CPA Quiz: Evaluate And Record Loss Contingencies
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Evaluate And Record Loss ContingenciesQuestion 1 of 20

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?

Disclose only; guarantees are off-balance-sheet instruments.
Recognize a contingent asset for the right of recovery from the subsidiary.
Accrue a $300,000 loss contingency liability.
Reduce the investment in the subsidiary by $300,000.
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CPA Quiz: Evaluate And Record Loss Contingencies

Practice Evaluate And Record Loss Contingencies in CPA with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

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This quiz focuses on Evaluate And Record Loss Contingencies, giving you a quick way to practice the rules, question types, and explanations that matter most for CPA.

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Question 1

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?

  1. Disclose only; guarantees are off-balance-sheet instruments.
  2. Recognize a contingent asset for the right of recovery from the subsidiary.
  3. Accrue a $300,000 loss contingency liability. (correct answer)
  4. Reduce the investment in the subsidiary by $300,000.
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.

Question 2

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?

  1. Accrue $150,000 as a tax liability.
  2. No accrual; no disclosure required since the likelihood is remote. (correct answer)
  3. Disclose the $150,000 assessment in the notes.
  4. Accrue $75,000 as a partial loss contingency.
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.

Question 3

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?

  1. Debit Warranty Expense $25,000; Credit Warranty Liability $25,000. (correct answer)
  2. Debit Warranty Liability $25,000; Credit Cash $25,000.
  3. Debit Warranty Expense $18,000; Credit Cash $18,000.
  4. Debit Warranty Expense $7,000; Credit Warranty Liability $7,000.
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.

Question 4

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?

  1. $280,000 (probability-weighted expected value).
  2. $500,000 (maximum loss).
  3. $200,000 (minimum of the estimated range). (correct answer)
  4. $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.

Question 5

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?

  1. Accrue a liability at the minimum possible loss.
  2. No disclosure required since likelihood cannot be assessed.
  3. Accrue a liability at the maximum possible loss.
  4. Disclose the nature and status of the contingency and state that an estimate of the loss cannot be made. (correct answer)
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.

Question 6

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?

  1. $750,000 (correct answer)
  2. $600,000
  3. $900,000
  4. $1,200,000
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.

Question 7

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?

  1. Debit Guarantee Expense $30,000; Credit Cash $30,000.
  2. Debit Loss on Guarantee $30,000; Credit Cash $30,000.
  3. Debit Guarantee Liability $30,000; Credit Guarantee Revenue $30,000.
  4. Debit Guarantee Liability $30,000; Credit Cash $30,000. (correct answer)
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.

Question 8

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?

  1. The $350,000 settlement is recorded in Year 2 only; Year 1 statements are not adjusted.
  2. The Year 1 accrual is adjusted to $350,000 because the settlement provides evidence of conditions existing at December 31, Year 1. (correct answer)
  3. The $300,000 accrual remains; a $50,000 loss is recorded in Year 2.
  4. No accrual in Year 1; the full $350,000 is recorded in Year 2.
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.

Question 9

Under ASC 450, which of the following is a required disclosure for a loss contingency that is reasonably possible but cannot be reasonably estimated?

  1. The contingency need not be disclosed.
  2. Accrue the contingency at a nominal amount of $1.
  3. Disclose only the maximum possible loss.
  4. Disclose the nature of the contingency and state that an estimate of the possible loss cannot be made. (correct answer)
Explanation: For a reasonably possible contingency that cannot be estimated, ASC 450 requires disclosure of the nature of the contingency and a statement that an estimate cannot be made. Answer D is correct. Answer A omits required disclosure. Answer B accrues a nominal amount with no basis in the standard. Answer C discloses only the maximum, which is not a prescribed approach when an estimate cannot be made.

Question 10

A company operates in a jurisdiction with an environmental cleanup statute. The company knows contamination exists on its property but asserts that cleanup costs cannot be reasonably estimated. Under ASC 450, what is the minimum required treatment?

  1. Accrue an estimated remediation liability at the minimum possible cost.
  2. No action required until a government order is received.
  3. Disclose the nature of the contingency and state that a loss amount cannot be estimated, if the loss is at least reasonably possible. (correct answer)
  4. Record a nominal $1 liability to acknowledge the obligation.
Explanation: If remediation is at least reasonably possible but cannot be estimated, ASC 450 requires disclosure: nature of the contingency and a statement that the amount cannot be estimated. Answer C is correct. Answer A accrues without a basis for estimation. Answer B defers all action, ignoring disclosure requirements. Answer D records a nominal liability with no GAAP basis.

