The outcome of the lawsuit has yet to be determined but could have negative future impact on the business. Contingencies are conditions, situations, or events that may occur in the future and may require an adjustment to recorded assets (liabilities), revenues (expenses). In the Standard, a contingency is defined as „an existing condition involving uncertainty as to possible gain or loss to an enterprise that gain contingency accounting will ultimately be resolved when one or more future events occur or fail to occur.“ For example, assume that a business places an order with a truck company for the purchase of a large truck. The business has made a commitment to pay for this new vehicle but only after it has been delivered. Although cash may be needed in the future, no event (delivery of the truck) has yet created a present obligation.
- The problem arises from the fact that a contingency exists as of the statement date and is resolved prior to the publication of the statements.
- Warranties arise from products or services sold to customers that cover certain defects (see Figure 12.8).
- The notes to the financial statements serve as the primary vehicle for these disclosures.
- No journal entry or financial adjustment in the financial statements will occur.
Just a Few More Details
Okay, so we’ve got a provision, and it is probable that it will be settled in cash. It’ll be measured at the amount that the entity would rationally pay to settle the obligation at the end of the reporting period (or to transfer it to a third party). This estimate includes considering risks and uncertainties related to the timing and amount of payment as well as the time value of money.
Which of these is most important for your financial advisor to have?
The problem arises from the fact that a contingency exists as of the statement date and is resolved prior to the publication of the statements. However, the company’s management may feel that providing this kind of treatment will effectively notify the plaintiff of the defendant’s willingness to settle. If it is adjusted, the amount should be treated as a reduction or increase of the current year’s expense.
Application of Measurement Requirement
A contingent liability can produce a future debt or negative obligation for the company. Some examples of contingent liabilities include pending litigation (legal action), warranties, customer insurance claims, and bankruptcy. The information is still of importance to decision makers because future cash payments will be required. However, events have not reached the point where all the characteristics of a liability are present. Thus, extensive information about commitments is included in the notes to financial statements but no amounts are reported on either the income statement or the balance sheet. In practice, companies must carefully assess the likelihood of realizing these potential gains.
At the end of the year, the lawyers for both companies believe Zebra will win the lawsuit, putting its chances of success of between 75-80%. Furthermore, Lion’s lawyers believe Lion will settle the lawsuit in the coming year, paying between $4.5 million and $8.5 million. Liquidity and solvency are measures of a company’s ability to pay debts as they come due. Liquidity measures evaluate a company’s ability to pay current debts as they come due, while solvency measures evaluate the ability to pay debts long term. One common liquidity measure is the current ratio, and a higher ratio is preferred over a lower one.
There are few cases in which there would be no justification for recognizing a warranty liability on the basis that the amount cannot be estimated. A common example of a loss contingency arises out of a manufacturer’s warranty agreement to repair or replace goods sold to consumers. The expense of servicing the goods is incurred in order to encourage their purchase. The loss can result in the impairment of an asset (such as bad debt losses on receivables) or the creation of a liability (such as guaranteeing the loans of a subsidiary company). We always use examples in our instructor-led training (ILT) materials as we believe it helps participants better understand the complex requirements within U.S.
A separate aspect of the litigation is still open to considerable interpretation, but could potentially require an additional $12 million to settle. Given the current situation, Armadillo should accrue a loss in the amount of $8 million for that portion of the situation for which the outcome is probable, and for which the amount of the loss can be reasonably estimated. Contingencies can have a variety of effects on the financial statements, depending on the type of contingency and its likelihood of occurrence. The most common effect is an increase in liabilities, which may result in a decrease in net income. In some cases, such as environmental liability, the effect may be a charge to income in the period when the contingency is incurred.
This involves evaluating the probability of the contingent event occurring and the ability to measure the gain with reasonable accuracy. For instance, a company involved in a lawsuit may have a potential gain if the court rules in its favor. However, until the judgment is rendered and the amount is determinable, the gain remains a contingency and is not recognized in the financial statements. A contingency refers to a condition, situation, or set of circumstances where it is uncertain whether or not a gain or loss will occur in the future. The result of the current condition, situation, or set of circumstances, is unknown until future events occur (or do not occur). Contingencies are different from estimates, even though both involve a level of uncertainty.
If the recognition criteria for a contingent liability are met, entities should accrue an estimated loss with a charge to income. If the amount of the loss is a range, the amount that appears to be a better estimate within that range should be accrued. If no amount within the range is a better estimate, the minimum amount within the range should be accrued, even though the minimum amount may not represent the ultimate settlement amount. If a contingency may result in a gain, it is allowable to disclose the nature of the contingency in the notes accompanying the financial statements. However, the disclosure should not make any potentially misleading statements about the likelihood of realization of the contingent gain. Doing so might lead a reader of the financial statements to conclude that a gain would be realized in the near future.