Accounting for
Contingencies:
Disclosure of Future
Business Risks
B Y J O N A T H A N S C H I F F, C M A , P H . D . ; A L L E N S C H I F F, P H . D . ;
AND HANNAH ROZEN, PH.D.
IN THIS ARTICLE, THE AUTHORS
TINGENCIES AND COMPARE
PROVIDE A CONCISE REVIEW OF ACCOUNTING FOR CON-
U.S. GAAP AND IFRS
REQUIREMENTS RELATED TO POTEN-
TIAL GAINS AND LOSSES. THEY ALSO INCLUDE SOME CONTEMPORARY ILLUSTRATIONS
THAT DEMONSTRATE HOW SOME COMPANIES ARE COMPLYING WITH FINANCIAL REPORTING
REQUIREMENTS FOR CONTINGENCIES.
ccounting and reporting for
contingencies—that is to say, potential
gains and losses—is a topic that is not regularly on the front burner of finance and
accounting professionals. It usually is covered in just a few pages in the standard intermediate
accounting college textbook. Now, however, the
increase in recession-induced merger and acquisition
activity, the enhancement of executive exposure as a
result of the Sarbanes-Oxley Act (SOX), and the business leadership focus on global risk management all
point to the need for a renewed focus on accounting for
contingencies. Also, related disclosures can shed valuable light on the potential of corporations to meet
future reported earnings and cash flow goals.
Accounting Standards Codification® (ASC) 450, “Con-
tingencies” (formerly Statement of Financial Accounting Standards No. 5 (SFAS No. 5), “Accounting for
Contingencies”), applies to both gain and loss contingencies. With the exception of tax loss carryforwards,
gain contingencies are not generally recognized because
they could result in recognition of revenue before it is
realized. In contrast, many types of loss contingencies
are recognized. Principally, these include loss contingencies that result in liabilities, as well as those that
involve asset impairments. ASC 450-20-25 (450, Contingencies; 20, Loss Contingencies; 25, Recognition)
requires consideration of the likelihood that a contingency will be realized, as well as an assessment of
whether the amount of the loss is reasonably
estimable.1 Likelihood estimates range along a continuum from probable to reasonably possible to remote. In
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necessary. A loss contingency is an existing condition,
situation, or set of circumstances involving uncertainty as
to possible loss to an entity that will ultimately be
resolved when one or more future events occur or fail to
occur.5 Generally, contingencies in this category are
considered loss contingencies either because of a potential liability or a potential asset impairment. Examples of
contingent liabilities include pending or threatened litigation, claims and assessments, and product warranties
and defects. Those that involve asset impairments
include collectability of receivables and threat of expropriation of assets.
general, loss contingencies are recorded when the likelihood of loss is probable and the amount is reasonably
estimable. Both recorded loss contingencies and nonrecorded loss contingencies are subject to disclosure.
International Accounting Standard (IAS) 37, Provisions, Contingent Liabilities and Contingent Assets, from the
International Accounting Standards Board (IASB) is the
principal international counterpart to ASC 450. Whereas
ASC 450 focuses on the income statement (i.e., gains
and losses), IAS 37 focuses on the balance sheet (i.e.,
recognition of an asset or liability/provision). Similar to
the stipulations in ASC 450, unless realization of
income is “virtually certain,” IAS 37 does not permit
the recognition of contingent assets. For liabilities, IAS
37 requires consideration of the likelihood that “an outflow of resources embodying economic benefits will be
required to settle the obligation,” as well as an assessment of whether the amount of the obligation is reasonably estimable.2
Treatment of Loss Contingencies
As contingencies are by nature vague and difficult to
estimate, their treatment differs based on the degree to
which a loss is probable. In some cases, disclosure in
the footnotes alone is adequate. In others, accrual and
recognition on the face of the financial statements is
required.
The first step to be taken in deciding whether and
how to account for a contingency is to verify its
existence.
Second, once it is known that a loss contingency
exists, the entity must determine where on a
continuum—from remote to reasonably possible to
probable—the contingency lies.
Third, the entity must perform one of the following
actions:
(a) If it is probable that a loss has been incurred at
the date of the financial statements and the amount of
loss can be reasonably estimated, the entity must accrue
the loss and disclose related information. (Under this
two-pronged test, the financial statement date is the
cutoff point for assessing whether an event has
occurred, resulting in the probability that an asset was
impaired or a liability incurred. The purpose of the two
conditions for accrual is to require recognition in the
current period’s financial statements when losses associated with the current or prior period are reasonably
estimable.)
