Loss Contingency - Accounting Treatment - Case Study Example

Loss Contingency Introduction This paper analyzes the accounting treatment, in accordance with ASC guidelines, of issues arising out of a long standing litigation between M International (M) and W Inc. (W). W filed a claim for patent infringement against M in May 2007. For the year ended December 2007, M estimated that a loss was probable and that the amount was likely to be between 15 and 20 million dollars. A jury trial was held in September 2009 resulting in a judgment ordering M to pay $18.5 million to W. In November 2010, M filed a Notice of Appeal with the Court of Appeals, which reversed the lower court order. On January 6, 2011, W filed a petition for rehearing, which was rejected by the appellate judges on February 10, 2011. The case involves a number of issues regarding the accounting treatment of loss contingency at various points in time in accordance with the estimates or facts prevailing. This paper discusses the relevant provisions of ASC and the accounting entries to be passed by M at various stages. Amount to be recorded as liability in the financial statements for year ending December 31, 2007 In accordance with the provisions of ASC 450, M is required to provide for accrual of the losses in its accounts. The relevant provisions are related to the likelihood of occurrence of the loss, which could vary from remote to probable, with an intermediate category of reasonably possible. M is required to make the accruals in its financial statements if the loss is probable and the amount of loss can be estimated. Both these conditions are satisfied and hence M was required to accrue the losses in 2007. According to ASC 450-20-25-1, two conditions need to be satisfied in order to accrue an estimated loss from a loss contingency as a charge to income. 1. Information, which is available prior to the issue of the financial statements for the period, shows that it is probable that a liability or loss has been incurred or is likely to be incurred. This implies that there is a probability that one or more events are likely to occur in the future to confirm the loss. 2. It should be possible to estimate the amount of the loss reasonably well (FASB, ASC 450-20-25-1). Alternatives Since the loss is estimable and is probable, M does not have many options regarding the accrual of losses in its income statement. The alternatives available to M are to make the accrual at the lower or higher end of the estimated range of losses, or by assessing the most likely value. M could also claim that the loss is not probable or that the amount cannot be estimated. This would be justifiable as it would be in the initial stages of the litigation, and the guidelines recognize the difficulty in assessing the exact amount of loss that is likely. However, the most appropriate course of action would be to provide for the amount estimated as most likely, since this is in line with the reality of the situation. Recommendation In the given case, W has filed a claim against M for patent infringement in May, 2007. This will result in a loss to the company, if the case is decided in favor of W and against M. In December, 2007, M has estimated that it is probable that a loss will occur and has estimated the amount of the loss to be between $15 million and $20 million, with $17 million as the most likely amount of loss within this range. Thus in this case, both the conditions have been satisfied. The occurrence of the loss has been estimated as probable, and the amount of the loss has been estimated within a range along with an estimate of the most likely amount of loss. ASC 450-20-55-22 further provides illustrations to clarify the point. In a case where the trial is incomplete and damages are unknown, if an unfavorable verdict is probable, and the amount of damages can be ascertained as one figure that is more likely than any other, that figure should be charged to income (FASB, ASC 450-20-55,22). Hence this case qualifies for accrual of the estimated loss by charging this amount to income. Since the most likely amount of loss has been estimated to be $17 million, it is this amount that will have to be accrued. The journal entry to be passed for this purpose will be as follows: Dr Estimated Expense from Loss on Patent Infringement 17,000,000 Cr Estimated Liability from Loss on Patent Infringement 17,000,000 Year-end December 31, 2009 –Liability, amount and nature of adjustment Alternatives As the case proceeds, and more information is available, the organization should include additional information. It should also show the carrying amounts of accruals at the beginning and end of the year, new amounts accrued, and changes. In 2009, pursuant to the judgment against it, M was required to pay $18.5 million. The alternatives before M, under the provisions regarding revision of estimates, are to recognize the increased contingency pursuant to the judgment and provide for it, or to take umbrage under its pending appeal and ignore the judgment. In either case, it will have to disclose the details of the judgment. Enhancing the loss contingency is a more appropriate alternative as it aligns closer to the facts of the case that are known on the date of preparation of the financial statements. Recommendation As at the end of the financial year ending December 31, 2009, the court has already given its verdict and the amount of damages to be paid has been determined by the court. In this case, there is no uncertainty about the occurrence of the event or of the amount. Although it is possible for M to go on appeal, it cannot be assumed that the appeal will be in its favor. In view of these facts, and the earlier assessment of M that it is probable that an adverse outcome would result, the situation as on December 2009 indicates that payment of damages of $18.5 million is either a certainty (if the judgment is not appealed against) or probable (if M goes on appeal). In either case, the payment of damages will have to be considered as probable and the most likely amount is $18.5 million. In accordance with the provisions of ASC 450-20-25-1, M should charge $18.5 to income. Since it has already provided a liability of $17 million to this end, which can be used to meet the estimated liability, M only needs to charge the differential amount to income so as to provide for the full estimated liability of $18.5 million. Hence a charge of $1.5 million should be made in the accounts for the year ending December 31, 2009. The journal entry for this purpose will be as follows. Dr Estimated Expense from Loss on Patent Infringement 1,500,000 Cr Estimated Liability from Loss on Patent Infringement 1,500,000 With this entry, the total liability provided for the expected loss will be $18.5 million, and the charge to current period income will be $1.5 million. Reduction of previously recorded loss contingency Alternatives In the case of litigation, the period of action and the probability of an unfavorable outcome are to be considered while making the accrual or disclosure. Under this provision, M has the option of making a disclosure of the pending appeal as of January 2011, in its statement for 2010, and reversing the earlier accrual, or leaving the earlier accrual as it is, with an explanatory statement regarding the pending appeal. Accrual is required only if there is a probability of adverse judgment. Recommendation In this case, even before the judgment of the appellate judges is known, it is apparent that an unfavorable judgment is unlikely. In December, 2010, the Court of Appeals reversed the earlier judgment, overturning the Jury verdict of damages amounting to $18.5 million against M. In January 6, 2011, W filed a petition for rehearing, which was rejected by the appellate judges on February 10, 2011. M decided to treat the case as close on February 28, 2011. The question is whether the reduction of the loss contingency should be given effect in the financial statements of 2010 or 2011. In the general case, if the trial is complete before the date of finalizing the statements of accounts, the outcome should be incorporated in the accounts. Since the verdict was handed over in December, 2010, prior to the end of the financial year, the effect of the judgment should be incorporated in the accounts for 2010. The only uncertainty in this case is the petition for rehearing filed by W. The test in this case would be whether it can be considered as probable that the petition for rehearing will be considered by the judges. Since the petition is filed before the same panel of judges who issued the earlier judgment, it cannot be considered as probable that they would entertain the appeal for rehearing in the absence of sound reasoning, which does not seem to have existed. Hence even after the filing of the petition for rehearing, the situation does not change fundamentally, as it is no longer probable that M would have to pay the damages. On the contrary, the facts now indicate that it is probable that M would not have to pay any damages. On February 10, the petition for rehearing is actually rejected. Thus at no point in time can the payment of damages be considered as probable. Hence the reduction of the loss needs to be done in the accounts for 2010. Hence the more appropriate action in this case is to reverse the earlier accrual and make a disclosure regarding the pending appeal. The journal entry for this purpose will be as follows. Dr Estimated Liability from Loss on Patent Infringement 18,500,000 Cr Gain on Patent Infringement 18,500,000 References FASB Accounting Standards Codification (ASC), n.d. Web. May 22. 2014. Read More