M International and W Inc. have been engaged in long-standing litigation over a specific patent infringement matter. Pertains to the accounting for this contingency loss, this memo has made the following conclusions: 1. For the year-end December 31, 2007, financial statements, M should record $17 million as a liability. 2. M should adjust its liability for the year-end December 31, 2009, financial statements. $1,500,000 should be recorded. And this adjustment should be considered a 2009 event. 3. M should record 18.5 millions of dollar as a reduction of the previously recorded loss contingency in 2010.
1. For the year-end December 31, 2007, financial statements, what amount should M record as a liability? In this case, the management of determined that a loss for the patent infringement was probable and represented that the estimate of loss was in the range of $15 million to $20 million and $17 million was the most likely amount of loss within the range. Per 450-20-55-32 through 35,
“Case D: Range of Loss and One Amount is a Better Estimate than Any Other 55-32 Assume that in Case A and Case B that condition in paragraph 450-20-25-2(a) has been met and a reasonable estimate of loss is a range between $3 million and $9 million but a loss of $4 million is a better estimate than any other amount in that range.” “55-33 In this Case, paragraph 450-20-30-1 requires accrual of $4 million.” In this case, $17 million should be accrued because this is the most likely amount of loss. “55-34 Paragraphs 450-20-50-1 through 50-2 require disclosure of the nature of the contingency and, depending on the circumstances, may require disclosure of the amount of the accrual.” “55-35 Paragraphs 450-20-50-3 through 50-8 require disclosure of the exposure to an additional amount of loss of up to $5 million.” Back to our case, M should disclose $3 million in the 2007 financial statement. M require disclosure of the exposure to an additional amount of loss of up to $3 million. To record this loss contingency, the journal entry here is suggested as: Infringement Loss (expense) $17,000,000
Infringement Liability $17,000,000
2. For the year-end December 31, 2009, financial statements, should M adjust its liability? If so, what amount should be recorded; and should the amount of the adjustment be considered a 2009 event or a prior period adjustment? According to FASB ASC 450-20-25 Recognition, M should adjust its contingency liability of $1.5 million. FASB ASC 450-20-25 Recognition
“25-2 An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met: a.Information available before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements.” “b. The amount of loss can be reasonably estimated.”
As stated in the case, “The jury reached a verdict on September 24, 2009, and a judgment was ordered in favor of W. The judgment required M to pay W $18.5 million.” We’ve discussed in the previous issue, M should record a contingency liability of $17 million in 2007. And this verdict is actually an event relating to an event in previous year, and it did indicate that it is probable that a liability had been incurred at the date of the financial statements. Thus M should adjust the amount recorded in previous year. Result from the verdict reached in 2009, the total amount in contingency liability should be $18.5 million. Since M had already recorded $17 million in 2007, M just needed to record an increase of $1.5 million in contingency liability in 2009. The suggested journal entry is as follows:
DR Lawsuit expense 1,500,000
CR Contingency liability 1,500,000
According to FASB ASC 450-20-25 Recognition, the amount adjustment should be considered as an event in 2009. “FASB ASC 450-20-25 Recognition
Events After the Date of the Financial Statements
25-7 If a loss cannot be accrued in the period when ti is probable that an asset had been impaired or a liability had been incurred because the amount of loss cannot be reasonable estimated, the loss shall be charged to the income of the period in which the loss can be reasonably estimated and shall not be charged retroactively to an earlier period. All estimated losses for loss contingencies shall be charged to income rather than charging some to income and others to retained earnings as prior period adjustments.” Even though the claim was first filed in 2007, the jury trial which leads to additional $1.5m contingency loss happened in 2009. Thus, the adjustment should be recorded an event in 2009.
3. Should M record the reduction of the previously recorded loss contingency in 2010 (upon the Court of Appeals overturning the verdict of the jury) or 2011 (once the appellate judges declined W’s petition for a re-hearing)?
Since the Court of Appeals issued a ruling in favor of M’s appeal and reversed the lower court’s ruling on the matter in 2010, which means the Court of Appeals overturned the jury verdict and the $18.5 million judgment against M. As ASC 450-20-25-2 states, an estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:
a. Information available before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. Date of the financial statements means the end of the most recent accounting period for which financial statements are being presented. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
b. The amount of loss can be reasonably estimated.
The verdict was overturned by the Court of Appeals in 2010; the recorded amount of loss contingency consequently has to be reversed. And ruling was issued in December 2010, of which information was available before the financial statements to be issued. This event are considered as a 2010’s and should be posted in the year 2010’s financial statement for subsequent event reason.
Journal entries are recorded as:
Reverse to previous contingency liability$18.5 million
Reverse to previous to previous Lawsuit losses$18.5 million
An alternative thinking of this question is to record this Reverse in 2011’s financial statement. To support this consideration, for the year end December 31st 2010, M should not reduce previously recorded contingent loss even if the Court of Appeals issued a ruling in favor of M’s appeal and reversed the lower court’s ruling on the matter. Because the verdict was overturned by the higher court in December 2010, option of further appeal is still available for W. And M can surely predict that W would do that later in year 2011.