Question 11

A company estimates warranty costs at 2% of annual sales. Sales are $4,000,000. Actual warranty claims paid during the year total $55,000. The beginning warranty liability balance is $30,000. What is the ending warranty liability balance?

  1. $55,000 (correct answer)
  2. $30,000
  3. $25,000
  4. $80,000
Explanation: Warranty expense accrued = $4,000,000 x 2% = $80,000. Ending balance = $30,000 + $80,000 - $55,000 = 55,000.AnswerAiscorrect.AnswerD(55,000. Answer A is correct. Answer D (80,000) is beginning balance plus accrual before deducting claims paid. Answer B is the beginning balance unchanged, ignoring both accruals and claims. Answer C results from subtracting claims paid from the beginning balance only, ignoring the current-year accrual.

Question 12

A company provides a product warranty and estimates 3% of all sales will result in warranty claims. Annual sales are $2,000,000. During the year, $45,000 of warranty claims are honored. What is warranty expense for the year?

  1. $45,000
  2. $60,000 (correct answer)
  3. $15,000
  4. $105,000
Explanation: Warranty expense is based on the estimate, not actual claims paid. Warranty expense = $2,000,000 x 3% = $60,000. Answer B is correct. Answer A records only actual claims paid (cash basis), ignoring the accrual requirement. Answer C is the difference between the estimate and claims paid. Answer D adds both the estimate and actual claims.

Question 13

A company has probable litigation losses with a best estimate of $400,000. The company also has a probable insurance recovery of $150,000 related to the same claim. How should these be presented on the balance sheet under U.S. GAAP?

  1. Liability of $400,000 and a separate receivable of $150,000, if receipt of the insurance proceeds is probable. (correct answer)
  2. Net liability of $250,000.
  3. Only the $400,000 liability; insurance recoveries are not recognized until received.
  4. No entry until the litigation is settled.
Explanation: Under U.S. GAAP, the gross liability ($400,000) is recorded separately from any recovery. An insurance recovery receivable may be recognized separately when receipt is probable (ASC 450-20-55-19 / ASC 410). The two cannot be netted on the balance sheet. Answer A is correct. Answer B nets the two amounts, which violates the gross presentation requirement. Answer C is overly conservative - probable insurance recoveries can be recognized. Answer D defers recognition of a probable, estimable loss.

Question 14

A company has an accrued litigation liability of $500,000 at year-end. New information received before the financial statements are issued indicates the actual settlement will be $200,000. What is the appropriate accounting treatment?

  1. Reduce the accrual to $200,000; the new information relates to conditions existing at the balance sheet date. (correct answer)
  2. Keep the $500,000 accrual; changes are recognized only in future periods.
  3. Reverse the full $500,000 accrual and record $200,000 in the next period.
  4. Average the two estimates and record $350,000.
Explanation: New information received after the balance sheet date but before financial statement issuance that provides evidence of conditions existing at the balance sheet date is a recognized subsequent event under ASC 855. The accrual is adjusted to $200,000. Answer A is correct. Answer B ignores Type I subsequent event guidance. Answer C reverses and defers, creating a period mismatch. Answer D has no basis in GAAP.

Question 15

A contingency that is remote in likelihood but could result in a very large loss is sometimes disclosed voluntarily. Under ASC 450, which of the following most accurately describes required disclosure for remote contingencies?

  1. Remote contingencies must always be disclosed because of the materiality of the potential loss.
  2. Remote contingencies must be disclosed if the potential loss exceeds 5% of total assets.
  3. Remote contingencies must be disclosed if they involve related parties.
  4. Remote contingencies generally need not be disclosed, except for certain guarantees of others' indebtedness. (correct answer)
Explanation: Under ASC 450, remote contingencies generally do not require disclosure. The primary exception is for guarantees of indebtedness of others - even if the probability of loss is remote, guarantees must be disclosed. Companies may also choose to voluntarily disclose large remote contingencies, but it is not required. Answer D is correct. Answers A, B, and C impose disclosure requirements for remote contingencies beyond what ASC 450 mandates.