(b) If it is not probable that a loss has been incurred
or a probable loss cannot be reasonably estimated, the
entity must disclose only related information.
(c) If there is only a remote possibility of loss, the
GAIN CONTINGENCIES
To ensure that stakeholders are provided with transparent, conservative, and reliable financial statements, the
Financial Accounting Standards Board (FASB) has formulated guidelines for corporations regarding the disclosure of potential, or “contingent,” gains and losses.3
In practice, entities follow a very conservative policy
with regard to gain contingencies and generally only
recognize tax-related uncertainties with a greater than
50% chance of being realized. Gain contingencies
include potential gifts, donations, and bonuses; possible
government refunds resulting from tax disputes; pending court cases in which a probable outcome is favorable; and tax carryforwards.
IAS 37 essentially treats gain contingencies the same
way that U.S. Generally Accepted Accounting Principles (U.S. GAAP) treats them. It prohibits an entity
from recognizing contingent assets and requires only
brief disclosure when a future gain will probably be
realized.4
LOSS CONTINGENCIES
The principle of conservatism, which guides entities to
refrain from disclosing gain contingencies, deems disclosure of loss contingencies not only permissible but
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Table 1:
Key Contingency Differences
Standard
U.S. GAAP
IFRS
ASC 450-20-25
(formerly SFAS No. 5)
IAS 37
Definition of Probable
Likely
More likely than not
Amount of Range of
Outcomes
Minimum in range
Midpoint in range
Discounting
Generally does not allow
discounting
Requires that the
liability be discounted
Disclosure Exception
None
In case of serious
prejudice to company
Contingent Gains
Not recognized
Some recognition
allowed
GAAP uses a higher threshold for accrual, namely,
likely to occur. Furthermore, IAS 37 requires companies
to disclose a roll-forward of the provision reported in
the financial statements, but ASC 450 does not. As
such, entities using IFRS are expected to report provisions more frequently than companies using U.S. GAAP
(see Table 1).
Now we present four of the most prevalent forms of
loss contingencies and discuss their treatment under
both U.S. GAAP and IFRS:
◆ Litigation,
◆ Environmental liabilities,
◆ Guarantees, and
◆ Product warranties.
entity does not accrue or disclose the loss contingency
(unless the contingency is with respect to guarantees).
One must keep in mind that the terms “probable”
and “reasonably estimated” are difficult to quantify, and
doing so is a subject of much debate within the FASB.
The Board’s current position is documented in detail
under ASC 450.
If disclosure is required, the entity must disclose in
the notes to the financial statements:
◆ The nature of the accrual and
◆ The amount of the accrual if nondisclosure would
result in financial statements that are misleading.
Under IAS 37, both recorded loss contingencies
(termed “provisions”) and nonrecorded loss contingencies (referred to by the IAS as “contingent liabilities”)
are subject to disclosure. In general, loss contingencies
for which it is probable that resources will be required
to satisfy the obligation must be recorded if the amount
is reasonably estimable. Reporting of provisions under
International Financial Reporting Standards (IFRS) is
similar to the accrual and disclosure of loss contingencies under U.S. GAAP. The key difference is that IFRS
prescribes accrual of provisions when the likelihood of
the event occurring is more likely than not, but U.S.
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Litigation, Claims, and Assessments
Microsoft, Inc., a corporation facing the most common
type of loss contingency—litigation—integrated ASC
450 (when it was SFAS No. 5) over the course of several
years.6 Its level of disclosure and need for accruals fluctuated as a civil lawsuit against it evolved. At the outset,
when litigation was only pending, ASC 450 dictated
that accrual and disclosure might be necessary, depending on two factors: the likelihood of an unfavorable outcome and the ability to estimate the loss.7 Once litigation began, Microsoft was required to comply with
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Air France-KLM, Inc.: Treatment of
Loss Contingency under IAS 37
Table 2:
Year
Disclosure
Provision:
No $ Amount
2006
✔
2007
✔
2008
✔
2009
✔
✔
2010
✔
✔
✔
given, as such information is likely to harm the companies in their defense towards the competition
authorities.”
Finally, in 2009 the fines were charged and paid, and
Air France-KLM not only disclosed details of the case
but also recorded a provision for the liability. The provision recorded in the books as of March 2010 “represents the best estimation of the risk...” (see Table 2).
ASC 450’s requirements (see Microsoft, Inc. vs. the
European Commission on the next page).
When leading European airline Air France-KLM
faced litigation concerning antitrust laws, it was
required by IFRS to comply with IAS 37 when presenting international financial statements.
