FAR · Select transactions · 6 practice questions
Noncancelable Purchase Commitments: When to Record a Loss
Accrue a loss on a firm, noncancelable inventory purchase commitment when year-end conditions make the loss unavoidable and reasonably estimable. Below: year-end checks from contract terms to the loss entry.
Try one first
Hint
Think about what existed at the balance sheet date and whether GAAP requires accrual (probable and reasonably estimable) or only disclosure for that condition.
Answer C. The noncancelable purchase commitment created an existing loss at the balance sheet date because the contract price ($900,000) exceeds the market price ($760,000), and that loss is measurable. U.S. GAAP requires recognition of an unfavorable firm commitment loss that exists at the measurement date. The negligence lawsuit is characterized as reasonably possible (not probable and reasonably estimable), so it is generally disclosed rather than accrued; the controlling factor is whether a loss existed at year-end and met accrual criteria.
Why not A: This is tempting because the items have different legal forms, but GAAP does not base recognition solely on whether a loss arises from a contract or litigation. Both contractual and litigation losses are accrued if, at the balance sheet date, a loss is probable and reasonably estimable; here the contract loss existed and was measurable, while the lawsuit was only reasonably possible.
Why not B: This distractor tempts by implying that a specified demand makes a loss measurable, but GAAP recognition depends on the facts existing at the balance sheet date and on whether the loss is probable and reasonably estimable, not on whether a claimant has demanded a specific amount prior to issuance. Outside counsel judged the lawsuit reasonably possible, so disclosure (not accrual) is appropriate.
Why not D: This is attractive because measurement seems necessary to accrue a loss, yet GAAP does not require exact certainty of the amount. A loss is accrued when it is probable and reasonably estimable even if the precise amount is uncertain. The purchase commitment loss is measurable from the contract versus market prices; the lawsuit lacks the probability threshold.
Step by step
- Check the binding terms
Confirm the inventory purchase commitment is firm and noncancelable at year-end. Check for unusual cancellation rights before treating the loss as unavoidable.
- Check for offsetting protection
Determine whether an effective hedge or fixed-price firm sales contract eliminates the loss exposure. If the exposure is eliminated, this test produces no loss.
- Compare prices at year-end
Compare the contract price with market price at the balance sheet date, not the delivery date. If contract price exceeds market without an offset, measure the loss.
- Calculate only the shortfall
Lark will buy raw materials next March under a $900,000 noncancelable commitment; their December 31 market price is $760,000. With no offset or unusual cancellation rights, the loss is $900,000 minus $760,000, or $140,000.
- Accrue before delivery
Because Lark's loss exists at year-end and is probable and reasonably estimable, debit loss and credit a purchase commitment loss liability for $140,000. Do not wait until the raw materials arrive.
- Evaluate disclosure separately
Disclose, rather than accrue, a reasonably possible loss or a probable loss that cannot be reasonably estimated. Disclose material commitments separately from any loss accrual.
Key points
- Remember: Accrue the price shortfall, not the full contract price, before inventory arrives.
- A market decline alone does not require recognizing a loss on an equipment purchase commitment.
- Reasonably estimable does not mean the loss amount must be known with certainty.
How the exam traps you
- Waiting for delivery to recognize an existing year-end loss. Accrue the probable, reasonably estimable loss in the period it exists.
- Recording the full contract price because the commitment is noncancelable. Accrue only the loss; the unperformed purchase contract is not automatically a payable.
- Applying the inventory loss calculation to equipment solely because its market price fell. Disclose a material equipment commitment; a market decline alone does not require a loss.
Question 2
Hint
Handle each item separately: accrual requires both probability and a reasonable estimate; for the purchase commitment, compare the contract price to current market to determine whether an unavoidable loss exists.
Answer C. The noncancelable purchase commitment creates an unavoidable loss because the contract price ($3.40) exceeds the market price ($3.00); the loss is (3.40 − 3.00) × 50,000 = $20,000 and should be recognized. Under GAAP (ASC 450) a loss contingency is accrued only when it is both probable and reasonably estimable; here counsel says an unfavorable outcome is probable but no amount or range can be reasonably estimated, so the lawsuit should be disclosed, not accrued.
Why not A: This is tempting for candidates who think losses are recognized only on settlement or delivery. It fails because GAAP requires recognizing an unavoidable loss on a firm, noncancelable purchase commitment at the reporting date; the lawsuit, being probable but not estimable, should be disclosed rather than deferred.
Why not B: This distractor appeals to the ASC 450 rule that, if a range of loss exists and no single amount is better, the minimum is accrued. It is wrong here because counsel indicated that no amount or range can be reasonably estimated, there is no basis to determine even a minimum amount, so accrual is not appropriate and disclosure is required.
Why not D: This option tempts those who believe lack of an estimate eliminates disclosure obligations. It is incorrect because GAAP requires disclosure of the nature of a probable loss contingency and a statement that an estimate cannot be made when the amount is not reasonably estimable.
