ASC 450 Loss Contingencies: Probable, Reasonably Possible and Remote, and How Auditors Use Legal Letters

A lawsuit, a regulatory investigation, a product recall or a disputed guarantee can turn a clean set of financial statements into a misleading one if it is handled badly. ASC 450, Contingencies, sets the rules for when an entity records a loss from an uncertain future event, when it only discloses, and when it does nothing. The auditor's side of the same problem sits in AU-C 501, which covers litigation, claims and assessments, including the letter of inquiry to legal counsel.

This guide covers ASC 450-20 loss contingencies, the three likelihood categories, estimating the amount, unasserted claims, gain contingencies under ASC 450-30, and the audit procedures. It paraphrases the Codification and the auditing standards and is not a substitute for them.

What is a contingency?

A contingency is an existing condition, situation or set of circumstances involving uncertainty as to possible gain or loss that will ultimately be resolved when one or more future events occur or fail to occur. The condition must exist at the balance sheet date. The uncertainty is about the outcome.

Typical loss contingencies for private companies include:

• pending or threatened litigation
• claims and assessments by tax or regulatory authorities (income tax uncertainties are handled under ASC 740 instead)
• product warranty and product liability claims
• guarantees of others' debt (with recognition guidance in ASC 460)
• environmental remediation obligations (with specific guidance in ASC 410-30)
• risk of loss from catastrophe for which the entity is self-insured

Some of these items have their own topics that refine or replace the general ASC 450 model. Those specific topics take precedence where they apply.

The three likelihood categories

ASC 450-20 uses three terms to describe how likely the future event is:

• Probable: the future event or events are likely to occur.
• Reasonably possible: the chance of the future event occurring is more than remote but less than likely.
• Remote: the chance of the future event occurring is slight.

These are not defined as percentages, and practice does not treat them as precise numbers. Probable in ASC 450 is generally understood as a higher threshold than more likely than not in ASC 740. Assessing likelihood requires judgment, usually informed by counsel.

When to accrue

An entity accrues an estimated loss from a loss contingency when both conditions are met:

1. Information available before the financial statements are issued or available to be issued indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements.
2. The amount of loss can be reasonably estimated.

Both conditions apply. A probable loss that cannot be reasonably estimated is not accrued, but it is disclosed. The first condition also requires that the underlying cause existed at the balance sheet date. A lawsuit filed after year end for an injury that occurred before year end can still lead to an accrual, which is why subsequent events work matters. See subsequent events under ASC 855.

Estimating the amount

When the loss is probable and a range of loss can be estimated:

• If some amount within the range is a better estimate than any other, accrue that amount.
• If no amount within the range is a better estimate than any other, accrue the minimum amount in the range, and disclose the nature of the contingency and the exposure to additional loss.

The minimum-of-the-range rule differs from IFRS (IAS 37), which uses the midpoint in some cases. It applies even when management would prefer to record nothing because the final amount is unknown.

Legal costs expected to be incurred in defending a claim may be accrued or expensed as incurred, based on a consistently applied accounting policy. Document which policy the client follows.

When to disclose

Disclosure may also be needed to keep the financial statements from being misleading, for example where an accrued amount is recorded under a generic caption.

Unasserted claims

An unasserted claim is one no claimant has yet made, such as a defect the company knows about but no customer has raised. Disclosure is not required unless it is probable that a claim will be asserted and it is at least reasonably possible that the outcome will be unfavorable. If both the assertion and the loss are probable and the loss can be estimated, an accrual is required.

Concentrations and other risks

ASC 275, Risks and Uncertainties, overlaps with ASC 450 on significant estimates and concentrations. A matter can be outside ASC 450 accrual criteria yet still require disclosure under ASC 275 because it is at least reasonably possible that the estimate will change materially in the near term.

Gain contingencies

Gain contingencies are covered by ASC 450-30. A contingency that might result in a gain is not recognized before it is realized or realizable. A favorable court ruling under appeal, for example, generally is not recorded until the uncertainty is resolved. Disclosure is appropriate where the gain is material, but care is needed to avoid misleading implications about the likelihood of realization.

Insurance recoveries related to a recognized loss are a separate question. Practice generally recognizes an insurance receivable when recovery is probable, limited to the amount of the recognized loss, with any excess treated as a gain contingency. The receivable is presented gross, not netted against the liability, unless a right of offset exists. The auditor obtains support for the coverage and the insurer's position.

