Reporting Contingencies
Loss Contingencies and Liabilities
Contingencies are reported as liabilities on the balance sheet and/or disclosed in the notes to the financial statements when it is probable they will incur a loss and when the loss can be reasonably estimated.
Probability
Probable is defined as more than 50% likely to occur due to a past obligation. The past obligating event defines a future payment event as a payment due on a specific date from the company, who is linked to an obligating event by a specific agreement.
Loss Contingency
A loss contingency is not reported if:
- A loss contingency is less than 50% likely to occur due to a past obligation.
- The amount of the loss can not be reliably measured or estimated.
Gain Contingency
Gain contingencies are reported on the income statement when they are realized (earned).
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Funds may be lost due to contingent liabilities.
Conservative accounting principles state that companies should report loss contingencies as they occur.
Estimating a Loss Contingency
Reliability
A probable loss contingency can be measured reliably if it can be estimated based on historical information. For example, to accrue a provision for product warranty costs, assume that minor repairs cost 5% of the total product sales and an estimated 5% of products may require minor repairs within 1 year of sale. Major repairs cost 20% and 1% of products may require major repairs in 3 years.
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Car Repairs
Cars require regular maintenance. Such contingent liabilities can be estimated reliably based on historical cost and readily available information.
Provision Estimation
The provision is calculated by multiplying 5% of total product cost by 5% of products needing minor repair and then adding 20% of cost for major repair, multiplied by 1% of products needing major repair.
5% x 5% + 20 % x 1% (of budgeted total sales)
A warranty expense is debited for the provision amount that will offset product sales revenue in the income statement and a credit is posted to warranty provision liability. The amount for repairs occurring in year one is reported in the current liability section of the balance sheet; the portion relating to major repairs in three years is disclosed as long-term liability. As the warranty claims are made, the liability account is debited and cash is credited for the cost of the repair. The long-term liability warranty provision is moved to the current liability section in the accounting period occurring three years after the product sale.