In February 2006, the European Commission charged
Air France-KLM and 27 other airlines with price fixing
air shipping services. Subsequently, more than 40 purported class-action lawsuits seeking compensatory damages for prices paid since January 2000 were filed against
air cargo operators. At the time, Air France-KLM reported that it was “unable to predict the outcome of these
investigations requested by antitrust and civil litigation
authorities, or the amount of penalties and compensatory damages which could be due.” Therefore, because of
the lack of information, Air France-KLM simply disclosed the case in its 2006 financial statements without
recording a provision for a loss.
The following year, when more civil suits were filed,
the outcome remained difficult to predict. Air FranceKLM disclosed the information and attempted to calm
investors by stating that it did “intend to defend these
cases vigorously.”
By 2008, however, it became apparent to Air FranceKLM that a loss was likely to occur and that the
amount of the loss was reasonably estimable. Therefore, the company reported a provision but (as permitted under IAS 37) did not disclose a dollar amount, stating, “the amount of the provision allocated…is not
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Provision:
$ Amount
Environmental Liabilities
In September 2009, the U.S. Environmental Protection
Agency (EPA) informed Energizer—the well-known
manufacturer of batteries, portable lighting, and personal care products—that it had been identified as a
“potentially responsible party” and might be required
to share in the cost of environmental cleanup. Although
litigation had just been initiated, Energizer immediately disclosed this information on its financial statements
in compliance with the first of ASC 450’s two disclosure
conditions. U.S. GAAP requires companies facing environmental litigation to disclose the loss contingency as
soon as litigation has commenced or is probable.
The second condition for disclosure existed as well—
that the probable outcome of such litigation would be
unfavorable. Practically speaking, big corporations facing the EPA generally lose—to the extent that U.S.
GAAP factors this reality into the guidelines. Taking
aim at the EPA, Energizer noted on its financial statements that “liability…which mandate(s) cleanup is
strict, meaning that liability may attach regardless of
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lack of fault, and…that a liable party may be responsible for all of the costs incurred in investigating and
cleaning up contamination…”
Despite its objections, once Energizer was able to
reasonably estimate the cost of environmental remediation, the company conformed with ASC 450 and
accrued the liability on its balance sheet. Energizer did
not, however, distinguish the environmental liability
but included it in “Other Liabilities.”
In contrast to U.S. GAAP, IFRS leaves the implementation of IAS 37 to the discretion of each firm’s
auditor regarding environmental remediation liabilities.
Remarkably, although IAS 37 provides few specific
guidelines, firms reporting under IFRS tend to disclose
more extensive information than those reporting under
U.S. GAAP. In fact, when Indesit, a European producer
of home appliances, faced environmental litigation
charges similar to those facing Energizer, the company
made detailed disclosures of the allegations. Furthermore, Indesit provided for the loss as a separate line
item in the liability portion of the balance sheet—
something Energizer had not done.
Microsoft, Inc. vs. the
European Commission
The case of Microsoft vs. the European Commission
(EC) illustrates how one company chose to integrate
ASC 450 (then SFAS No. 5) disclosure rules into its
financial statements.
In June 1993, Novell, the world’s second-largest
computer software company, alleged that Microsoft
was engaging in anticompetitive practices in that
Microsoft required wholesaler customers to pay royalties based on the number of computers sold
whether or not the computers actually contained preinstalled Microsoft software.1 In July 1994, following a
period of intense negotiations, Microsoft agreed to
end some of its licensing practices.2 More than four
years later, however, in December 1998, Sun
Microsystems asserted that Microsoft should be
obligated to disclose its interfaces to competitors in
order to allow interoperability with non-Microsoft
server software since it held a near monopolistic position in the PC operating system market.3 The Commis-
Guarantees and Product Warranties
While most loss contingencies follow the guidelines
specified above, guarantees are subject to more stringent rulings. A guarantee is “a right to proceed against
an outside party in the event that the guarantor is called
upon to satisfy the guarantee.”8 Examples include:
◆ Guarantees of indebtedness to others,
◆ Obligations of commercial banks under “standby letters of credit,” and
◆ Guarantees to repurchase receivables that have been
sold or otherwise assigned.
sion verified these claims over the next several years
and also expanded its investigation to include charges
that Microsoft illegally bundled Windows Media Player into the Windows operating system.4
In 2003, the Commission proposed that Microsoft
reveal necessary interface information in order to
facilitate full interoperability between low-end servers
and Windows PCs and servers. It also urged Microsoft
to either agree to unbundle Windows Media Player
from Windows or to offer similar media players that
are compatible with the Windows operating system.5
In financial statements for the fiscal year ending in
In this article, we focus on a fourth type: product
warranties.
