ASC 450-20: Accounting for Loss Contingencies

The Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) 450-20 provides the structure for how businesses must identify, measure, and report on uncertain situations that could result in a financial loss. These uncertainties are known as loss contingencies. By establishing clear criteria, the standard dictates when a potential loss must be formally recorded in the financial statements versus when it should simply be described in the accompanying notes. This distinction is designed to create consistency in financial reporting, allowing investors and other stakeholders to understand the potential risks a company faces based on information available at the time.

Core Principles of Loss Contingencies

A contingency is defined as an existing condition, situation, or set of circumstances involving uncertainty as to a possible loss. This uncertainty will be resolved when one or more future events occur or fail to occur. A loss contingency is a potential negative financial outcome stemming from a past event.

To bring uniformity to this assessment, ASC 450-20 establishes three thresholds of likelihood. The first is “probable,” which means the future event is likely to occur. The standard requires companies to use professional judgment to make this determination rather than a specific percentage. The next level is “reasonably possible,” which describes a chance of occurrence that is more than remote but less than likely. The final threshold is “remote,” indicating that the chance of the future event occurring is slight. These definitions are the determining factors that drive whether a potential loss is recorded or disclosed.

Accrual Criteria for a Loss

For a company to formally record, or accrue, a liability for a loss contingency, two conditions must be satisfied. The first condition is that information available before the financial statements are issued must indicate it is probable a liability was incurred as of the balance sheet date. This means the underlying cause of the potential loss, such as an accident, must have happened on or before the last day of the reporting period.

The second condition is that the amount of the loss can be reasonably estimated. This does not require a single, precise figure, as a company can use various estimation techniques and historical data to arrive at a reliable estimate. Without a reasonable estimate, an accrual cannot be made even if the loss is probable.

In situations where the loss can only be estimated as a range of possible amounts, and no single amount within that range appears to be a better estimate, the company is required to accrue the minimum amount in the range. If, however, a specific figure within the range is considered the most likely outcome, that “best estimate” is the amount that should be accrued.

Disclosure Requirements in Financial Statements

When a potential loss does not meet both criteria for accrual, it may still require disclosure in the footnotes of the financial statements. Disclosure is required in two primary scenarios. The first is when a loss is determined to be “reasonably possible,” regardless of whether the amount can be estimated. The second scenario is when a loss is “probable,” but a reasonable estimate of the amount cannot be determined.

The disclosure must include a description of the nature of the contingency, explaining the circumstances that give rise to the potential loss. It must also include an estimate of the possible loss or range of loss, and if an estimate cannot be made, the company is required to state that fact. For example, a company defending a lawsuit where the outcome is reasonably possible would disclose the facts of the case in its footnotes.

Common Examples of Loss Contingencies

The principles of ASC 450-20 are applied to many common business situations. One of the most frequent examples is pending or threatened litigation. When a company is sued, it must assess the probability of an unfavorable outcome. If its legal counsel advises that it is probable the company will lose and the amount can be reasonably estimated, the company must accrue a liability. If the loss is only reasonably possible, it would instead disclose the details in its financial statement footnotes.

Another prevalent example involves product warranty obligations. When a company sells products with a warranty, it is creating a contingency. Based on historical data, such as past claim rates and repair costs, the company can typically estimate the probable cost of future warranty claims. Companies accrue a liability for warranty expenses in the same period the product revenue is recognized.

Environmental liabilities represent another area where loss contingencies are common. A company may learn it is responsible for cleaning up a contaminated site. The assessment would involve determining if it is probable that the company will have to incur cleanup costs and if those costs can be reasonably estimated.