Question 16

A company is involved in litigation. Legal counsel advises that it is probable the company will lose and estimates the loss at between $500,000 and $800,000, with no amount in the range being a better estimate than another. Under ASC 450, what amount should be accrued?

  1. $500,000 (correct answer)
  2. $650,000
  3. $800,000
  4. $0; the range is too wide to estimate.
Explanation: When a loss is probable and a range of loss can be estimated but no amount within the range is a better estimate than another, ASC 450 requires accrual of the minimum amount of the range. Answer A ($500,000) is correct. Answer B (the midpoint) is the IFRS approach under IAS 37 but not U.S. GAAP. Answer C accrues the maximum, which overstates the liability. Answer D is incorrect because a range constitutes a reasonable estimate.

Question 17

Apex Manufacturing is facing three separate legal matters as of December 31, 2024. The company's legal counsel has provided the following assessments:

  1. Product liability lawsuit: A customer filed a $2.5 million lawsuit claiming injury from a defective product. Legal counsel believes there is a 30% chance of losing the case, and if lost, the settlement would likely be between $800,000 and $1.2 million.

  2. Environmental cleanup: The EPA has notified Apex of potential contamination at a former facility. Cleanup costs are estimated at $1.8 million. Legal counsel believes it is probable that Apex will be required to pay, but the amount could range from $1.5 million to $2.2 million based on the extent of contamination discovered.

  3. Patent infringement: A competitor has filed a $3.0 million patent infringement claim. Legal counsel believes it is reasonably possible that Apex will lose, with potential damages of $500,000 to $750,000 if the case is lost.

What total amount should Apex Manufacturing record as a loss contingency liability in its December 31, 2024 financial statements?

  1. $1,500,000 for the environmental cleanup matter only, as it is the only probable loss with a reasonably estimable amount (correct answer)
  2. $3,300,000 representing the minimum estimated amounts for all three matters since they all involve potential future cash outflows
  3. 2,300,000representingtheenvironmentalcleanup(2,300,000 representing the environmental cleanup (1,500,000) plus the product liability lawsuit ($800,000) since both have determinable minimum amounts
  4. $0 because none of the contingencies meet both the probable likelihood and reasonably estimable criteria for accrual under GAAP
Explanation: Under ASC 450-20, a loss contingency should be accrued when (1) it is probable that a loss has been incurred and (2) the amount can be reasonably estimated. Only the environmental cleanup meets both criteria - legal counsel believes it is probable Apex will be required to pay, and a range of $1.5M to 2.2Misprovided.Whenarangeisgivenwithnobestestimate,theminimumamount(2.2M is provided. When a range is given with no best estimate, the minimum amount (1.5M) should be accrued. The product liability lawsuit is only 30% likely (not probable), and the patent case is only reasonably possible. Choice B incorrectly accrues all matters regardless of probability. Choice C incorrectly accrues the product liability case that isn't probable. Choice D incorrectly concludes that the environmental matter doesn't meet accrual criteria.

Question 18

Omega Corp operates retail stores and has been involved in a slip-and-fall lawsuit filed in March 2024. The case involves a customer who was injured in one of Omega's stores in January 2024. Legal counsel has provided the following timeline of assessments:

  • March 2024 (case filed): Probability of loss assessed as remote
  • August 2024 (after discovery): Probability revised to reasonably possible, potential damages $400,000-$600,000
  • November 2024 (after expert testimony): Probability revised to probable, likely damages $525,000
  • January 2025 (before financial statement issuance): Settlement reached for $475,000

Omega's fiscal year ends December 31, 2024.

What amount should Omega record as a loss contingency in its December 31, 2024 financial statements?

  1. $525,000 based on the November 2024 assessment of probable loss, since this represents the best estimate available at year-end
  2. $475,000 based on the January 2025 settlement, since this provides definitive evidence of the actual loss amount before financial statements are issued (correct answer)
  3. $500,000 representing the midpoint of the August 2024 range, since this provides a more objective estimate than legal counsel's November assessment
  4. $0 because the assessment changed multiple times during the year, indicating the loss amount was not reasonably estimable throughout the period
Explanation: The January 2025 settlement of $475,000 is a Type I subsequent event that provides additional evidence about the liability that existed at December 31, 2024. Since the settlement occurred before the financial statements were issued and relates to the lawsuit that was pending at year-end, it provides definitive evidence of the loss amount that should be accrued. ASC 855 requires recognition of subsequent events that provide evidence about conditions existing at the balance sheet date. Choice A incorrectly uses the year-end estimate when better evidence is available. Choice C incorrectly uses an outdated range estimate. Choice D incorrectly concludes that changing assessments eliminate the requirement to accrue when the final amount becomes known.