The auditor's procedures under AU-C 501

AU-C 501 requires the auditor to design and perform procedures to identify litigation, claims and assessments involving the entity that may give rise to a risk of material misstatement.

Identifying matters

• inquiry of management and, where applicable, others in the entity, including in-house legal counsel
• review of minutes of meetings of those charged with governance
• review of legal expense accounts and invoices from outside counsel
• review of correspondence with regulators, insurers and counsel
• reading contracts, loan agreements and leases for guarantees and indemnities

Legal expense invoices are a useful source. A new law firm on the vendor list, or an invoice describing a matter not on management's list, is a lead that needs to be followed.

Letters of inquiry to legal counsel

Where the procedures to identify litigation, claims and assessments point to matters that may give rise to a risk of material misstatement, AU-C 501 requires the auditor to seek direct communication with the entity's external legal counsel, through a letter of inquiry prepared by management and sent by the auditor. The letter asks counsel to communicate directly with the auditor.

The letter typically lists pending or threatened litigation and unasserted claims identified by management, and asks counsel to comment on them and to identify any omissions regarding pending or threatened matters. Lawyers' responses in the US are shaped by the American Bar Association's statement of policy on responding to auditors' requests, which is why responses about unasserted claims are limited and why counsel may decline to evaluate likelihood.

Timing matters. The response should cover a period ending close to the date of the auditor's report, so requests are often sent near fieldwork completion and updated if the report date moves.

When counsel will not respond

AU-C 501 treats a refusal by management to permit the auditor to communicate with counsel, or a refusal by counsel to respond appropriately where the auditor cannot obtain sufficient appropriate evidence through alternative procedures, as a scope limitation, which leads to a modified opinion under AU-C 705. See types of audit opinions.

Written representations

AU-C 501 also requires written representations that all known actual or possible litigation and claims whose effects should be considered have been disclosed to the auditor and accounted for and disclosed in accordance with the framework. These go in the management representation letter; see the representation letter template.

Evaluating the accounting

Compare counsel's responses with management's accrual and disclosure. Where counsel cannot assess likelihood, the auditor still has to conclude, using management's analysis, insurance coverage, settlement discussions and subsequent events. Differences go to the summary of misstatements under AU-C 450. A disclosure omission can be material even when no accrual is needed.

Common errors

• No accrual because the final amount is uncertain, instead of accruing the minimum of the range.
• Remote matters disclosed at length, or reasonably possible matters omitted.
• Insurance recoveries netted against the liability.
• Legal letters dated weeks before the report date.
• Legal invoices never reviewed, so a matter handled by a second firm is missed.

Frequently asked questions

When must a loss contingency be accrued under ASC 450?

A loss contingency is accrued when it is probable that a liability had been incurred or an asset impaired at the balance sheet date and the amount can be reasonably estimated. Both conditions must be met.

What if only a range of loss can be estimated?

Accrue the best estimate within the range. If no amount in the range is better than any other, accrue the minimum and disclose the exposure to additional loss.

Do reasonably possible losses need to be disclosed?

Yes. A reasonably possible loss is not accrued, but the entity discloses the nature of the contingency and an estimate of the possible loss or range, or states that an estimate cannot be made.

Are gain contingencies ever recorded?

Not until they are realized or realizable. ASC 450-30 permits disclosure of material gain contingencies, written carefully to avoid misleading implications about likelihood.

Is a legal letter always required in an audit?

AU-C 501 requires the auditor to seek direct communication with external legal counsel, through a letter of inquiry, when the procedures to identify litigation, claims and assessments point to matters that may give rise to a risk of material misstatement.

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Sources

• FASB ASC 450-20, Loss Contingencies, and ASC 450-30, Gain Contingencies
• FASB ASC 275-10-50, Risks and Uncertainties
• FASB ASC 460 (guarantees), ASC 410-30 (environmental obligations), ASC 740 (income taxes), ASC 855 (subsequent events)
• AICPA, AU-C Section 501, Audit Considerations Regarding Litigation, Claims, and Assessments (and Section 705 for modified opinions)
• AICPA, AU-C Section 450 and Section 580
• American Bar Association, Statement of Policy Regarding Lawyers' Responses to Auditors' Requests for Information (1975)

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error