Editor: Mark Heroux, J.D.
FASB Accounting Standards Codification (ASC) Topic 450, Contingencies, requires companies to assess the degree of probability of an unfavorable outcome before reporting a loss contingency. According to Topic 450, when a loss contingency exists, the likelihood that future events will confirm the loss or impairment of an asset or the incurrence of a liability can range from "probable" to "reasonably possible" to "remote." This item discusses these standards in the context of potential loss contingencies related to sales and use taxes.
ASC Subtopic 450-20 defines a loss contingency as "[a]n 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."
Accrual of a loss contingency is required when (1) it is probable that a loss has been incurred and (2) the amount can be reasonably estimated. As such, a company must determine the probability of the uncertain event and demonstrate the ability to reasonably estimate the loss from the uncertain event in order to accrue a loss contingency. However, loss contingencies that do not meet both of these criteria for recognition may still need to be disclosed in the financial statements.
The analysis in determining whether a company is required to make an accrual or disclosure begins with determining the likelihood of the future event. In this context, there are three potential options as defined by Subtopic 450-20: "probable," "reasonably possible," and "remote."
Probable: The ASC master glossary's definition of "probable" provides no quantitative thresholds, so the company should exercise judgment when applying the term. According to the glossary, "probable" is defined as "the future event or events are likely to occur." If the likelihood of a material loss is probable, then the company must move to the second piece of the standard, which is to determine whether the amount of the loss is reasonably estimable.
If the amount of the loss is reasonably estimable, then the company is required to make an accrual for the loss contingency. The company is required to accrue either (1) the company's estimate of the loss, or (2) if the reasonably estimable loss is a range, then it must accrue either the amount within the range that appears to be the better estimate or the minimum amount in the range.
If the amount of the loss is not reasonably estimable, then the company is not required or allowed to record an accrual for the contingency. Instead, the company is required to disclose the nature of the contingency and describe why it is unable to estimate the amount of the loss.
Consider the following example of reporting a "probable" contingency:
Example 1: Company C is undergoing a sales and use tax audit that spans more than two years. This is C's second audit in the state, and C is aware of issues and assessments that will likely arise in the current audit. C disclosed it is undergoing a sales and use tax audit but has not previously provided an assessed amount. At the conclusion of the audit, the auditor proposed the final assessment, which is material in nature. C should record the accrual and disclose the nature of the assessment and the material amount of the accrual to ensure the financial statements are not misleading.
Reasonably possible: The ASC master glossary defines "reasonably possible" as "the chance of the future event or events occurring is more than remote but less than likely." An accrual for the loss contingency is not required for a reasonably possible contingency. However, the company should make a disclosure about the contingency. Prior to making a disclosure, the company must first consider whether the amount of the reasonably possible loss is estimable.
If the amount of the reasonably possible loss is estimable, then the company should disclose the nature of the contingency and provide its estimate of the amount or range of the loss. If the reasonably possible loss is not estimable, then the company should disclose the nature of the contingency and describe why it is unable to estimate the amount of the loss.
Consider the following example of reporting a "reasonably possible" contingency:
Example 2: Company C is undergoing a sales and use tax audit that spans three years. This is C's first audit in the state, and C believes it is properly reporting sales and use tax in the state. The sales and use tax audit has concluded, and the auditor has provided the proposed final assessment, which is material in nature. C disagrees with the proposed final assessment. C appeals the decision of the auditor. C has documentation and case law to support its position, which is in conflict with the final proposed assessment. In this instance, C believes the assessment is reasonably possible but not probable due to the authority supporting its position. Since the proposed final assessment is reasonably possible but not probable, C will likely be required to disclose the nature of the assessment and an estimate of any reasonably possible amount.
Remote: The definition of a "remote" contingency is one where "the chance of the future event or events occurring is slight." If the likelihood of a material loss is remote, Topic 450 does not require the company to make a disclosure or an accrual of the contingency.
Consider the following example of a "remote" contingency:
Example 3: Company C is internally reviewing its sales and use tax posture to determine if any potential exposure is present. C believes a small potential exposure could exist, but its sales are negligible in the state and the company has never undergone a sales and use tax audit. Since the possible exposure is minimal and the likelihood of material loss is remote, C is likely not required to make a disclosure or accrual for the potential exposure at this time.
Since no quantitative thresholds exist within the standards of Topic 450, companies will need to exercise judgment when applying the rules. This item has discussed how to apply Topic 450 in the context of sales and use tax loss contingencies, but there are additional thresholds to consider when disclosing gain contingencies as well as the application of Topic 450 to other nonincome taxes.
Mark Heroux, J.D., is a tax principal in the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly US, LLP.