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Contingencies

FASB defines a contingency as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an entity that will ultimately be resolved when one or more future events occur or fail to occur.1 

Recognition

Gain contingencies are not recognized on the financial statements, but are disclosed in the notes to the financial statements. Loss contingencies are often recognized on the financial statements. This means that a liability for the future loss will be created and the loss will be recognized as an expense in operating income today. Loss contingencies should be recognized when (1) the occurance of the loss is probable and (2) the loss can be reasonably estimated.2 

These two requirements must be met for the loss contingency to be recognized in the financial statements instead of the notes. The first requirement tells us that the likely existence of a liability must relate to the events that occured before the balance sheet date. The second requirement tells us that there must be a way to reasonably estimate the amount of the liability based on the company's own experience, the experience of other company's in the industry, engineering or research studies, legal advice or educated guesses. 

Probable: The future event or events are likely to occur.

Reasonably possible: The chance of the future event or events is more than remote but less than likely.

Remote: The chance of the future event or events occuring is slight.3 

Current accounting practice rely heavily on the wording of lawyers to determine whether a future event is probable or not.4 This observation likely results from the fact that the most common types of loss contingencies have to do with litigation. 

Disclosure

Company's may also be required to disclose their contingent liabilities. Disclosure means that the nature of the contingency and an estimate of the possible losses or range of losses a company might experience must be explained in the notes to the financial statements. Disclosure is required when there is a possibility that a loss or additional loss might occcur and either (a) the liability is not recognized on the financial statements because its probability is unknown or it can't be estimated or (b) where a range of estimates for future loss are equally likely, the lowest estimate should be accrued on the balance sheet and the range of estimates should be disclosed in the notes. 

Examples

Examples of loss contingencies include:
a) Collectibility of receivables
b) Obligations related to produt warranties and product defects
c) Risk of loss or damage of enterprise prperty by fire, explosion, or other hazards
d) Threat of expropriation of assets
e) Pending or threatened litigation
f) Actual or possible claims and assessments
g) Risk of loss from catastrophers assumed by property and casualty insurance or reinsurance companies
h) Guarantees of indebtedness of others
i) Obligations of commercial banks under "standby letters of credit"
j) Agreements to repurchase receivables (or to repurchase the related property) that have been sold.6  


References:

1. FASB ASC Glossary
2. FASB ASC 450-20-25-2
3. FASB ASC 450-20-20
4. Kieso, Weygandt, Warfield, Young, and Wiecek (ed). Intermediate Accounting: Volume 2. Eighth Canadian Edition. Wiley. 
5. FASB ASC 450-20-30-1
6. FASB Statement No. 5

 

Categories within Contingencies

Guarantees

Postings: 0

There are a number of types of guarantees that a guarantor company can undertake. Importantly, FASB requires special recognition for contracts that require a guarantor to indemnify another for losses, performance guarantees, and some guarantees of the indebtedness of others.

Commitments

Postings: 0

Commitments refer to contracts that a company enters into with customers, suppliers, employees and other parties. While commitments are not recognized as liabilities, they do represent a claim on the company's assets and should be disclosed in certain circumstances.

Lawsuits Payable

Postings: 0

A liability may sometimes be recognized where a threatened or pending lawsuit is likely to be settled unfavourably.

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