FAR · Select transactions · 6 practice questions
Contingencies and Subsequent Events: Adjust or Disclose?
A settlement before issuance updates the year-end accrual if it confirms a condition that existed at year-end. Follow one lawsuit through the timeline, then try free practice questions.
Try one first
Hint
Ask first whether the underlying condition existed at year-end, then ask whether the later event occurred in time to change the Year 1 measurement.
Answer A. The lawsuit arose from a condition that existed at December 31, Year 1 and was probable. The settlement on February 10, Year 2 occurred before the Year 1 financial statements were issued and supplied additional evidence about the amount of the liability; under U.S. GAAP subsequent events that provide additional evidence of conditions existing at the balance sheet date require adjustment. Therefore Arlo should adjust Year 1 and accrue the settled amount of $1.5 million, superseding the earlier range estimate.
Why not B: When no amount within a loss range is a better estimate, the minimum is accrued if no better information is available by issuance. Here, however, the pre‑issuance settlement provided better information about the amount, so recording the settled $1.5 million is required instead of merely accruing the minimum.
Why not C: This mistakes the timing: the underlying condition (the lawsuit and probable loss) existed at year‑end, and the settlement before issuance clarified the amount. That makes the event adjusting, requiring accrual rather than disclosure only.
Why not D: Recognition depends on whether the underlying condition existed at the balance sheet date and whether later information before issuance clarifies the amount. Because both are true here, the loss is recognized in Year 1 despite the settlement date falling after year‑end.
The timeline
- Year 1An incident leads to a lawsuit against Arlo Co.
The underlying condition exists before year-end.
- Before December 31, Year 1Outside counsel concludes that a loss is probable.
Arlo must also be able to reasonably estimate the loss before recording an accrual.
- December 31, Year 1Counsel estimates a loss range of $1.2 million to $1.8 million.
No amount is a better estimate. Without better evidence before issuance, accrue the $1.2 million minimum.
- February 10, Year 2Arlo settles for $1.5 million before issuing its Year 1 financial statements.
The settlement confirms the year-end liability. Update the Year 1 accrual from $1.2 million to $1.5 million.
- After February 10, Year 2Arlo issues its Year 1 financial statements with a $1.5 million lawsuit accrual.
The Year 2 settlement measures a Year 1 condition. It is not merely a disclosure in the Year 1 statements.
Key points
- Remember: The condition's date, not the settlement date, determines whether a pre-issuance settlement adjusts year-end statements.
- A loss accrual still requires a probable loss and a reasonably estimable amount.
- Disclose a material nonrecognized event's nature and estimated financial effect, or state that no estimate can be made.
How the exam traps you
- Keep the range minimum even after settlement. Replace the minimum with the settlement amount when settlement before issuance confirms the year-end liability.
- Disclose every post-year-end settlement without adjusting. Check whether the underlying condition existed at year-end; confirming evidence before issuance requires adjustment.
- Accrue any probable loss known before issuance. A new condition arising after year-end does not create a prior-year accrual, even if the loss is probable.
Question 2
Hint
Separate the two matters, then ask for each: did the underlying condition exist by year-end, and is the loss both probable and reasonably estimable?
Answer B. Accrue $480,000 for the warranty because the sales creating the obligation occurred in Year 1 and the amount is reasonably estimable. The lawsuit, though filed after year-end, concerns defects that existed at December 31 and counsel states an unfavorable outcome is probable; because counsel gives a range of $700,000 to $1,100,000 and no amount in the range is a better estimate, GAAP requires accrual of the minimum ($700,000) and disclosure of the remainder. Total accrual = $480,000 + $700,000 = $1,180,000, with disclosure of the possible additional $400,000.
Why not A: Tempting because candidates focus on the filing date, but incorrect: the underlying condition (defective goods) existed at year-end and the post-year-end filing gave evidence before issuance that the loss was probable and estimable, so accrual is required.
Why not C: Tempting since both items relate to Year 1, but incorrect: when a loss is given as a range and no single amount is a better estimate, GAAP requires accruing the minimum amount in the range ($700,000) and disclosing the remainder, not accruing the upper bound.
Why not D: This reflects a cash-settlement view; incorrect because accrual accounting requires recognition when losses are probable and reasonably estimable and when conditions existed at the balance sheet date, payment or settlement is not required to accrue.
Question 3
Hint
Separate the two matters by asking: Did the underlying condition exist at year-end, and did anything before issuance provide better evidence about that condition?
Answer A. The patent lawsuit was for a condition that existed at 12/31/20X5 and the settlement on 2/18/20X6 (a pre-issuance event) provided additional evidence about that condition. Under subsequent-events guidance, this is an adjusting event and Morn should accrue the settled amount of $1,100,000 in the 20X5 statements. The customer injury occurred after year-end and is a nonadjusting (nonrecognized) subsequent event; because it is material it should be disclosed, not accrued.
Why not B: This is tempting because at 12/31/20X5 counsel estimated a range with no better estimate, which by itself often leads to accruing the minimum. However, the settlement reached before issuance provided additional evidence of the amount, so the accrual should be updated to the settled amount of $1,100,000.
