Case Study

Case 13-08:
Accounting for a loss contingency for a verdict overturned on appeal

There are 3 discussion questions and various alternatives for each discussion. Please choose the most appropriate alternative for each discussion and support your choice by stating the applicable pronouncements and explaining why they are appropriate and applicable.

Objective of the Case

This case gives students an opportunity to apply the key concepts of accounting for contingencies pursuant to the guidance in ASC 450.

Applicable Professional Pronouncements

ASC 310, Receivables (ASC 310)
ASC 410-30, Asset Retirement and Environmental Obligations: Environmental Obligations (ASC 410-30)
ASC 450, Contingencies (ASC 450)
FASB Concept Statement No. 6, Elements of Financial Statements (Con 6)

Discussion 1 — Accounting for year-end financial statements December 31, 2007

For the year-end December 31, 2007, financial statements, what amount should M International (“M”) record as a liability?

Accounting Alternatives

Alternative 1 — Recognize and disclose $20 million.

M should record $20 million as an accrued liability for the loss contingency and disclose the nature of this liability within notes to the financial statements. This is in accordance with guidance under ASC 450-20-25-2, which states, in part:

An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

a. 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.

b. The amount of loss can be reasonably estimated.
c. After considering the above guidance, given that the loss is probable of occurring and is estimable, it is prudent, reasonable, and conservative of M to record an accrual at the high end of the $15 million to $20 million range as a loss contingency. Disclosure of the nature and amount of the liability should follow disclosure requirements under ASC 450- 20-50.

Alternative 2 — Recognize $17 million and disclose $3 million.

Consistent with the guidance under ASC 450-20-25-2 quoted above, M should recognize an accrued liability for the loss contingency in its December 31, 2007 financial statements. An amount of $17 million, being the most likely amount in the range, should be accrued as the amount of the loss contingency and recorded in the financial statements, and disclosure should be made for the difference between the most likely amount of $17 million and maximum loss amount of $20 million.

Alternative 3 — Recognize $15 million and disclose $5 million.

Consistent with the guidance under ASC 450-20-25-2 quoted above, M should recognize
an accrued liability for the loss contingency in its December 31, 2007 financial statements. Given that the loss is probable of occurring and is estimable, it is prudent and reasonable for M to record an accrual at the low end of the $15 million to $20 million range as a loss contingency. Disclosure of the nature and amount of the liability should follow disclosure requirements under ASC 450-20-50.

Solution — Choose the Most Appropriate Alternative and Give Supporting Evidence for Your Choice Providing the Correct Pronouncement Guidance

Discussion 2 — Accounting for year-end financial statements December 31, 2009

For the year-end December 31, 2009, financial statements, should M adjust its liability? If so, what amount should be recorded? Should the amount of the adjustment, if any, be considered a 2009 event or a prior period adjustment?

Accounting Alternatives

Alternative 1 — Yes. Accrue an incremental liability of $1.5 million for the year ended December 31, 2009.

The jury reached a verdict against M in September 2009. This verdict required M to pay W Inc. (“W,” a competitor of M) $18.5 million. This contingency is now probable, and the amount of the contingency of $18.5 million is reasonably estimable (as the amount was determined by the jury as the outcome of the litigation). Thus, given that M had already accrued $17 million in a prior year, it should record an additional $1.5 million in the current period based on the change in circumstances determined by the verdict of the jury, which occurred during 2009.
Alternative 2 — Yes. Accrue an incremental liability of $1.5 million as a prior period adjustment.

This alternative is very similar to the above view; however, using this alternative, will have to restate its prior two years of financial statements. The 2007 financial statements would be restated to change the income statement charge and the amount of the accrued liability to $18.5 million. The 2008 financial statements would be restated to increase the amount of the accrued liability to $18.5 million.

Solution 2 – Choose the Most Appropriate Alternative and Give Supporting Evidence for Your Choice Providing the Correct Pronouncement Guidance

Discussion 3 — Accounting for events after verdict overturned on appeal

Should M record the reduction of the previously recorded loss contingency in 2010 (upon the Court of Appeals overturning the verdict of the jury) or 2011 (once the appellate judges declined W’s petition for a re-hearing)?

Accounting Alternatives

Alternative 1 — Reduce the amount of the loss contingency in 2011 upon the appellate judge’s decision to decline W’s petition for a re-hearing.

Since there is a possibility that the Court of Appeals verdict can be overturned through a subsequent re-hearing following the appellate judge’s decision to decline W’s petition, M should wait to reverse the previously accrued loss contingency liability following the re-hearing.

Alternative 2 — Reduce the amount of loss contingency in 2010 upon the Court of Appeals overturning the verdict of the jury.

The Company should reduce the amount of its loss contingency given the ruling reached by the Court of Appeals to overturn the verdict, since the loss contingency is no longer probable. Further, M should treat the reduction in the amount of the loss contingency as a change in estimate.

Solution 3 – Choose the Most Appropriate Alternative and Give Supporting Evidence for Your Choice Providing the Correct Pronouncement Guidance