Question 3
Hint
Evaluate the two items separately: one involves a probable loss from a past event, and the other involves a commitment to a future purchase with no separate present obligation.
Answer A. Under U.S. GAAP (ASC 450), a loss contingency that is probable and reasonably estimable must be accrued. If the estimate is a range and no amount is a better estimate than another, the minimum of the range is accrued, so Rho should record $1.2 million. A material executory purchase commitment for equipment not yet received is generally disclosed, not recognized as a liability, absent a separate present obligation or an expected loss on the contract.
Why not B: Tempting because students often use the midpoint, but ASC 450 requires accruing the minimum of the range when no single amount is a better estimate.
Why not C: Incorrect: the lawsuit meets recognition thresholds (probable and reasonably estimable), so it must be accrued before settlement. The equipment commitment remains a disclosure item only.
Why not D: A noncancelable purchase commitment may feel binding, but executory purchase contracts for assets not yet received are normally disclosed rather than recorded as liabilities unless there is a separate present obligation or an expected loss.
Question 4
Hint
Evaluate each matter separately: first decide whether it creates a present loss at year-end, then measure that loss under the applicable rule.
Answer B. Accrue $400,000 for the lawsuit because the loss is probable and, when no amount in a range is a better estimate than another, GAAP requires accrual of the minimum of the range. Recognize a $140,000 loss on the noncancelable purchase commitment because the contract price ($900,000) exceeds the inventory market value ($760,000) at year-end. The board-approved warehouse plan creates no present obligation at December 31 and is not recognized as a loss.
Why not A: Tempting if the candidate applies the lawsuit accrual correctly but overlooks that a noncancelable purchase commitment that results in an expected loss (contract price > market) requires recognition of the loss in the period the decline exists.
Why not C: This reflects using the top of the lawsuit range ($700,000) plus the $140,000 purchase-commitment loss. GAAP requires accrual of the minimum of the range when no amount is a better estimate.
Why not D: This sums the lawsuit (range) and purchase-commitment loss and also recognizes the board-approved warehouse cost. A mere internal plan without a signed contract or present obligation at year-end is not accrued.
Question 5
Hint
Analyze the lawsuit and the purchase contract separately: first decide whether each item requires recognition, then consider how GAAP handles a loss range with no best estimate and a material commitment with no current loss.
Answer B. Under U.S. GAAP, a loss that is probable and reasonably estimable must be accrued. When a range of loss exists and no single amount is a better estimate, the minimum of the range is accrued (here, $700,000) and the nature of the contingency and the possible additional exposure are disclosed. The noncancelable purchase contract does not create a loss here, so no liability is recorded, but a material commitment should be disclosed in the notes.
Why not A: This option incorrectly uses the midpoint of the range. GAAP requires accruing the minimum amount when no amount in the range is a better estimate than any other.
Why not C: This is incorrect because once a loss is both probable and reasonably estimable, GAAP requires an accrual rather than disclosure only. The treatment of the equipment commitment in this option is acceptable, but the lawsuit accrual is missing.
Why not D: Although the lawsuit accrual is correct, it is incorrect to omit disclosure of a material noncancelable purchase commitment. Material commitments entered into before year-end should be disclosed even if they do not give rise to a loss.
Question 6
Hint
Handle the two matters separately: first decide how to measure a probable loss given a range with no best estimate, then determine whether the purchase commitment itself creates a year-end loss.
Answer B. Accrue $420,000 for the lawsuit because a loss is probable and, when no amount in a range is a better estimate, U.S. GAAP requires accrual of the minimum amount in the range. For the noncancelable purchase commitment, accrue a $60,000 loss measured as the excess of the commitment price over the current market price ($900,000 − $840,000). Total accrued liability = $420,000 + $60,000 = $480,000.
Why not A: Tempting because it applies the minimum-of-range rule for the lawsuit correctly, but it ignores the separate $60,000 loss that must be recognized on the noncancelable purchase commitment when the contract price exceeds market price.
Why not C: This reflects using the maximum of the lawsuit range; when no amount within the range is a better estimate, GAAP requires recording the minimum amount. It also omits the $60,000 commitment loss.
Why not D: This combines the maximum lawsuit amount ($600,000) with the $60,000 purchase-commitment loss. While the commitment loss should be included, the lawsuit should be recorded at $420,000 here because no single amount within the range is a better estimate.
Common questions
When do you accrue a loss on a noncancelable purchase commitment?
For inventory, accrue the loss at the balance sheet date when it is unavoidable, probable, and reasonably estimable. Delivery in the next year does not delay recognition.
How do you calculate a purchase commitment loss?
Without offsetting protection, subtract year-end market price from contract price when contract price is higher. For per-unit prices, multiply the difference by the committed quantity.
Are purchase commitment losses covered by ASC 450?
ASC 330 provides specific guidance for firm inventory purchase commitment losses. ASC 450 governs loss contingencies generally and requires accrual when a loss is probable and reasonably estimable.
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