Financial Accounting Standards for Loss Contingencies: Practice Questions and Solutions

This section of the study guide is intended to provide practice problems and solutions to accompany the Financial Accounting Standards Board documents cited below. Students are encouraged to read these documents before attempting the problems. This study guide is entirely an independent effort by Mr. Stolyarov and is not affiliated with any organization(s) to whose textbooks it refers, nor does it represent such organization(s).

Some of the questions here ask for short written answers. This is meant to give the student practice in answering questions of the format that will appear on Exam 6. Students are encouraged to type their own answers first and then to compare these answers with the solutions given here. Please note that the solutions provided here are not necessarily the only possible ones.

Sources:

Financial Accounting Standards Board, "Statement of Financial Accounting Standards No. 5, Accounting for Contingencies," Paragraphs 1-4, and 8-10.

Financial Accounting Standards Board, "Interpretation No. 14," Paragraphs 1-6.

Original Problems and Solutions from The Actuary's Free Study Guide

Problem S6-21-1. According to the FASB "Statement of Financial Accounting Standards No. 5" (Hereafter, FAS 5), should depreciation be treated as a contingency? Why or why not?

Solution S6-21-1. Depreciation should not be treated as a contingency, as its occurrence in the future is not uncertain, even though it does involve a loss to the asset in question and may often need to be estimated. (See FAS 5, Paragraph 2.)

Problem S6-21-2.

(a) What are the three degrees of likelihood for a contingency used by FAS 5?

(b) Give five examples of loss contingencies, as mentioned in FAS 5.

Solution S6-21-2.

(a) The three degrees of likelihood for a contingency used by FAS 5 (Paragraph 3) are, in order of increasing likelihood, remote, reasonably possible, and probable.

(b) The following examples of loss contingencies are mentioned in FAS 5 (Paragraph 4):

1. The possibility of a receivable not being collected
2. The possibility of a claim
3. The possibility of having to perform on a product warranty
4. The possibility of having assets expropriated
5. The possibility of having property damaged by fire or explosion, or similar hazards
6. The possibility of catastrophe for which the exposure is assumed by an insurer
7. The possibility of litigation
8. Agreements to repurchase receivables
9. "Guarantees of indebtedness to others"
10. "Obligations of commercial banks under 'standby letters of credit'"

Any five of the above suffice as an answer. Other valid answers may also be possible.

Problem S6-21-3. According to FAS 5, what are the two conditions that must be met in order for accrual of an estimated loss from a loss contingency to be justified?

Solution S6-21-3. In order for accrual of an estimated loss from a loss contingency to be justified, the following two conditions must be met (See FAS 5, Paragraph 8):

1. It should be possible to reasonably estimate the amount of the loss.

2. It must be probable that an asset was already impaired or a liability was already incurred as of the date of the financial statement in question. Future events must be able to verify that the loss happened.

Problem S6-21-4.

(a) According to FAS 5, under what circumstances is disclosure of a loss contingency necessary?

(b) Fill in the blanks: "According to FAS 5, Paragraph 10, disclosure is not required of a loss contingency involving ___________ when _________ unless __________."

Solution S6-21-4.

(a) According to FAS 5, Paragraph 10, if there is at least a reasonable possibility that a loss or additional loss may have occurred, the nature of the contingency should be disclosed, and either an estimate of the loss/loss range should be given, or a statement should be made that no estimate is possible.

(b) According to FAS 5, Paragraph 10, "disclosure is not required of a loss contingency involving an unasserted claim or assessment when there has been no manifestation by a potential claimant of an awareness of a possible claim or assessment unless it is considered probable that a claim will be asserted and there is a reasonable possibility that the outcome will be unfavorable."

Problem S6-21-5. Montezuma and Imhotep work for an insurer which will probably get an adverse court verdict handed to it soon. The insurer is barely profitable as is, and the management has hired Montezuma and Imhotep to come up with independent estimates of the likelihood of the damages accompanying the verdict.

Montezuma estimates the following probabilities:
$2,000,000 - 25%; $3,000,000 - 50%; $5,000,000 - 25%.

Imhotep estimates the following probabilities:
$2,000,000 - 25%; $4,000,000 - 25%; $6,000,000 - 25%; $8,000,000 - 25%.

The two estimators have an in-depth debate about their estimates in front of the management, and the management cannot decide conclusively that one of them is more correct than the other. In this case, explain why the management would have a financial incentive to choose a particular one of these estimates over the other, in accordance with FASB Interpretation No. 14.

Solution S6-21-5. If the management were to only consider the requirements implied in FASB Interpretation No. 14, its incentive would be to choose Imhotep's estimate, because it assigns equal probabilities to each of the possible outcomes, and so no one outcome is more likely than any other. Under this situation, FASB Interpretation No. 14 requires accrual of the minimum amount - $2 million - and disclosure of possible additional loss. In the case of Montezuma's estimate, even though the upper estimate is less than Imhotep's, FASB Interpretation No. 14 requires the accrual of the most likely amount - here, $3 million. If the management is concerned with making the financial statements of the already barely profitable insurer look as favorable as possible for the current time period, then Imhotep's estimate may be selected on these grounds. Unintended consequences, anyone?

See other sections of The Actuary's Free Study Guide for Exam 6.