Accounting for contingencies
/What is a Contingency?
A contingency arises when there is a situation for which the outcome is uncertain, and which should be resolved in the future, possibly creating a loss. This situation commonly arises when a business is the defendant in a lawsuit, or has guaranteed the payment of a debt incurred by a third party.
Examples of Contingencies
Here are several examples of contingencies:
Property remediation liability. Armadillo Industries has been notified by the local zoning commission that it must remediate abandoned property on which chemicals had been stored in the past. Armadillo has hired a consulting firm to estimate the cost of remediation, which has been documented at $10 million. Since the amount of the loss has been reasonably estimated and it is probable that the loss will occur, the company can record the $10 million as a contingent loss. If the zoning commission had not indicated the company’s liability, it may have been more appropriate to only mention the loss in the disclosures accompanying the financial statements.
Litigation liability. Armadillo Industries has been notified that a third party may begin legal proceedings against it, based on a situation involving environmental damage to a site once owned by Armadillo. Based on the experience of other companies who have been subjected to this type of litigation, it is probable that Armadillo will have to pay $8 million to settle the litigation. 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.
How to Account for a Contingency
The accounting for a contingency is essentially to recognize only those losses that are probable and for which a loss amount can be reasonably estimated. Examples of contingent loss situations are:
Injuries that may be caused by a company’s products, such as when it is discovered that lead-based paint has been used on toys sold by the business
The threat of asset expropriation by a foreign government, where compensation will be less than the carrying amount of the assets that will probably be expropriated
A threatened lawsuit
When deciding upon the appropriate accounting for a contingency, the basic concept is that you should only record a loss that is probable, and for which the amount of the loss can be reasonably estimated. If the best estimate of the amount of the loss is within a range, accrue whichever amount appears to be a better estimate than the other estimates in the range. If there is no “better estimate” in the range, accrue a loss for the minimum amount in the range.
Related AccountingTools Courses
If it is not possible to arrive at a reasonable estimate of the loss associated with an event, only disclose the existence of the contingency in the notes accompanying the financial statements. Or, if it is not probable that a loss will be incurred, even if it is possible to estimate the amount of a loss, only disclose the circumstances of the contingency, without accruing a loss.
If the conditions for recording a loss contingency are initially not met, but then are met during a later accounting period, the loss should be accrued in the later period. Do not make a retroactive adjustment to an earlier period to record a loss contingency.
Sample Contingency Disclosure
The following is a generic disclosure of contingencies that could be included in the footnotes that accompany an organization’s financial statements:
Note X: Contingencies
The Company is subject to various legal proceedings, claims, and regulatory actions arising in the ordinary course of business. The outcomes of these matters are inherently unpredictable, and the Company intends to defend itself vigorously against all claims.
As of [Date], the Company is a defendant in a lawsuit filed by [Plaintiff Name], alleging [nature of claims, e.g., breach of contract, patent infringement, etc.]. The plaintiff seeks damages in the amount of $[X]. Based on information currently available, management, after consultation with legal counsel, believes that it is not probable that a material loss will occur. Accordingly, no liability has been recorded in the accompanying financial statements.
However, if an unfavorable resolution were to occur, the potential loss could range from $[Y] to $[Z]. The Company is unable to estimate the likelihood or amount of any additional losses beyond this range at this time.
Additionally, the Company has identified potential environmental liabilities at its [location(s)] facilities, related to [specific environmental concerns, e.g., contamination, cleanup]. While these matters are still under investigation, the Company has recorded a reserve of $[amount] based on currently available information. Future developments could require adjustments to this estimate.
The Company continually monitors and evaluates its exposure to contingent liabilities and adjusts its accruals and disclosures as necessary.
Accounting for a Gain Contingency
The recognition of a gain contingency is not allowed, since doing so might result in the recognition of revenue before the contingent event has been settled.