SFAS 5
Accounting for Contingencies
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A loss contingency exists when a potential loss depends on whether some future event occurs (e.g., a pending lawsuit at year-end for which the outcome will not be known until after the financial statements are issued). Whether a contingency is accrued and reported as a liability depends on: (a) the likelihood that the confirming event will occur: 1. probable – confirming event is likely to occur 2. reasonably possible– the chance the confirming event will occur is more than remote but less than likely 3. remote– the chance the confirming event will occur is slight and (b) what can be determined about the amount of loss. 1. known 2. reasonably estimable 3. not reasonably estimable
A contingent liability is recorded if (1) a loss is probable (the confirming event is likely to occur) and (2) the amount of loss can be at least reasonably estimated. If either of these criteria is not met, and if there is at least a reasonable possibility that the loss will occur, only footnote disclosure should be made. Most consumer products are accompanied by a warranty or guarantee. Warranties and guarantees are loss contingencies for which the conditions for accrual almost always are met.
Thus, we record the costs of satisfying guarantees as expenses in the same accounting period as the revenues from the products sold (matching principle). Similarly, we also accrue a liability in connection with premium offers. Companies frequently offer premium (cash rebates, cents-off coupons, toys for boxtops, etc.) to stimulate sales. The cost of premiums estimated to be provided to customers represents an expense and an estimated liability in the reporting period the product is sold. Subsequent Events Several weeks usually pass between the end of a company’s fiscal year and the date the financial statements for that year are issued. When the cause of a loss contingency occurs before the year-end, a clarifying event after the year-end but before the financial statements are issued can be used to determine how the contingency is reported. Unasserted Claims and Assessments Even if a claim has yet to be made when the financial statements are issued, we still may need to accrue or disclose a contingency. For instance, the EPA may have been investigating a chemical spill by a chemical company but hasn’t yet proposed a penalty for violation of environmental laws. Even then, if it is probable that an unasserted claim or assessment or an unfiled lawsuit will occur, we apply the usual criteria (probable unfavorable outcome and reasonably estimable amount) to consider whether and how to report the possible loss. Gain Contingencies A gain contingency (an uncertain situation that might result in a gain) is not accrued. Instead, we disclose them in the notes to the financial statements, being careful not to give misleading implications about the likelihood of their being realized. Executory Contracts Executory (unperformed) contracts or agreements, such as purchase agreements and lines of credit, usually are not recorded because a transfer of assets or liabilities has not yet occurred. However, if the anticipated considerations are material, note disclosure is required. |