Contingencies



Gain Contingencies

Gain contingencies, or possible occurrences of a gain on a claim or obligation involving the entity, are reported when realized (earned).

Learning Objectives

Explain how a company reports a gain contingency on their financial statements

Key Takeaways

Key Points

  • If a specific event that can cause the gain occurs, and the gain is realized, then the gain is accrued for and reported in the financial statements. It is also disclosed in the notes section.
  • Probable and quantifiable gains are not accrued for reporting purposes, but they can be disclosed in the notes to the financial statements if they are material. If the gain is not probable or reasonably estimated, but could materially effect financial statements, the gain is disclosed in a note.
  • The materiality concept states that if a gain contingency, that remains unrealized, affects the economic decision of statement users, it should be disclosed in the notes.
  • Following conservative constraints for a gain contingency, only a realized gain should be accrued for and disclosed on an income statement.

Key Terms

  • unrealized: Not realized; possible to obtain, yet not obtained.
  • Contingency: A possibility; something which may or may not happen. This also can mean a chance occurrence, especially in, unexpected expenses

Gain Contingency

Gain contingencies, or the possible occurrences of a gain on a claim or obligation that involves the entity, are reported when realized (earned). If a specific event that can cause the gain occurs, and the gain is realized, then the gain is disclosed. If the gain is probable and quantifiable, the gain is not accrued for financial reporting purposes, but it can be disclosed in the notes to financial statements. If the gain is not probable or its amount cannot be reasonably estimated, but its effect could materially affect financial statements, a note disclosing the nature of the gain is also disclosed in the notes. Care should be taken that misleading language is not used regarding the potential for the gain to be realized. The disclosure of gain contingencies is affected by the materiality concept and the conservatism constraint.

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Renovation: Renovation plans and projects can increase the value of a building and eventually bring about a gain. However these gains should only be accrued when the gain is realized.

Materiality

Materiality is a concept or convention within auditing and accounting that relates to the importance/significance of an amount, transaction, or discrepancy. For example, an auditor expresses an opinion on whether financial statements are prepared, in all material aspects, in conformity with generally accepted accounting principles (GAAP). Professional judgment is required to determine what is material and what isn’t. Generally, if the omission or misstatement of information can influence the economic decision of financial statement users, the missing or incorrect information is considered material. Thus, if a gain contingency, that remains unrealized, affects the economic decision of statement users, it should be disclosed in the notes.

Conservatism

Most accounting principles follow the conservative constraint, which encourages the immediate disclosure of losses and expenses on the income statement. This constraint also encourages the omission of revenues and gains until those gains are realized. Thus, for a gain contingency, only a realized gain is accrued for and disclosed on the income statement. A material gain contingency that is both probable and reasonably estimated can be disclosed in the notes to financial statements.

Loss Contingencies

A loss contingency may be incurred by the entity based on the outcome of a future event, such as litigation.

Learning Objectives

Summarize how a company would report a loss contingency on their financial statements

Key Takeaways

Key Points

  • Due to conservative accounting principles, loss contingencies are reported on the balance sheet and footnotes on the financial statements, if they are probable and their quantity can be reasonably estimated.
  • Unlike gain contingencies, losses are reported immediately as long as they are probable and reasonably estimated. They do not have to be realized in order to report them on the balance sheet.
  • For losses that are material, but may not occur and their amounts can not be estimated, a note to the financial statements disclosing the loss contingency is reported.

Key Terms

  • incur: To render somebody liable or subject to.
  • probable: Likely or most likely to be true.

Definition of Loss Contingencies

A loss contingency is incurred by the entity based on the outcome of a future event, such as litigation. Due to conservative accounting principles, loss contingencies are reported on the balance sheet and footnotes on the financial statements, if they are probable and their quantity can be reasonably estimated. A footnote can also be included to describe the nature and intent of the loss. The likelihood of the loss is described as probable, reasonably possible, or remote. The ability to estimate a loss is described as known, reasonably estimable, or not reasonably estimable.

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Calculating cash flow: The indirect method adjusts net income (rather than adjusting individual items in the income statement).

Contingent Liabilities for Losses

Loss contingencies can refer to contingent liabilities that may arise from discounted notes receivable, income tax disputes, or penalties that may be assessed because of some past action or failure of another party to pay a debt that a company has guaranteed. Unlike gain contingencies, losses are reported immediately as long as they are probable and reasonably estimated. They do not have to be realized in order to report them on the balance sheet. At least a minimum amount of the loss expected to be incurred is accrued. For losses that are material, but may not occur and their amounts cannot be estimated, a note to the financial statements disclosing the loss contingency is reported.

Example of a Disclosed Loss Contingency

A jury awarded $5.2 million to a former employee of the Company for an alleged breach of contract and wrongful termination of employment. The Company has appealed the judgment on the basis of errors in the judge’s instructions to the jury and insufficiency of evidence to support the amount of the jury’s award. The Company is vigorously pursuing the appeal. The Company and its subsidiaries are also involved in other litigation arising in the ordinary course of business. Since it presently is not possible to determine the outcome of these matters, no provision has been made in the financial statements for their ultimate resolution. The resolution of the appeal of the jury award could have a significant effect on the Company’s earnings in the year that a determination is made. However, in management ‘s opinion, the final resolution of all legal matters will not have a material adverse effect on the Company’s financial position.