Gain and Loss Contingencies
The financial accounting term contingency is defined as an event with an uncertain outcome that can have a material effect on the balance sheet of a company. Gain and loss contingencies are noted on the company's balance sheet and income statement when they are both probable and reasonably estimated.
Contingencies are one of several types of information that is supplementary to the items appearing on a company's balance sheet. Generally, this information is of two types:
- Gain Contingencies: a claim or right to receive an asset or the reduction in a liability. Examples include favorable outcomes from litigation, or a tax refund based on a positive ruling from the IRS.
- Loss Contingencies: a reduction in the value of an asset or an increase to a liability based on the outcome of a future event. Examples include obligations under a manufacturer's warranty or a negative outcome from litigation.
Generally Accepted Accounting Principles, and specifically the Conservatism Constraint, applies when contingencies arise. This principle states that when in doubt, report information that does not overstate income or assets or does not understate expenses or liabilities, therefore:
- Gain contingencies are not recorded on the income statement or balance sheet, but are noted when the probability of a favorable outcome is high and the gain can be reasonably estimated.
- Loss contingencies are accrued to the balance sheet and expensed on the income statement when the future event is both probable and the loss can be reasonably estimated.
The value of the loss should be classified as not reasonably estimable, reasonably estimable, or known. Furthermore, accounting principles require the categorizations of a loss occurrence as:
- Probable: the event is likely to occur
- Reasonably Possible: the event can occur, but not likely
- Remote: the chance of the event occurring is small
The soil surrounding a manufacturing plant owned by Company A was found to contain fuel oil, which was leaked from an underground tank removed back in 1992. Initial estimates provided by an engineering firm indicate cleanup costs of $200,000. Since this loss is both probable and reasonably estimable, Company A would record the following loss contingency: