Construct and BigMix, Inc.
December 10, 2015
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Contingencies are an important concept in accounting. They represent a possible gain or loss from an event that might occur but has not yet occurred. If the contingent event occurs, then a company’s financial position can be greatly affected. However, firms must be very careful how they report contingencies so that they do not violate the faithful representation concept by overstating or understating accounts. The United States generally accepted accounting principles (GAAP) and the International Financial Reporting Standards (IFRS) vary slightly on how to deal with contingencies. Because of these variations between GAAP and IFRS, Construct must be careful to report its contingencies differently depending on the audience of its financial statements.
Contingencies can be classified based on the probability of their occurrence. The probability of a contingency can fall into one of three categories: remote, reasonably likely, or probable. IFRS defines probable as “more likely than not”, meaning a likelihood of more than fifty percent. However, GAAP is a bit more stringent and defines probable as “likely”, meaning a high probability. While GAAP has no probability percentage threshold, to be considered probable, a contingency would need to have a high probability of occurring such as 70-90 percent, not any probability higher than fifty percent.
When Construct purchased land from BigMix in 2007, it had no reason to believe that the probability of a loss contingency for environmental liabilities was more than remote or reasonably likely. Additionally, GAAP requires the amount of a liability to be reasonably estimated to record the liability, and in 2007 Construct had no reasonable estimate for a liability. Because in 2007 a contingency that was probable or reasonably estimated had not been identified, Construct would not have recorded a liability for environmental liabilities.
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In 2008, after Construct purchased the land from BigMix Inc., BigMix filed for Chapter 11 bankruptcy. Construct was unable to gain an interest in BigMix’s assets. If an environmental liability were to arise, Construct would be responsible for the costs and liabilities. However, at the time of the bankruptcy, Construct still had no way to reasonably estimate the cost or occurrence of a potential loss contingency. Therefore, under both GAAP and IFRS, it should not have recorded an environmental liability. However, to be on the conservative side, Construct may have considered recording a footnote disclosing the possibility of an economic liability.
In 2009, the EPA informed Construct that it would be testing for water contamination on the property that Construct had acquired from BigMix. Proactively, Construct contacted an agency to do some testing for potential contamination. The agency estimated that the probability of Construct incurring fees from the EPA was sixty percent and that the fees would be approximately $250,000, including legal fees. Construct now had a reasonably estimated, contingent environmental liability. Under GAAP, however, the probability of the contingent liability occurring would most likely be considered reasonably likely but not yet probable. Therefore, the contingent liability should have been disclosed but not accrued. However, this contingent liability qualifies as probable under IFRS and therefore should have been recorded as an accrued liability in 2009.
In 2010, the EPA placed the property obtained from BigMix on its National Priorities List. It named BigMix, Construct, and other former shareholders of BigMix as the potentially responsible parties. The EPA ordered that Construct would oversee the remedial investigation and feasibility study (RI/FS). To avoid the penalties of noncompliance, Construct began the RI/FS, and it filed a suit against BigMix’s other
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former stakeholders. The amount of the suit was currently unspecified. Although, at the time, Construct was unable to reasonably estimate the cost of the completion of the remediation efforts, it could estimate the legal costs of the remediation and the costs of the investigation. The legal costs were estimated at $100,000, and the cost of the RI/FS was estimated at $300,000. Since the costs were reasonably estimated and the research into the remediation effort was already in process, Construct could expect to incur these contingent liabilities. Therefore, an accrued liability should have been recorded in 2010 under both GAAP and IFRS in the amount of $400,000, the total of the legal and RI/FS costs.
In 2011, the RI/FS was completed, and the total cost of the remediation plan was estimated and presented to the EPA. The implementation of the remediation plan was estimated to cost $1.5 million as of 2011. Because the likelihood of the remediation plan’s occurrence was probable, the likelihood of the contingent liability was also probable.
Additionally, the amount of liability was reasonably estimated. So again, under GAAP and IFRS, Construct should have recorded an accrued liability in the amount of $1.5 million.
In addition to being classified based on the probability of their occurrence, contingencies can also be classified as gain contingencies or loss contingencies. Until 2012, Construct had dealt only with loss contingencies. In 2012, it faced a gain contingency due to its lawsuit against other former BigMix stakeholders. Under GAAP, gain contingencies are recognized only when they are “assured beyond a reasonable doubt”. Under IFRS, gain contingencies, called contingent assets, are recognized only when the reception is “virtually certain”. While loss contingencies are recognized according to their probability, gain contingencies are hardly ever recognized. Companies are hesitant to recognize gain contingencies because unrealized gains can make a company’s net income look much
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higher and can very easily be misleading to financial statement users. Recording gain contingencies can very easily cause a company to violate the concept of faithful representation. However, gain contingencies are very often disclosed in a footnote.
Construct’s attorneys had estimated that the probability of Construct receiving money in a settlement with the former stakeholders was seventy-five percent. They estimated that this settlement would probably be about $1 million. This probability of a gain contingency is too low to recognize under GAAP or IFRS, so Construct should not have reported the gain in 2012. Perhaps in subsequent years the gain will be realized and will be recorded. Until then it should remain a footnote.
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