General Motors (GM), one of the world’s largest
automakers, clearly follows ASC 450 for the presentation of manufacturer warranties. GM provides extensive
disclosures regarding past and current warranties, as
well as a reconciliation table of warranty liabilities as
required by U.S. GAAP (FASB Interpretation No. 45
(FIN 45), “Guarantor’s Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guar-
June 2003, Microsoft disclosed the allegations in the
footnotes, describing the case and the potential loss.
It did not specify dollar amounts but did inform
investors that the fine would be “an amount that
could be as large as 10% of our worldwide annual
revenue.” Further, the company said it did “deny the
European Commission’s allegations and intend to
contest the proceedings vigorously.”6
In March 2004, the EC found that Microsoft had
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antees of Indebtedness of Others, an interpretation of
FASB Statements No. 5, 57, and 107 and rescission of
FASB Interpretation No. 34”). It estimates that costs
related to policy and product warranties are accrued at
the time products are sold. The accrued liabilities are
presented in the “current liabilities” portion of the balance sheet, but GM asserts that it tries to minimize
claims by constantly improving vehicle quality. Because
warranties are product-specific, there are cases where
little or no claims experience exists for a model year or
a vehicle line. In such a case, the estimate is based on
long-term historical averages, and revisions are made
based on changes in these factors.
Some warranties are priced and sold separately (such
as extended warranties or product maintenance contracts) and are treated differently from those packaged
with the product. Revenue from these warranties is
generally amortized on a straight-line basis over the life
of the contract in proportion to the costs expected to be
incurred in performing services under the contract.
Therefore, a loss should be recognized on extended
warranties or product maintenance contracts only if the
sum of expected costs and unamortized acquisition
costs exceeds related unearned revenue.
Under IFRS, disclosures for warranty liabilities are
much the same as for those under U.S. GAAP.
European automaker PSA Peugeot Citroën is
required to report disclosures similar to those reported
by General Motors. Following IAS 37, PSA Peugeot
Citroën records provisions for estimated product warranty costs when it is probable that a loss will be incurred
and that loss can be estimated reliably. Further, the
automaker’s disclosure includes a roll-forward of the
provision as per IAS 37.
abused its dominant position and ordered Microsoft
to pay $794 million—the heftiest fine ever ordered
by the EC at the time—in addition to previous penalties, which included 120 days to divulge the server
information and 90 days to produce a version of
Windows without Windows Media Player.7 In its
2004 financials, Microsoft disclosed the lawsuit and
included the dollar amount that it was fined, but it
did not accrue any liability. Until 2004, Microsoft
considered there to be at least a reasonable possibility that a liability had not been incurred. Therefore,
no accrual was made because the amount of the
loss could not, according to Microsoft, be reasonably
estimated.
Although Microsoft strongly opposed the ruling
and actually appealed it, the company paid the fine
in full in July 2004. The following year, Microsoft
supplied interested parties with even more information in its 2005 financial statement disclosures. The
company included figures for both current and longterm liabilities related to the matter and not only disclosed the information but also accrued a liability.
One may, therefore, presume that Microsoft considered it probable that a liability had been incurred at
that point and was capable of reasonably estimating
the loss.
Although Microsoft paid the fine, it did not fully
comply with the information release requirements.
In response, the EC fined Microsoft an additional
$448 million—$2.39 million per day from December
16, 2005, to June 20, 2006—for its failure to comply.
In the notes to the 2006 financial statements,
Microsoft, having already experienced heavy fines,
added the additional notice:
C O N T I N G E N CY A C C O U N T I N G —
“There exists the possibility of adverse outcomes
which we estimate could be up to $1.0 billion in
A LO O K TOWA R D
aggregate beyond recorded amounts. Were an unfa-
In June 2008, the FASB issued an Exposure Draft: Disclosure of Certain Loss Contingencies. The Exposure Draft
would replace the disclosure requirements in ASC 450
for loss contingencies with new, enhanced disclosure
requirements, including the dollar amount of claims
asserted against an entity, disclosure of qualitative information about such claims, a reconciliation of changes in
loss contingencies (which is similar to that required by
vorable final outcome to occur, there exists the possibility of a material adverse impact on the Company’s financial position and on the results of
operations for the period in which the effect
becomes reasonably estimable.”
