Current U.S. GAAP governing the accounting for contingent liabilities leaves a substantial amount of liabilities off the balance sheet. The codification of accounting standards gives the rules.

450-20-25-2 (SH) 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 indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. 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.

It is widely understood that in practice probable is interpreted to mean about a seventy percent or greater possibility (Deloitte 2019, 21). As a result, liabilities with a probability of zero to 69% are not reported in the financial statements. In addition, the rules require reporting only if the amount of loss can be reasonably estimated. Thus, a contingent loss of seventy percent or greater probability will still not be reported if the amount cannot be reasonably estimated. Thus, in practice it would be reasonable to assume that a large portion of contingent liabilities go unreported.

The primary alternative to this probability-based measure of the loss and liability would be a fair values-based measurement. The FASB codification defines fair value as follows:

800-10-35-2 This Topic defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

The significance of this definition of fair value measurement would be significant to the reporting of contingent liabilities.

fair value is not an estimate of the ultimate settlement amount or the present value of an estimate of the ultimate settlement amount. Uncertainty in the amount and timing of the future cash flows necessary to settle a liability and the likelihood of possible outcomes are incorporated into the measurement of the fair value of the liability. For example, a third party would charge a price to assume an uncertain liability even though the likelihood of a future sacrifice is less than probable. Similarly, when the likelihood of a future sacrifice is probable, the price a third party would charge to assume an obligation incorporates expectations about some future events that are less than probable. Recognizing the fair value of an obligation results in recognition of some obligations for which the likelihood of future settlement, although more than zero, is less than probable from a loss contingencies perspective. For the same reason, measurement of a liability at fair value also requires consideration of events whose amounts cannot be reasonably estimated. (ASC 450-20-05-6)

BARD EXAMPLE

C.R. Bard, Inc. (Bard) a manufacturer of medical, surgical, and diagnostic and patient care devices was one of several companies sued for failure of its surgical mesh products. The product is used in pelvic repair surgeries on female patients and has been used extensively over the last two decades. In the United States more than 2 million women have been implanted with transvaginal mesh (Chughtai et al 2020). Complications from the surgery include bleeding, infection, pain, erosion (mesh interfering with neighboring organs), and readmission (Scottish Government 2019).

Table 1 Plaintiffs, Charges, and Accrued Expense by Year
Year	Number of Plaintiffs	Charge to Other Expenses (in millions)	Accrued Expense (in millions)
2010	120	*	$142
2011	532		$380
2012	2,320		$243
2013	10,395	$368	$294
2014	14,090	$238	$288
2015	12,605	$553	$729
2016	6,235	$139	$810
Total		$1,298
* Charges were not broken out by product prior to 2013.

In December 2017, Bard was purchased by Becton, Dickinson and Company (BD). The accounting rules for an acquisition require that liabilities acquired be valued at fair value. BD included the product liabilities acquired from Bard at $2.029 billion. Not all of this $2 billion would be attributed to the pelvis mesh related product liability. Bard had two other products that were the subject of significant product-liability lawsuits, i.e., hernia surgery mesh and interior vena cava filters. However, the accrued expense column in Table 1 includes the liabilities for all of Bards product liabilities as well.

WHAT WE LEARN FROM THE BARD EXAMPLE

Two things stand out to us from the Bard example. First, a large liability was left off the balance sheet for several years. Second, fair value rules would result in the liability being reported earlier and at a higher amount.

The first product liability suits for the pelvic mesh were filed in 2010. By the end of 2016, Bard had accrued charges of $1.2 billion dollars. At the end of 2016, Bard carried an accrued liability of $0.8 billion. When BD acquired Bard, it valued the liability at $2 billion, $1.2 billion more than what was last reported by Bard. So if we consider total of the charges Bard reported and add to that the additional liability that BD determined, the total loss would have been about $2.4 billion dollars. A liability of that magnitude existed in 2010 through 2020, but Bard never reported a liability greater than $0.8 billion and did not report that until 2016.

In using the fair value method to value the contingent liability, BD immediately recognized the liability at $2 billion dollars. It continued to report a liability for product liability in excess of $2 billion because of additional suits that were filed for other products.

CONCLUSION

Under current GAAP reporting, Bard reported the contingent loss in other expenses and in small bits over at least four years time. It reported the liability in accrued expenses. When acquired by BD, the liability was recorded at its fair value of $2.029 billion. The practical implication is that BD added $1.2 billion to both the charges and the liability because of a difference in measurement rules. The fair value rules result in reporting contingent liabilities more accurately.

Required:

1. Review the definition of liabilities from FASB Statement of Financial Accounting Concepts No. 6. Does the probability-based measure or the fair value-based measure best fit the definition of a liability?

2. Review the objective of general-purpose financial reporting in FASB Statement of Financial Accounting Concepts No. 8. Which set of measurement rules best satisfies the objective of financial reporting.

3. Can you think of any reasons, other than the difference in measurement rules, that BD would report the liability $1.2 billion higher than Bard reported it? Might there be different incentives for the company with a product failure than with a company valuing net assets in corporate acquisition?

4. You are a member of the FASB with the obligation to set standards that conform to the conceptual framework. If this question were to come up, which set of standards would you favor; the current standards or standards based on fair value? Why?