Accounting Standards Codification (ASC) 420, Exit or Disposal Cost Obligations

A liability (expense) should be recognized for a cost associated with an exit or disposal activity when the liability is incurred. The FASB concluded that a liability for a cost associated with an exit or disposal activity is incurred when the definition of a liability in CON 6 is met. CON 6, paragraph 35, defines a liability as follows: "Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events." CON 6, paragraph 36, further requires that all of the three essential characteristics of a liability must be present to meet the definition of a liability. They are: 1. "a present duty or responsibility to one or more other entities that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand." 2. "the duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice." 3. "the transaction or other event obligating the entity has already happened."

Initial measurement The liability initially should be recognized at fair value in the period in which it is incurred (except for certain employee termination liabilities)

ASC 820-10-20 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." This definition is based on fair value as an exit price and, as such, is a market-based measurement, not an entity-specific measurement.

Because fair value is a market-based measurement, not an entity-specific measurement, it should reflect the assumptions that market participants would use in pricing an asset or liability, including assumptions about risk.

The risk-adjusted expected cash flows used to estimate the fair value of a liability associated with exit or disposal activities should be discounted using an interest rate that equates to a risk-free rate adjusted for the effect of the entity's credit standing unless risk related to the entity's credit standing is reflected in the expected cash flows.

In periods subsequent to the initial measurement of a liability for costs associated with an exit or disposal activity, the FASB decided, as indicated in paragraph B15 of the Basis for Conclusions of Statement No. 146, not to require remeasurement at fair value. As a result, the liability should not be marked to fair value on an ongoing basis but instead should be adjusted solely for revisions in the estimated timing and/or amount of future cash flows, using the credit-adjusted risk-free rate that was used to measure the liability initially. The cumulative effect of changes in the estimated timing or amounts of the future cash flows should be recognized as an adjustment to the liability in the period of change and reported in the same line item in the income statement used to initially record the expense. Changes that are due to the passage of time (the accretion of the liability) should be recognized as an increase in the carrying amount of the liability and as an expense in the income statement.

Guidance on how to determine the fair value of the liability if the contract that has ceased to be used is an operating lease can be found in ASC 420. In such a case, the fair value of the liability at the cease-use date should include the remaining lease rentals, adjusted for the effects of any prepaid or deferred items recognized, reduced by estimated sublease rentals that could be reasonably obtained even if the entity does not intend to sublease. Remaining lease rentals cannot be reduced to an amount less than zero. That is, an entity cannot assume sublease rentals in excess of lease costs (or create an asset). 

ASC 420 specifies that a liability should not be recognized before it is incurred even if the costs are incremental to other operating costs and will be incurred as a direct result of that plan.