A Roadmap to Accounting for Contingencies and Loss Recoveries Deloitte US

Since not all warranties may be honored (warranty expired), the company needs to make a reasonable determination for the amount of honored warranties to get a more accurate figure. While a contingency may be positive or negative, we only focus on outcomes that may produce a liability for the company (negative outcome), since these might lead to adjustments in the financial statements in certain cases. As another example, 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.

Guidance on ASC 450 and ASC 460

We hope this example has helped you to understand the accounting for both gain (and loss) contingencies in accordance with ASC 450. If the entity can estimate a range, and no single amount within that range represents the best estimate (in other words, each amount is equally likely to occur), the midpoint of that range should be accrued. Warranties arise from products or services sold to customers that cover certain defects (see Figure 12.8). It is unclear if a customer will need to use a warranty, and when, but this is a possibility for each product or service sold that includes a warranty. The same idea applies to insurance claims (car, life, and fire, for example), and bankruptcy.

Can a company ever eliminate a contingency?

For example, a firm might have to disclose the possibility that it will be subject to legal actions after a set of complex government regulations are finally interpreted by the courts. Strict compliance with this requirement would result in the company's declaration that it had done something wrong but that no injured party had yet taken action to seek recovery. However, a disclosure can be provided if the management wants to inform the statement readers of the particular facts surrounding the situation. The liability balance should be carefully monitored to determine whether it is reasonable in light of present expectations and experiences. Except when a product is newly created, the service costs can generally be estimated based on prior experience.

Accounting Overview for Contingencies under IAS 37

• For example, if a legal dispute is considered probable and the amount in dispute can be reasonably estimated, then a liability would be recorded on the balance sheet.
• Check out Google’s contingent liability considerations in this press release for Alphabet Inc.’s First Quarter 2017 Results to see a financial statement package, including note disclosures.
• Moreover, companies should disclose any significant assumptions and judgments used in estimating the gain.

However, if fraud, either purposely or through gross negligence, has occurred, amounts reported in prior years are restated. Contingent gains are only reported to decision makers through disclosure within the notes to the financial statements. Gain contingencies exist when there is a future possibility of acquisition of an asset or reduction of a liability. Typical gain contingencies include tax loss carryforwards, probable favorable outcome in pending litigation, and possible refunds from the government in tax disputes. Unlike loss contingencies, gain contingencies should not be accrued as doing so would result in recognizing revenue before it is realized.

When determining if the contingent liability should be recognized, there are four potential treatments to consider. 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.

The sales price per soccer goal is $1,200, and Sierra Sports believes 10% of sales will result in honored warranties. The company would record this warranty liability of $120 ($1,200 × 10%) to Warranty Liability and Warranty Expense accounts. Since this warranty expense allocation will probably be carried on for many years, adjustments in the estimated warranty expenses gain contingency accounting can be made to reflect actual experiences. Also, sales for 2020, 2021, 2022, and all subsequent years will need to reflect the same types of journal entries for their sales. 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.

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.

If the initial estimation was viewed as fraudulent—an attempt to deceive decision makers—the $800,000 figure reported in Year One is physically restated. All the amounts in a set of financial statements have to be presented in good faith. Any reported balance that fails this essential criterion is not allowed to remain. Furthermore, even if there was no overt attempt to deceive, restatement is still required if officials should have known that a reported figure was materially wrong. Such amounts were not reported in good faith; officials have been grossly negligent in reporting the financial information.

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. Since the company’s inventory of supply parts (an asset) went down by $2,800, the reduction is reflected with a credit entry to repair parts inventory. The accounting for contingencies depends on the likelihood of the event occurring and its potential financial impact. For example, if a legal dispute is considered probable and the amount in dispute can be reasonably estimated, then a liability would be recorded on the balance sheet. If the contingency is less likely to occur or the amount in dispute cannot be reasonably estimated, then no liability would be recorded.

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