A contingency is an existing condition, situation, or set of circumstances involving uncertainty about possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.
Table of Contents
Contingency Liability
Contingent liabilities are possible obligations arising from past events and depend upon the occurrence or non-occurrence of one or more future events to confirm the amount payable to the payee, the date payable, or its existence.
Contingent liabilities are possible obligations arising from past events and depend upon the occurrence or non-occurrence of one or more future events to confirm the amount payable to the payee, the date payable, or its existence.
Types of Contingencies
2 types of contingencies are;
- Gain Contingencies.
- Loss Contingencies.
Gain Contingencies
Gain contingencies are claims or rights to receive assets (or have liabilities reduced) whose existence is uncertain but which may become valid eventually. Gain contingencies are not recorded.
They are disclosed in the notes only when high probabilities are that a gain contingency will become a reality.
The typical gain contingencies are:
- Possible receipts of monies from gifts, donations, bonuses, and so on.
- Possible refunds from the government in tax disputes.
- Pending court cases where the probable outcome is favorable,
- Tax losses carryforwards.
Companies follow a conservative policy in this area. Except for tax loss carryforwards, they do not record gain contingencies.
A company discloses gain contingencies in the notes only when a high probability exists for realizing them. As a result, it is unusual to find information about contingent gains in the financial statements and the accompanying notes.
The illustration below presents an example of a gain contingency disclosure.
| Note 5: Contingencies: During the period from November 13 to December 23, a change in an additive component purchased from one of its suppliers caused certain oil refined and shipped to fail to meet the Company’s low-temperature performance requirements. The Company has recalled this product and has arranged for reimbursement to its customers and the ultimate consumers of all costs associated with the product. The estimated cost of the recall program, net of estimated third party reimbursement, for $3,500,000 has been charged to current operations. |
Loss Contingencies
Loss contingencies involve possible losses. A liability incurred as a result of a loss contingency is by definition, a contingent liability.
Contingent liabilities depend on the occurrence of one or more future events to confirm the amount payable, the payee, the date payable, or its existence. That is, these factors depend on a contingency.
Likelihood of Loss
When a loss contingency exists, the likelihood that the future event or events will confirm the incurrence of a liability can range from probable to remote.
The FASB uses the terms probable, reasonably possible, and remote to identify three areas within that range and assigns the following meanings.
Probable
Future events or events are likely to occur.
Reasonably possible
The chance of the future event or events occurring is more than remote but less than likely.
Remote
The chance of future events or events occurring is slight. Companies should accrue an estimated loss from a loss contingency by a charge to expense and liability recorded only if both of the following conditions are met.
- The information available before the issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements.
- The amount of the loss can be reasonably estimated.
To record a liability, a company does not need to know the exact payee nor the exact date payable. What a company must know is whether it is probable that it incurred a liability.
To meet the second criterion, a company needs to be able to reasonably determine an amount for the liability. To determine a reasonable estimate of the liability, a company may use its own experience, the experience of other companies in the industry, engineering or research studies, legal advice, or educated guesses by qualified personnel.
The illustration below shows an accrual recorded for a loss contingency from the annual report of Quaker State Oil Refining Company.
| Note 5: Contingencies: During the period from November 13 to December 23, a change in an additive component purchased from one of its suppliers caused certain oil refined and shipped to fail to meet the Company’s low-temperature performance requirements. The Company has recalled this product and has arranged for reimbursement to its customers and the ultimate consumers of all costs associated with the product. The estimated cost of the recall program, net of estimated third-party reimbursement, for $3,500,000 has been charged to current operations. |
Use of the terms probable, reasonably possible, and remote to classify contingencies involves judgment and subjectivity. The illustration below lists examples of loss contingencies and the general accounting treatment accorded them.
| Usually Accrued Loss Related to: Collectability of receivables Obligations related to product warranties and product defects Premiums offered to customers Not Accrued Loss Related to: Risk of loss or damage of enterprise property by fire, explosion, or other hazards General or unspecified business risks Risk of loss from catastrophes assumed by property and casualty insurance companies, including reinsurance companies May Bc Accrued* Loss Related to: The threat of expropriation of assets Pending or threatened litigation Actual or possible claims and assessments.** Guarantees of indebtedness of others. Obligations of commercial banks under “standby letters of credit”. Agreements to repurchase receivables (or the related property) that have been sold. * Should be accrued when both criteria—probable and reasonably estimable— are met. **Estimated amounts of losses incurred before the balance sheet date but settled subsequently should be accrued as of the balance sheet date. |
Practicing accountants expire concern over the diversity that now exists in the interpretation of “probable,” “reasonably possible,” and “remote.
