US GAAP - Issues and Solutions for Pharmaceutical and Life Sciences: Chapter 2

Chapter 2: Intellectual Property

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2-1 Accounting for a loss contingency when a settlement offer has been made in a lawsuit

Background

Company A is the defendant in a patent infringement case. Company B (the plaintiff) alleges that Company A owes it $10 million for use of a specific patent and an additional $25 million for revenue lost because of competition. The trial has gone through the discovery phase, and as of December 31, 20X2, Company A has offered $15 million to settle both issues.

Company A has not received a response from the plaintiff as of December 31, 20X2. Therefore, Company A believes that the case may still be going to trial. Company A believes it is probable that a loss has been incurred, and the loss amount was estimated in the range of $15 million (the amount of its settlement offer) to $35 million (the maximum estimated loss in the event the case goes to trial). Company A does not believe there is a best estimate within this range.

Question: What amount should Company A accrue as of December 31, 20X2?

Solution

As the contingent loss related to an event that had already occurred as of the balance sheet date, and a loss is probable, Company A should accrue its best estimate of the contingency as of December 31, 20X2. A settlement offer is generally presumed to establish a minimum “probable loss.” This presumption could be overcome based on the specific facts and circumstances. As no estimate within the range represents a better estimate than any other, Company A should generally accrue the minimum amount in the range ($15 million). Company A should also disclose the nature and amount of the accrual.

If it is reasonably possible that an estimate of a contingent loss on the financial statements will change in the near term due to one or more future confirming events and the effect of the change would be material to the financial statements, disclosure of the nature and potential change in the accrual is also required.

Relevant guidance

ASC 450-20-25-2: An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

  • Information available before the financial statements are issued or are 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...
  • The amount of the loss can be reasonably estimated...

ASC 450-20-50-1: Disclosure of the nature of an accrual made pursuant to the provisions of paragraph 450-20-25-2, and in some circumstances the amount accrued, may be necessary for the financial statements not to be misleading. Terminology used shall be descriptive of the nature of the accrual, such as estimated liability or liability of an estimated amount. The term reserve shall not be used for an accrual made pursuant to paragraph 450-20-25-2; that term is limited to an amount of unidentified or unsegregated assets held or retained for a specific purpose. Examples 1 (see paragraph 450-20-55-18) and 2, Cases A, B, and D (see paragraphs 450-20-55-23, 450-20-55-27, and 450-20-55-32) illustrate the application of these disclosure standards.

ASC 450-20-50-2: If the criteria in paragraph 275-10-50-8 are met, paragraph 275-10-50-9 requires disclosure of an indication that it is at least reasonably possible that a change in an entity's estimate of its probable liability could occur in the near term. Example 3 (see paragraph 450-20-55-36) illustrates this disclosure for an entity involved in litigation.

ASC 275-10-50-8: Disclosure regarding an estimate shall be made when known information available before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) indicates that both of the following criteria are met:

a.  It is at least reasonably possible that the estimate of the effect on the financial statements of a condition, situation, or set of circumstances that existed at the date of the financial statements will change in the near term due to one or more future confirming events.

b.  The effect of the change would be material to the financial statements.

ASC 275-10-50-9: The disclosure shall indicate the nature of the uncertainty and include an indication that it is at least reasonably possible that a change in the estimate will occur in the near term. If the estimate involves a loss contingency covered by Subtopic 450-20, the disclosure also shall include an estimate of the possible loss or range of loss, or state that such an estimate cannot be made. Disclosure of the factors that cause the estimate to be sensitive to change is encouraged but not required. The words reasonably possible need not be used in the disclosures required by this Subtopic.

ASC 450-20-30-1: If some amount within a range of loss appears at the time to be a better estimate than any other amount within the range, that amount shall be accrued. When no amount within the range is a better estimate than any other amount, however, the minimum amount in the range shall be accrued. Even though the minimum amount in the range is not necessarily the amount of loss that will ultimately be determined, it is not likely that the ultimate loss will be less than the minimum amount...

2-2 Accounting for legal costs incurred in connection with a loss contingency

Background

Company A is the defendant in a patent infringement case. The case was still in discovery as of December 31, 20X2 (Company A’s year-end), and there have been no discussions of possible settlement. Company A believes it will incur at least $2 million in litigation costs based on a case with similar facts for which it reached a settlement; however, it cannot make a determination of what the legal costs may be if the case goes to trial. A trial is scheduled to commence in the first quarter of 20X3 should a settlement not be reached.

Question: Should Company A accrue legal costs it expects to incur in connection with a loss contingency?

Solution

In the absence of authoritative guidance, Company A should make an accounting policy election with regard to the accounting for such litigation costs and disclose such policy, if material. Acceptable accounting policies include: (1) accrue the costs when they are probable and reasonably estimable and (2) expense such costs as incurred.

Relevant guidance

As discussed in ASC 450-20-S99-2, there is no definitive guidance on whether an accrual must be made for legal costs that the entity expects to incur in connection with a loss contingency. ASC 450-20-S99-2 also states: The SEC Observer noted that the SEC staff would expect a registrant's accounting policy to be applied consistently and that APB Opinion No. 22, Disclosure of Accounting Policies, requires disclosure of material accounting policies and the methods of applying those policies.

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Laura Robinette

US Pharmaceutical & Life Sciences Assurance Leader, PwC US

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