Question 19

Zeta Manufacturing has three pending legal matters at December 31, 2024:

Case A: Employment discrimination lawsuit seeking $800,000 in damages. Legal counsel believes there is a 60% chance of an unfavorable outcome. If lost, damages would likely be $300,000 to $500,000.

Case B: Breach of contract claim for $1.2 million. Legal counsel believes there is a 75% chance of an unfavorable outcome, with likely damages of $850,000.

Case C: Product defect class action seeking $5 million. Legal counsel believes there is a 45% chance of an unfavorable outcome. If lost, settlement would likely be $2 million to $3 million.

Which of the following best describes the appropriate financial statement treatment for these contingencies?

  1. Accrue Case A at $300,000 and Case B at $850,000; disclose Case C as reasonably possible with potential exposure of $2-3 million
  2. Accrue only Case B at $850,000 since it has the highest probability; disclose Cases A and C as reasonably possible contingencies
  3. Accrue Case B at $850,000; disclose Case A as reasonably possible; make no mention of Case C since it is less than 50% likely (correct answer)
  4. Disclose all three cases as reasonably possible contingencies since none exceeds the 80% probability threshold required for accrual under GAAP
Explanation: Under ASC 450-20, 'probable' is generally interpreted as more likely than not (>50%). Case B at 75% probability meets the probable threshold and should be accrued at the best estimate of 850,000.CaseAat60850,000. Case A at 60% also exceeds 50% but the stem provides only a range (300,000-$500,000) with no indication of the best estimate, so the minimum should be accrued - however, this makes Choice A partially correct. Case C at 45% is reasonably possible and should be disclosed. Choice C is the best answer because it correctly identifies Case B for accrual and properly treats the others. Choice A incorrectly assumes the minimum for Case A when the range requires more analysis. Choice B incorrectly treats 60% as not probable. Choice D incorrectly states an 80% threshold that doesn't exist in GAAP.

Question 20

Gamma Industries has been involved in ongoing litigation regarding alleged violations of labor laws. The case has been in progress for 18 months. As of September 30, 2024, Gamma's legal counsel provided the following updated assessment:

  • Probability of an unfavorable outcome: Probable
  • If the case is lost, the most likely settlement amount is $1.6 million
  • However, depending on the court's interpretation of damages, the amount could range from $900,000 to $2.4 million
  • Legal fees incurred to date: $180,000
  • Estimated additional legal fees through trial completion: $220,000

Gamma had previously recorded a $1.2 million liability in 2023 when the loss was first deemed probable.

What journal entry should Gamma Industries record in the third quarter of 2024 to properly account for this contingency?

  1. Debit Loss on Contingency $400,000; Credit Contingent Liability $400,000 to increase the liability to the most likely settlement amount of $1.6 million (correct answer)
  2. Debit Loss on Contingency $1.6 million; Credit Contingent Liability $1.6 million to record the full most likely settlement amount as an additional provision
  3. Debit Loss on Contingency $620,000; Credit Contingent Liability 620,000torecordboththeincreasedsettlementestimate(620,000 to record both the increased settlement estimate (400,000) and remaining legal fees ($220,000)
  4. Debit Legal Expense $220,000; Credit Contingent Liability $220,000 to record only the estimated additional legal fees since the settlement estimate represents the best available estimate
Explanation: When new information becomes available about a probable loss contingency, the accrual should be adjusted to reflect the best estimate. Since legal counsel now indicates the most likely amount is $1.6 million (increased from the previous $1.2 million accrual), an additional $400,000 should be accrued. Legal fees are period costs and should be expensed as incurred, not accrued as part of the contingent liability. Choice B incorrectly records the full amount rather than the incremental increase. Choice C incorrectly includes legal fees in the contingent liability. Choice D incorrectly treats legal fees as a liability rather than a period expense and fails to adjust the settlement estimate.