hypotheses concerning these issues and then empirically test them by conducting an experiment involving federal financial officials.
5. If the best estimate of the amount of the loss is within a range, accrue whichever amount appears to be a better estimate than the other estimates in the range.

Any probable contingency needs to be reflected in the financial statements—no exceptions. Possible contingencies—those that are neither probable nor remote—should be disclosed in the footnotes of the financial statements. Companies operating in the United States rely on the guidelines established in the generally accepted accounting principles (GAAP).

Exhibit I—Excerpts from Statement of Financial Accounting Standards No. 5: Accounting for Contingencies

Based on past experience and data, AutoTech anticipates that 5% of the cars sold will require warranty-covered repairs in the first year, with an average repair cost of $2,000 per car. These materials were downloaded from PwC's Viewpoint (viewpoint.pwc.com) under license.

© 2024 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG global organization of independent member firms affiliated with KPMG International Limited, a private English company limited by guarantee. The $600 most likely outcome was not used because the other estimates were all lower; instead, an expected value was used as a better estimate of the expected outcome. If a user or application submits more than 10 requests per second, further requests from the IP address(es) may be limited for a brief period. Once the rate of requests has dropped below the threshold for 10 minutes, the user may resume accessing content on SEC.gov.

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In the event of an audit, the company must be able to explain and defend its contingent accounting decisions. Reimbursement assets are not netted against the related provision (loss contingency) on the balance sheet. However, the expense and related reimbursement may be netted in profit or loss under both IFRS and US GAAP. Certain legal claims may be subject to reimbursement, in the form of insurance proceeds, indemnities or reimbursement rights, such as in these examples. IFRS also requires risks that are specific to the liability to be reflected in the best estimate. This can be done by (1) adjusting the cash flows for risk, or (2) using a risk-adjusted discount rate.

Gain contingencies exist when there is a future possibility of acquisition of an asset or reduction of a liability. Typical gain contingencies include tax loss carryforwards, probable favorable outcome in pending litigation, and possible refunds from the government in tax disputes. Unlike loss contingencies, gain contingencies should not be accrued as doing so would result in recognizing revenue before it is realized. Disclosure should be made in the financial statements when the probability is high that a gain contingency will be recognized. Fn 6 For example, disclosure shall be made of any loss contingency that meets the condition in paragraph 8(a) but that is not accrued because the amount of loss cannot be reasonably estimated (paragraph 8(b)).

Both represent possible losses to the company, and both depend on some uncertain future event. Given the uncertainty about the timing or amount of future expenditures needed to settle legal claims, the recognition and measurement of a provision can often require companies to make significant judgments and assumptions. It is therefore important for companies to be cognizant of the IFRS measurement requirements and to have robust processes and controls in place to ensure timely recognition and appropriate measurement of provisions, including subsequent changes. In some cases, it may not be clear whether a present obligation exists, even if there is a past event – e.g. a legal claim that is disputed by the company.

Statement of Federal Financial Accounting Standards Number 1, Accounting for Selected Assets and Liabilities

Under GAAP, a contingent liability is defined as any potential future loss that depends on a "triggering event" to turn into an actual expense. Any case with an ambiguous chance of success should be noted in the financial statements but do not need to be listed on the balance sheet as a liability. The actual accounting for warranty liabilities can be more complex, including changes in estimates over time and impacts on cash flows. Always consult with a financial professional or auditor for accurate accounting. When deciding upon the appropriate accounting for a contingency, the basic concept is that you should only record a loss that is probable, and for which the amount of the loss can be reasonably estimated. If the best estimate of the amount of the loss is within a range, accrue whichever amount appears to be a better estimate than the other estimates in the range.

Accounting for a Gain Contingency

Acceptable accounting policies include expensing related costs as incurred or accruing related costs when they are deemed probable and reasonably estimable. The very nature of this uncertainty presents challenges in determining when to recognize a provision and how to measure it. Here we reconsider the IFRS requirements specific to legal claims, identify some of the practical implications, and outline differences between IFRS and US GAAP. Subjects in the experiment were 151 federal finance officials who were attending a continuing education session sponsored by FASAB in 1999. Subjects were randomly assigned to four different treatment conditions and were asked to complete a one-page experimental questionnaire and to answer some background questions. Answers to the background questions indicated that most respondents had some or substantial experience making accrual decisions in federal agencies.

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The condition for accrual in paragraph 8(a) would be met if an unfavorable outcome is determined to be probable. If an unfavorable outcome is determined to be reasonably possible but not probable, or if the amount of loss cannot be reasonably estimated, accrual would be inappropriate, but disclosure would be required by paragraph 10 of this Statement. When both of these criteria are met, the expected impact of the loss contingency is recorded.

“Reasonably possible” is defined in vague terms as existing when “the chance of the future event or events occurring is more than remote but less than likely” (paragraph 3). The professional judgment of the accountants and auditors is left loss contingency to determine the exact placement of the likelihood of losses within these categories. GAAP accounting rules require probable contingent liabilities—ones that can be estimated and are likely to occur—to be recorded in financial statements.

A loss contingency is a potential financial obligation that arises from past events whose outcome is uncertain but will be resolved by some future event. The accounting for loss contingencies specifically involves potential losses that might come as a result of certain kinds of events. The filing of a suit or formal assertion of a claim or assessment does not automatically indicate that accrual of a loss may be appropriate.