How to Account for Gain and Loss Contingencies

A loss contingency gives the readers of an organization’s financial statements early warning of an impending payment related to a likely obligation. An example of determining a warranty liability based on a percentage of sales follows. The sales price per soccer goal is $1,200, and Sierra Sports believes 10% of sales will result in honored warranties.

1. This amount could be a reasonable estimate for the parts repair cost per soccer goal.
2. It should be observed that the uncertainty about effect does not relate to the cause but to the results of that event.
3. Also, sales for 2020, 2021, 2022, and all subsequent years will need to reflect the same types of journal entries for their sales.

If the most likely amount is unknown, but there is a reasonably estimated range, then it is acceptable to use the range and apply the minimum limit of the range. In our case, we make assumptions about Sierra Sports and build our discussion on the estimated experiences. Pending litigation involves legal claims against the business that may be resolved at a future point in time. The outcome of the lawsuit has yet to be determined but could have negative future impact on the business.

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This ratio—current assets divided by current liabilities—is lowered by an increase in current liabilities (the denominator increases while we assume that the numerator remains the same). When lenders arrange loans with their corporate customers, limits are typically set on how low certain liquidity ratios (such as the current ratio) can go before the bank can demand that the loan be repaid immediately. This second entry recognizes an honored warranty for a soccer goal based on 10% of sales from the period. Yes, a company can eliminate a contingency by resolving the event or occurrence that created the contingency. Apart from financial guarantees, GAAP does not require the disclosure of contingencies when there is only a remote likelihood that a loss will be confirmed on a future date.

Probable and Estimable

In this instance, Sierra could estimate warranty claims at 10% of its soccer goal sales. The GAAP guidelines require that loss contingencies be recorded in a company’s financial statements if the loss is likely and can be reasonably estimated. Imagine your business faces a lawsuit over a patent infringement written by an inventor. If there’s a reasonable probability that you’ll lose the case and the probable loss amount can be estimated, you should report a loss and related liability on your financial statements. The determination of whether a contingency is probable is based on the judgment of auditors and management in both situations. This means a contingent situation such as a lawsuit might be accrued under IFRS but not accrued under US GAAP.

An entity may choose how to classify business interruption insurance recoveries in the statement of operations, as long as that classification is not contrary to existing generally accepted accounting principles (GAAP). Thus, for example, if a litigation contingency exists as of 31 December such that a company does not know if it will win or lose, but the court rules early in January that it lost, it should report the loss as a fact. When no particular amount within the range is thought to be more likely than any other, the firm should record the loss as the minimum figure in the range. Except when a product is newly created, the service costs can generally be estimated based on prior experience. The objective of the requirement is to prevent the exclusion of losses and liabilities simply because the details are not yet known with certainty. If it is anticipated that the final effect of a contingency will be a loss, the form of the disclosure depends on the perceived likelihood of confirmation.

How to Tell If a Contingent Liability Should Be Recognized

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If some amount within the range of loss appears at the time to be a better estimate than any other amount within the range, that amount shall be accrued. When no amount within the range is a better estimate than any other amount, however, the minimum amount in the range should be accrued. We are available to discuss and constructing the effective tax rate reconciliation and income tax provision disclosure help you determine how to properly account for these situations. A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation. GAAP adopts the position that the effect (loss) and the amount should be reported as if they were known at the statement date.

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. If the warranties are honored, the company should know how much each screw costs, labor cost required, time commitment, and any overhead costs incurred. This amount could be a reasonable estimate for the parts repair cost per soccer goal.

Types of Contingencies

Sierra Sports may did you have any interest or dividend income have more litigation in the future surrounding the soccer goals. These lawsuits have not yet been filed or are in the very early stages of the litigation process. Since there is a past precedent for lawsuits of this nature but no establishment of guilt or formal arrangement of damages or timeline, the likelihood of occurrence is reasonably possible. Since the outcome is possible, the contingent liability is disclosed in Sierra Sports’ financial statement notes. If the contingent liability is probable and inestimable, it is likely to occur but cannot be reasonably estimated. In this case, a note disclosure is required in financial statements, but a journal entry and financial recognition should not occur until a reasonable estimate is possible.

In essence, as long as Sierra Sports sells the goals or other equipment and provides a warranty, it will need to account for the warranty expenses in a manner similar to the one we demonstrated. For example, Sierra Sports has a one-year warranty on part repairs and replacements for a soccer goal they sell. Sierra Sports notices that some of its soccer goals have rusted screws that require replacement, but they have already sold goals with this problem to customers. There is a probability that someone who purchased the soccer goal may bring it in to have the screws replaced.

For example, if the confirmation of a loss is deemed to be probable and the company can estimate its amount, then a liability should be accrued. In the event that the likelihood of confirmation of a loss is lower than probable but still reasonably possible, the firm is required to provide a note describing the situation. This position was adopted in order to prevent the accrual in the financial statements of amounts so uncertain as to impair the integrity of the statements. Future costs are expensed first, and then a liability account is credited based on the nature of the liability. In the event the liability is realized, the actual expense is credited from cash and the original liability account is similarly debited.

Recognition of loss contingencies fosters financial transparency, aids in risk assessment, impacts decision-making for all stakeholders, and ensures regulatory compliance. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

To simplify our example, we concentrate strictly on the journal entries for the warranty expense recognition and the application of the warranty repair pool. If the company sells 500 goals in 2019 and 5% need to be repaired, then 25 goals will be repaired at an average cost of $200. The average cost of $200 × 25 goals gives an anticipated future repair cost of $5,000 for 2019. Assume for the sake of our example that in 2020 Sierra Sports made repairs that cost $2,800. Following are the necessary journal entries to record the expense in 2019 and the repairs in 2020. The resources used in the warranty repair work could have included several options, such as parts and labor, but to keep it simple we allocated all of the expenses to repair parts inventory.