Current practice relies heavily on the exact language used in responses received from lawyers (such language is necessarily biased and protective rather than predictive).
As a result, accruals and disclosures of contingencies vary considerably in practice. Some of the more common loss contingencies are:
- Litigation, claims, and assessments.
- Guarantee and warranty costs.
- Premiums and coupons.
- Environmental liabilities.
As discussed in the opening story, companies do not record or report in the notes to the financial statements general risk contingencies inherent in business operations (e.g., the possibility of war, strike, uninsurable catastrophes, or a business recession).
Loss Contingencies
Loss contingencies are situations involving uncertainty as to possible loss.
The typical loss contingencies are:
- Guarantee and warranty costs
- Premiums and coupons
- Environmental liabilities
- Self-insurance risks.
Contingent Assets
Contingent assets are a possible asset that arises from past events and is dependent upon the occurrence or non-occurrence of one or more future events to confirm the amount payable to the payee, the date payable, or its existence.
An accountant has adopted a conservative policy in this area. Gain contingencies are not recorded. They are disclosed in the notes only when high probabilities are that a. gain contingency will become a reality. As a result, it is unusual to Imd information about contingent gains in the financial statements.
Contingent Liability
A contingent liability should be recorded and charge accrued to expenses and liability only if both of the following conditions are met;
- The information available before the issuance of the financial statements indicates that it is probable that a ‘liability has been incurred at the date of the financial statements.
- The amount of the loss can be reasonably estimated.
Presentation of Contingencies
A company records a loss contingency and a liability if the loss is probable and estimable. But, if the loss is either probable or estimable but not both, and if there is at least a reasonable possibility that a company may have incurred a liability, it must disclose the following in the notes.
- The nature of the contingency.
- An estimate of the possible loss or range of loss or a statement that an estimate cannot be
This table presents an extensive litigation disclosure note from the financial statements of Remark Corporation. The note indicates that Remark charged actual losses to operations and that a further liability may exist, but that the company cannot currently estimate this liability.
| Remark Corporation | |
| Litigation. The remark is a defendant or co-defendant in a substantial number of lawsuits alleging wrongful injury and/or death from exposure to asbestos fibers in the air. The following table summarizes the activity in these lawsuits: | |
| Claims | |
| Pending at beginning of the year | 8,719 |
| Received during year | 4,494 |
| Settled or otherwise disposed of | (1,445) |
| Pending at end of year | 11,768 |
| Average indemnification cost |
3,364 |
| The average cost per case, including defense costs |
6,499 |
| Trial activity | |
| Verdicts for the Company | 23 |
| Total trials | 36 |
| The following table presents the cost of defending asbestos litigation, together with related insurance and workers’ compensation expenses. | |
| Included in operating profit | 1,872,000 |
| Non-operating expense | 9,077,000 |
| Total | 10,949,000 |
| The company is seeking to reasonably determine its liability. However, it is not possible to predict which theory of insurance will apply, the number of lawsuits still to be filed, the cost of settling and defending the existing and untiled cases, or the ultimate impact of these lawsuits on the Company’s consolidated financial statements. | |
Companies should disclose certain other contingent liabilities, even though the possibility of loss may be remote, as follows.
- Guarantees of indebtedness of others.
- Obligations of commercial banks under “standby letters of credit.”
- Guarantees to repurchase receivables (or any related property) that have been sold or assigned.
Disclosure should include the nature and amount of the guarantee and, if estimable, the amount that the company can recover from outside parties. Cities Service Company disclosed its guarantees of others’ indebtedness in the following note.
