Contingencies exist when a company has an existing circumstance as of the date of the financial statements that may cause a gain or loss in the future, depending on events that haven’t yet happened and, indeed, may never happen. You just can’t take a quick look into the crystal ball to decide what contingencies to book and for how much.
It seems somewhat of an oxymoron to discuss gains in a chapter about liabilities. Most intermediate accounting textbooks throw in a quick discussion about gain contingencies right before discussing loss contingencies.
Gain contingencies
When you realize that some gain contingencies reduce liabilities, it makes more sense to include the info in a chapter about current liabilities. If you understand just the basic concept of these four gain contingencies, you’ll ace any test question on the subject:
Possible future sources of cash from the sale of assets or other sources, such as gifts.
Ongoing tax examination that may result in adjustments in the company’s favor, resulting in a tax refund. Woo-hoo!
Ongoing litigation that may result in cash awards in the company’s favor.
Future tax loss carryforwards that may reduce income tax payable in the future.
A conservative approach to gain contingencies is the key. Except for tax loss carryforwards, companies don’t record gain contingencies. They disclose them only if there’s a high possibility that they will indeed come to fruition.
Loss contingencies
Loss contingencies hinge on situations that may cost the company money in the future. However, keep in mind that these events haven’t yet happened and, indeed, may never happen.
Let’s get crackin’ on these contingencies:
Litigation occurs when the company either is actively involved in a lawsuit that it hasn’t yet settled or knows that a filing of legal action against the company is imminent, a common type of contingent liability. Most publicly traded companies have at least a few litigation disclosures in their footnotes to the financial statements.
You’ll almost never see a legal contingent liability show up on the balance sheet. Until the jury returns with a judgment and award, companies can seldom predict the outcome of litigation with enough certainty to meet the criteria for booking the accrual.
Guarantees occur if a company guarantees the obligation of another. For example, you might have someone with more established credit co-sign on your first auto loan. If you don’t make the payments, the lender expects the cosigner to step up to the plate — ruining her credit if she doesn’t (this is the stuff of Judge Judy!).
Warranties — As a consumer, you’re probably very familiar with product warranties. They cover repairs or replacement if a product fails to work within a certain period of time. Based on what you bought, the warranty may be either an assumed part of the purchase price or something you elect to buy, usually at the time of purchase.
Environmental issues and asset retirements — In certain instances, companies have to report a liability when they have a future cost (obligation) associated with its retirement. Most intermediate accounting textbooks mention the following four types of assets that are environment issues: closing landfills, decommissioning nuclear plants, closing down oil and gas wells, and closing down mines.
