Evaluate And Record Loss Contingencies
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CPA Financial Accounting and Reporting (FAR) › Evaluate And Record Loss Contingencies
A company guarantees the debt of a subsidiary. The subsidiary is in financial distress and it is probable the parent will have to pay $300,000 under the guarantee. The amount is reasonably estimable. How should the parent account for this?
Accrue a $300,000 loss contingency liability.
Reduce the investment in the subsidiary by $300,000.
Recognize a contingent asset for the right of recovery from the subsidiary.
Disclose only; guarantees are off-balance-sheet instruments.
Explanation
When payment under a guarantee is probable and reasonably estimable, ASC 450 requires accrual of a loss contingency. The parent records a $300,000 liability. Answer C is correct. Answer A incorrectly treats all guarantees as off-balance-sheet. Answer B records an asset rather than a liability - recovery rights may be disclosed but the primary entry is the liability. Answer D reduces the investment account, which is not the correct entry for a guarantee payment obligation.
A lawsuit is filed against a company in December Year 1. At December 31, Year 1, legal counsel believes the likelihood of an unfavorable outcome is remote. How should this be reported?
Disclose and accrue the probable loss.
Accrue the minimum estimated loss.
Disclose only; remote contingencies must always be disclosed.
No accrual and no disclosure required.
Explanation
Under ASC 450, remote contingencies generally require neither accrual nor disclosure. When the likelihood is remote, the loss is not accrued and disclosure is not required (with limited exceptions for guarantees). Answer A is correct. Answer B incorrectly requires disclosure for all remote contingencies. Answers C and D require accrual, which is only appropriate when loss is probable and estimable.
A company receives a notice of proposed assessment from a state environmental agency for $150,000 in fines related to alleged permit violations. Legal counsel advises that the company has a strong defense and the probability of an unfavorable outcome is remote. How should this be reported in the financial statements?
Disclose the $150,000 assessment in the notes.
Accrue $150,000 as a tax liability.
Accrue $75,000 as a partial loss contingency.
No accrual; no disclosure required since the likelihood is remote.
Explanation
Under ASC 450, when the likelihood of an unfavorable outcome is remote, neither accrual nor disclosure is required. Answer B is correct. Answer A accrues a remote contingency, which is not warranted under ASC 450 - accrual requires the loss to be both probable and reasonably estimable. Answer C requires disclosure for a remote contingency, which is generally not required except in limited circumstances such as guarantees of others' indebtedness. Answer D accrues 50% of a remote contingency with no basis in the standard.
A company sells products with a one-year warranty. At year-end, the company has $20,000 in its warranty liability account from the prior year. During the current year, warranty claims of $18,000 are paid and new warranty expense of $25,000 is accrued. What journal entry records the current-year warranty expense accrual?
Debit Warranty Expense $7,000; Credit Warranty Liability $7,000.
Debit Warranty Expense $18,000; Credit Cash $18,000.
Debit Warranty Liability $25,000; Credit Cash $25,000.
Debit Warranty Expense $25,000; Credit Warranty Liability $25,000.
Explanation
The warranty expense accrual entry records the estimated future obligation: Debit Warranty Expense and Credit Warranty Liability for the current-year estimate of $25,000. Answer A is correct. Answer B debits the liability and credits cash, which records payment of claims, not the accrual. Answer C records the cash payments as expense, bypassing the liability account. Answer D records only the net change in the liability, which is not the correct accrual entry.
A company is a defendant in a lawsuit. Legal counsel provides the following assessment: 30% chance of no loss, 40% chance of $200,000 loss, 30% chance of $500,000 loss. The loss is deemed probable. Under ASC 450, what amount should be accrued?
$280,000 (probability-weighted expected value).
$200,000 (minimum of the estimated range).
$500,000 (maximum loss).
$0; the uncertainty precludes accrual.
Explanation
Under ASC 450, when a range can be identified and no amount within the range is a better estimate, the minimum of the range is accrued. The range of probable loss is $200,000 to $500,000. The minimum is $200,000. Answer C is correct. Answer A uses expected value (probability-weighted), which is the IFRS approach under IAS 37, not U.S. GAAP. Answer B accrues the maximum. Answer D incorrectly concludes the uncertainty precludes accrual.
A company is being sued for patent infringement. The case is complex and ongoing. At year-end, legal counsel is unable to assess the likelihood of an unfavorable outcome. Under ASC 450, how should this be reported?
No disclosure required since likelihood cannot be assessed.
Accrue a liability at the minimum possible loss.
Accrue a liability at the maximum possible loss.
Disclose the nature and status of the contingency and state that an estimate of the loss cannot be made.
Explanation
When the likelihood of loss cannot be assessed, neither accrual nor omission of disclosure is appropriate. ASC 450 requires disclosure of the nature of the contingency and a statement that an estimate cannot be made. Answer D is correct. Answers A and C accrue a liability when the loss is not assessed as probable. Answer B omits required disclosure - even uncertain contingencies of significance require disclosure.
A company faces a probable loss from a lawsuit. Its attorneys estimate the most likely outcome is a $750,000 settlement, but the range of possible outcomes is $600,000 to $1,200,000. Under ASC 450, what amount should be accrued?
$750,000
$900,000
$1,200,000
$600,000
Explanation
When a single amount within the range is a better estimate than any other (the most likely outcome), that amount is accrued. Legal counsel has identified $750,000 as the most likely settlement. Answer A is correct. Answer B accrues the minimum, which applies only when no amount in the range is a better estimate. Answer C is the midpoint. Answer D is the maximum.
A company issues a financial guarantee for a third party's debt. Under ASC 460, the guarantee is initially recognized at its fair value of $30,000. Subsequently, the guaranteed party defaults and the company must pay $30,000 under the guarantee. What entry records the payment?
Debit Guarantee Expense $30,000; Credit Cash $30,000.
Debit Guarantee Liability $30,000; Credit Cash $30,000.
Debit Loss on Guarantee $30,000; Credit Cash $30,000.
Debit Guarantee Liability $30,000; Credit Guarantee Revenue $30,000.
Explanation
Under ASC 460, the guarantee liability recognized at inception is reduced when payment is made. The entry debits the Guarantee Liability and credits Cash. Answer D is correct. Answers A and B record an expense or loss at payment, but the expense was recognized at the inception of the guarantee when the liability was established. Answer C credits revenue, which is incorrect - settling a liability does not generate revenue.
Which of the following best describes a 'reasonably possible' contingency under ASC 450?
The chance of the future event occurring is slight.
The future event is likely to occur.
The future event will virtually certainly occur.
The chance of the future event occurring is more than remote but less than probable.
Explanation
ASC 450 defines three likelihood categories: probable (likely to occur), reasonably possible (more than remote but less than probable), and remote (slight chance). Answer C correctly describes 'reasonably possible.' Answer A describes 'remote.' Answer B describes 'probable.' Answer D describes 'virtually certain,' which is not a defined ASC 450 term.
A company is sued in Year 1. At December 31, Year 1, the loss is probable and estimated at $300,000. By the time the Year 1 financial statements are issued in March Year 2, the lawsuit settles for $350,000. Under ASC 855 (subsequent events), how should the settlement be reflected?
The $300,000 accrual remains; a $50,000 loss is recorded in Year 2.
The Year 1 accrual is adjusted to $350,000 because the settlement provides evidence of conditions existing at December 31, Year 1.
No accrual in Year 1; the full $350,000 is recorded in Year 2.
The $350,000 settlement is recorded in Year 2 only; Year 1 statements are not adjusted.
Explanation
Under ASC 855, a recognized subsequent event provides additional evidence of conditions that existed at the balance sheet date. The settlement of a lawsuit that existed at year-end is a Type I (recognized) subsequent event. The Year 1 accrual is adjusted to $350,000 before issuance. Answer B is correct. Answer A treats the settlement as a non-recognized (Type II) event. Answer C records the additional $50,000 in Year 2. Answer D defers all recognition to Year 2.