Levels of Probability

ASC defines the different levels of probability as to whether or not future events will confirm the existence of a loss as follows:

1. Probable—The future event or events are likely to occur.
2. Reasonably possible—The chance of the future event or events occurring is more than remote but less than likely.
3. Remote—The chance of the future event or events occurring is slight.

   (ASC 450-20-25-2)

Professional judgment is required to classify the likelihood of the future events occurring. All relevant information that can be acquired concerning the uncertain set of circumstances needs to be obtained and used to determine the classification.

Estimating the Loss

When estimating the fair value of the loss, it is not necessary that a single amount be identified. A range of amounts is sufficient to indicate that some amount of loss has been incurred and is required to be accrued. (ASC 450-20-25-5) The amount accrued is the amount within the range that appears to be the best estimate. If there is no best estimate, the minimum amount in the range is accrued, since it is probable that the loss will be at least that amount. (ASC 450-20) The maximum amount of loss is required to be disclosed. (ASC 450-20-30-1) If future events indicate that the minimum loss originally accrued is inadequate, an additional loss is to be accrued in the period when this fact becomes known. This accrual is a change in estimate, not a prior period adjustment.

Probable. When a loss is probable and no estimate is possible, these facts are also to be disclosed in the current period. The accrual of the loss is to be made in the earliest period in which the amount of the loss can be estimated. Accrual of that loss in future periods is a change in estimate. It is not treated as a restatement (prior period adjustment).

Reasonably possible. If the occurrence of the loss is reasonably possible, the facts and circumstances of the possible loss and an estimate of the amount, if determinable, are to be disclosed. If the occurrence of the loss is remote, no accrual or disclosure is usually required.

Amount not estimable. When a public company cannot estimate the reasonably likely impact of a contingent liability, but a range of amounts are determinable, the SEC requires disclosure of those amounts. Disclosure of contingencies for public companies is also to include quantification of the related accruals and adjustments, costs of legal defense, and reasonably likely exposure to additional loss, as well as the assumptions that management has made about those amounts and the extent to which the resulting estimates of loss are sensitive to changes in those assumptions.

Events Subsequent to Balance Sheet Date

Events that give rise to loss contingencies that occur after the date of the statement of financial position (i.e., bankruptcy or expropriation) but before issuance of the financial statements may require disclosure so that statement users are not misled. Note disclosures or pro forma financial statements may be prepared as supplemental information to show the effect of the loss.

Unasserted Claims or Assessments

It is not necessary to disclose loss contingencies for an unasserted claim or assessment where there has been no manifestation of an awareness of possible claim or assessment by a potential claimant unless it is deemed probable that a claim will be asserted and a reasonable possibility of an unfavorable outcome exists. Under the provisions of ASC 450, general or unspecified business risks are not loss contingencies and therefore no accrual is necessary. Disclosure of these business risks may be required under ASC 275.

Estimate Versus Contingency

Distinguishing between an estimate and a contingency can be difficult because both involve an uncertainty that will be resolved by future events. However, an estimate exists because of uncertainty about the amount of a loss resulting from an event requiring an acknowledged accounting recognition. The event has occurred and the effect is known, but the amount itself is uncertain. For example, depreciation is an estimate, but not a contingency because the actual fact of physical depreciation is acknowledged, although the amount is obtained by an assumed accounting method.

In a contingency, the amount is also usually uncertain, although that is not an essential characteristic. Instead, the uncertainty lies in whether the event has occurred (or will) and what the effect, if any, on the enterprise would be. Collectibility of receivables is a contingency because it is uncertain whether a customer will not pay at a future date, although it is probable that some customers will not pay. Similar logic would hold for obligations related to product warranties. That is, it is uncertain whether a product will fail, but it is probable that some will fail within the warranty period.

Other contingencies are rarely recognized until specific events confirming their existence occur. Every business risks loss by fire, explosion, government expropriation, or casualties in the ordinary course of business. To the extent those losses are not (or cannot be) insured, the risks are contingencies. Because those events are often random in their occurrence, uncertainty surrounds whether the future event confirming the loss will or will not take place. The passage of time usually resolves the uncertainty. Until the event confirming the loss occurs (or is probable of occurrence) and the amount of the loss can be reasonably estimated, the potential loss is not recognized in financial statements.

Litigation

The most difficult area of contingencies is litigation. Accountants must rely on attorneys' assessments concerning the likelihood of such events. Unless the attorney indicates that the risk of loss is remote or slight, or that the loss if it occurs would be immaterial to the company, disclosure in financial statements is necessary and an accrual may also be necessary. In practice, attorneys are loathe to state that the risk of loss is remote, as that term is defined by ASC 450, although the likelihood of obtaining a definitive response to lawyers' letters under AU-C Section 501 is improved if the auditors explicitly cite a materiality threshold. In cases where judgments have been entered against the reporting entity, or where the attorney gives a range of expected losses or other amounts and indicates that an unfavorable outcome is probable, accruals of loss contingencies for at least the minimum point of the range must be made. In most cases, however, an estimate of the contingency is unknown and the contingency is reflected only in footnotes.

Accruals for contingencies, including those arising in connection with litigation, are limited under GAAP to expected losses resulting from events occurring prior to the date of the statement of financial position. (ASC 450-20-25-6) One unresolved issue is whether expected legal costs to be incurred in connection with a loss contingency that is being accrued should be accrued as well. Apparently, GAAP would permit such an accrual, but practice is varied. With respect to SEC registrants, the SEC staff expects consistency and the decision to do so to be disclosed in the financial statements and applied consistently. (ASC 450-20-S99)