Definition
The term disclosing of loss contingencies refers to the reporting of potential liabilities that are both probable and can be estimated. A loss contingency is one that will be incurred by a company if a future event is triggered. Such contingencies are classified on the balance sheet as a current liability if they are both probable and can be reasonably estimated.
Explanation
Current liabilities are defined as debts that must be paid within one year or one operating cycle, whichever is longer. In order to be classified as contingent, the debt obligation depends on one or more future events to confirm the amount owed.
If the likelihood of the future event is probable, and the financial obligation can be reasonably estimated, the company should accrue the expense and place the current liability on their balance sheet. If the likelihood of the event meets only one of the two standards (probable or reasonably estimated, but not both), the company is required to include a note in their financial statements.
GAAP requires companies to confirm the likelihood of the future event using the following terms and definitions as guidance:
Probable: confirms the event is likely to occur.
Reasonably Possible: the chance the event will occur is more than remote, but less than probable (likely).
Remote: the chance of the event occurring is slight.
If there is a range of possible financial losses, the one representing the most likely outcome should be accrued. If all of the possible financial losses appear to be equally likely, the minimum financial loss should be recorded, but the potential for additional losses needs to be disclosed. Examples of loss contingencies include pending lawsuits, penalties and fines in litigation, and other monetary claims against the company.
Example
Company A is being sued by Company XYZ, which claims the transformers they received were defective. Company XYZ is looking to recover not only the cost of the transformers, but the cost to remove and reinstall new units. While Company A believes the units were used incorrectly, they have good reason to believe Company XYZ will be successful in their claim. Company XYZ is seeking $1,200,000 in this lawsuit.
Since the loss is both probable and reasonably estimated, Company A has decided to accrue the expense and disclose the loss contingency. The following journal entry was recorded by Company A:
Debit | Credit | |
Product Defect Expense | $1,200,000 | |
Current Liabilities | $1,200,000 |
Related Terms
Also known as a statement of financial position, the balance sheet is used to show the financial health of a company at a particular point in time. The balance sheet consists of assets, liabilities, and owner's equity in the company. It is one of the four key financial statements issued by public companies.
Moneyzine EditorNovember 6th, 2024
The financial accounting term contingent liabilities refers to near-term debt obligations that cannot be precisely measured, or the actual existence of the liability is uncertain. Contingent liabilities are classified as a current liability if the debt obligation is reasonably expected to come due in a single operating cycle or one year.Moneyzine EditorNovember 6th, 2024
The term pending litigation, claims, and assessments refers to a potential near-term liability due to possible, threatened, or pending assertions, lawsuits, or monetary charges. Pending litigation, claims, and assessments are classified as a contingent liability and appear on the balance sheet as a current liability if the debt obligation is reasonably expected to come due in a single operating cycle or one year.Moneyzine EditorJanuary 23rd, 2024
The term guarantee and warranty costs refers to the financial obligations of a company that result from a deficiency in the quality or performance of a product or service. Guarantee and warranty costs are considered loss contingencies, which are incurred if a future event is triggered. There are two ways to account for these costs: the cash and accrual basis.Moneyzine EditorJanuary 19th, 2024- The term premiums and coupons refers to promotions by companies offered to customers such as redeemable certificates, rebates, box tops, and cash discounts. Premiums and coupons are categorized as contingency losses, since they require a future event to trigger the liability.Moneyzine EditorSeptember 21st, 2023
- The term self-insurance refers to a risk management approach whereby a company sets aside money to pay for certain losses. Large companies will oftentimes adopt a self-insurance approach when the risk of loss over time is thought to be less than the premiums paid to traditional insurance carriers plus the deductibles paid on claims.Moneyzine EditorNovember 6th, 2024
