CPA Exam - FAR (Financial Accounting and Reporting)Financial ReportingHard
A company has a liability for environmental remediation costs. The company can estimate a range of possible outcomes, with probabilities assigned to each. The estimated costs are $5,000,000 (20% probability), $7,000,000 (50% probability), and $10,000,000 (30% probability). What amount should the company recognize as a liability under U.S. GAAP, assuming all outcomes are equally likely to occur within their respective ranges?
- A$10,000,000
- B$7,500,000
- C$6,500,000
- D$7,000,000
Show answer & explanationAnswer & explanation
Correct answer: B. $7,500,000
When a range of possible outcomes and their probabilities are known, the liability should be recognized at the expected value. Expected Value = ($5,000,000 * 0.20) + ($7,000,000 * 0.50) + ($10,000,000 * 0.30) Expected Value = $1,000,000 + $3,500,000 + $3,000,000 = $7,500,000.
Why the other options are wrong
- A. This is the maximum possible outcome, which would only be used if it was the single best estimate or the expected value was not calculable.
- C. Incorrect calculation.
- D. This is the most likely amount, but under U.S. GAAP, if probabilities are available, the expected value is often preferred for a range of outcomes.
Contingent Liability Measurement (Expected Value)
When a contingent liability is probable and a range of outcomes exists, if no amount within the range is a better estimate than any other, and probabilities are estimable, U.S. GAAP generally requires recognition at the expected value (sum of each potential outcome multiplied by its probability).
- Liability is probable and estimable
- Range of outcomes with probabilities
- Recognize at expected value
- If no amount is better estimate, and probabilities not estimable, use minimum of range
Memory trick: Probable and Estimable? Book it! If a range, use expected value; if not, use the minimum.