Why not C: This option is wrong for two reasons: it ignores that the pre-issuance settlement is an adjusting event that requires updating the accrual to the settlement amount, and it incorrectly omits disclosure of a material nonadjusting subsequent event (the customer injury), which should be disclosed even though the event arose after year-end.
Why not D: This reflects a cash-basis misunderstanding. Under ASC 450, a probable loss related to an existing condition should be accrued when reasonably estimable. The settlement before issuance makes the amount estimable at $1,100,000, so disclosure alone is insufficient for the patent lawsuit.
Question 4
Hint
Separate the two matters by asking whether the later information confirms a condition that already existed at year-end or instead reflects a new condition arising after year-end.
Answer A. Matter 1 is accrued because the February Year 2 development provided additional evidence about a condition that existed at December 31, Year 1; once that preexisting condition was shown before issuance to make the loss probable and reasonably estimable, Year 1 recognition is appropriate. Matter 2 arose from a fire that occurred after year-end and did not relate to a condition existing at December 31, Year 1, so it is not accrued in Year 1; however, it may require disclosure as a nonrecognized subsequent event if material.
Why not B: This is tempting because both losses were judged probable before issuance; however, accrual for Year 1 requires that the evidence relates to a condition existing at the balance sheet date. Matter 2 arose from a post-year-end fire and did not exist at December 31, Year 1.
Why not C: This choice ignores that later information (the internal test results) existed as of year-end and changed the assessment for Matter 1 before issuance, making accrual appropriate for Year 1. Matter 2 remains nonadjusting.
Why not D: This distractor applies an overbroad timing rule. For Matter 1 the post-year-end discovery provided evidence about a preexisting condition, so it is recognized in Year 1; Matter 2, which arose after year-end, is not accrued.
Question 5
Hint
Classify each matter separately first. Then total only the amounts that are both probable and reasonably estimable, using the correct measurement rule for each range.
Answer A. Under ASC 450, accrue a loss contingency when a loss is probable and the amount can be reasonably estimated. For Litigation A no single amount in the $600,000-$1,000,000 range is better than another, so accrue the minimum ($600,000). For Litigation B the better estimate is $350,000, so accrue that amount. Litigation C is only reasonably possible and is not accrued. Total accrual = $600,000 + $350,000 = $950,000.
Why not B: Tempting if the candidate applies the minimum-of-the-range rule to Litigation A but fails to also recognize and accrue Litigation B (which is probable and has a better estimate of $350,000). It omits the $350,000 accrual for Litigation B.
Why not C: Tempting if the candidate uses the midpoint or an average for Litigation A (midpoint = $800,000) and then adds Litigation B's $350,000 ($800,000 + $350,000 = $1,150,000). ASC 450 requires using the minimum of the range when no amount is better, not the midpoint.
Why not D: Tempting if the candidate records the maximum exposure for both probable matters (Litigation A at $1,000,000 and Litigation B at $550,000 = $1,550,000). This overstates the accrual because A should be recorded at the minimum when no single amount is a better estimate, and B should be recorded at its better estimate of $350,000.
Question 6
Hint
Decide whether the Feb 20 letter supplies evidence about conditions existing at Dec 31, 20X5 (an adjusting subsequent event); if so, apply the guidance for loss ranges and use a single better estimate when one exists.
Answer A. The counsel letter, received before issuance, provides evidence about conditions that existed at the balance sheet date and therefore is an adjusting subsequent event. Counsel identified $3.2 million as a better estimate within the $2.0-$5.0 million range, so Halden should accrue $3.2 million. Because counsel also indicated a reasonable possibility of loss above the accrued amount (up to $5.0 million), the nature of the contingency and the potential additional exposure should be disclosed.
Why not B: This is tempting based on the rule to accrue the minimum when a range exists, but that rule applies only when no single amount in the range is a better estimate. Here counsel explicitly identified $3.2 million as the better estimate, so accruing $2.0 million understates the liability.
Why not C: Recording an accrual does not eliminate disclosure obligations when there is a reasonable possibility of additional loss beyond the recorded amount. Counsel indicated potential additional loss up to $5.0 million, so omitting disclosure about the remaining exposure would be inappropriate.
Why not D: This treats the counsel letter as a nonadjusting subsequent event. However, the letter attributes probability and an estimate to the condition as of the balance sheet date; therefore an accrual is appropriate rather than only disclosure.
Common questions
Does a lawsuit settlement after year-end adjust the prior-year financial statements?
Yes, if it occurs before issuance and confirms a condition that existed at year-end. Use the settlement amount for that year's accrual.
What if a lawsuit is filed after year-end?
The filing date is not the test. If the underlying condition existed at year-end, evidence received before issuance can require accrual when the loss is probable and reasonably estimable.
Do you accrue a loss caused by a new event after year-end?
No, not in the prior-year statements. Disclose a material event's nature and estimated financial effect, or state that no estimate can be made.
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