In the following fiscal year, June 2007, Microsoft
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Table 3:
Microsoft, Inc.: Treatment of Loss Contingency
under ASC 450 (formerly SFAS No. 5)
Year
Disclosure
2003
✔
2004
✔
2005
✔
2006
✔
2007
✔
2008
✔
2009
✔
Accrual:
Separate Item
Accrual:
Lump-Sum
✔
✔
✔
✔
presented the fines levied against it in even greater
address the competition law concerns, which were wel-
detail, indicating that it considered the contingent loss
comed by the European Commission. The following
probable and reasonably estimable. Because Microsoft
year, the trade association withdrew its complaint that
presented a lump-sum figure, however, it is unclear
was the basis of the investigation.10 In June 2012, how-
whether it accrued an appropriate amount or, rather, a
ever, even after the allegations were withdrawn, the
minimum figure.
European General Court upheld the fine for noncompli-
On September 17, 2007, Microsoft lost its appeal
ance but reduced it slightly (by approximately $50 mil-
against the European Commission. The fine and the
information release requirements were
upheld.8
lion) because of a claimed miscalculation. Microsoft has
Fur-
not announced yet whether they will again appeal the
Court’s decision.11
thermore, Microsoft was held responsible for 80% of the
legal costs of the Commission. Finally, in February 2008,
the European Commission fined Microsoft an additional
1 Press Release IP/94/653, European Commission, July 17,
$1.44 billion for failure to comply with the March 2004
1994.
2 Ibid.
3 Press Release IP/00/906, European Commission, August 3,
2000.
4 Press Release IP/01/1232, European Commission, August 30,
2001.
5 Press Release IP/03/1150, European Commission, August 6,
2003.
6 Microsoft Annual Report, 10-K, 2003.
7 Press Release CJE/07/63, European Commission, September
17, 2007.
8 Ibid.
9 Press Release SPEECH/08/105, European Commission,
February 27, 2008.
10 Microsot Annual Report, 10-K, 2010.
11 Vanessa Mock, “European Court Upholds $1 Billion Microsoft
Fine,” The Wall Street Journal, June 27, 2012.
antitrust decision.9 In response, Microsoft lodged an
appeal, seeking to overturn that latest fine. The financial
statements for the fiscal year ending June 2008 included this information.
Surprisingly, after accruing detailed figures regarding
the European Commission lawsuit for years 2005
through 2008, Microsoft stopped accruing this contingent liability. For the fiscal year ended June 2009,
Microsoft disclosed information only, stating “the outcome and range…is not reasonably estimable.” (See
Table 3.)
In December 2009, Microsoft submitted proposals to
whelmingly negative and because several other projects
were more urgent (because of conditions in the financial markets in late 2008), the FASB decided to redelib-
IAS), and disclosure of certain loss contingencies that
are judged to have a remote likelihood of occurrence.
Because initial reaction to the Exposure Draft was over-
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erate the Exposure Draft in the second quarter of 2009.
At the time of the writing of this article, the FASB has
taken no other action on this project. ■
Jonathan Schiff, CMA, Ph.D., is a professor of accounting
at Fairleigh Dickinson University and is a member of the
Bergen-Rockland-Meadowlands Chapter of IMA®. He can
be reached at schiff@fdu.edu.
Allen Schiff, Ph.D., is a professor of accounting and director
of the accounting and tax master’s degree programs at Fordham University’s Graduate School of Business.
Hannah Rozen, Ph.D., is assistant professor of accounting
at Fairleigh Dickinson University.
The authors are grateful to Sami Baroody for his contributions to this article.
E N D N OT E S
1 Financial Accounting Standards Board, Accounting Standards
Codification 450-20-25. [Predecessor literature: Statement of
Financial Accounting Standards No. 5: Accounting for Contingencies, paragraph 3, Norwalk, Conn., 1975.]
2 International Accounting Standards Board, International
Accounting Standard No. 37, Provisions, Contingent Liabilities and
Contingent Assets, paragraph 10 (b), 2009.
3 Financial Accounting Standards Board, Accounting Standards
Codification 450-30-25. [Predecessor literature: SFAS No. 5, paragraph 17(a), Norwalk, Conn., 1975.]
4 International Accounting Standards Board, IAS 37, paragraph
31, 34, 2009.
5 International Accounting Standards Board, IAS 37, Provisions,
Contingent Liabilities and Contingent Assets, (paragraph 10 (b),
2009.
6 All company information was taken from each firm’s annual
reports (10-K).
7 Financial Accounting Standards Board, Accounting Standards
Codification 450-20-55 [Predecessor literature: SFAS No. 5, paragraph 33(b), Norwalk, Conn., 1975.]
8 Financial Accounting Standards Board. Accounting Standards
Codification 450-20-60 [Predecessor literature: SFAS No. 5, paragraph 12, Norwalk, Conn., 1975.]
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