I'm Larry Walther, this is principlesofaccounting.com, Chapter 12.
And in this module, we will look at the accounting for contingent liabilities.
Contingent liabilities are those obligations that are uncertain or
potential, or they may give rise to actual liabilities or they may not, and
the timing and amounts are uncertain.
Examples include legal disputes, environmental contamination problems,
product warranty, other firm specific risks perhaps.
They're different from general business risks, such as the risk of war, storms,
where no specific accounting is made in advance.
We have some criteria driven outcomes here.
First of all, if the liability,
the contingency becoming an actual liability is probable and subject to
reasonable estimation, then we record the liability in the financial statement.
However, if it's only reasonably possible that we'll have an unfavorable outcome,
we generally only footnote the existence of the contingency.
And for contingencies where an unfavorable outcome is viewed as being remote,
no disclosure is required.
So continuing, we record a contingent liability in the accounts
if it is probable that the future event will occur and
the amount can be reasonably estimated.
In that case, a loss is recorded, or debit to a loss, and
a liability is established or a credit liability.
If the estimated loss can only be defined as a range of outcomes,
we can't identify a specific point estimate, then under USA gap,
we generally record only the low end of the estimated liability.
The midpoint is used for international accounting standards.
There's an interesting history and
logic behind these particular ideas about what amounts should be recorded.
But it's certainly not the most conservative approach to record the lower
end of the range.
It's simply the approach that's stipulated under gap.
So one needs to be very careful when they look at contingent liabilities and
their calculation presentation of the financial statements,
because the firm risk can actually run much higher than that.
If it's only reasonably possible that the contingent liability
will become a real liability, a note to the financial statements is appropriate.
A similar treatment is afforded when it is probable a loss has occurred and
the loss cannot even be estimated.
Normally accounting tends to be conservative, but
that's certainly not the case with contingent liabilities.
Remote risks do not need to be disclosed,
they're viewed as needless clutter, distractions, for example,
a frivolous law suit where there's almost no chance of an unfavorable outcome.
Disclosures of business decision risks are not required, but
neither are they discouraged.
For example, a company may decide to reduce their insurance
coverage to save money to avoid a high premium.
While that exposes the company to certain risks, but
it was a business decision that was made.
And as I say, that's not required to be disclosed, but neither is it discouraged.
Contingent assets or
contingent gains are almost never recognized in the financial statements,
at least never until the payment or the benefit of that is actually received.
For example, a company's claim against another company for
a patent infringement, while it could be significant and
material, we ordinarily would not report that as a benefit or an asset.
The timing of events also needs to be considered.
For example, if a customer was injured by a defective product in year one, but
we did not even learn about the injury until year two, the question is,
should we go back assuming year one financial statements have not been
issued and adjust them for the event that we did not even know about in year one?
And the answer in that case is yes,
because the event giving rise to the loss occurred in year one,
we should adjust year one financial statements for that amount.
If we flip this around, the injury occurred in year two, even though it might
be very material and add verse, year one's financial statements are not affected
because the event giving rise to the loss did not occur until year two.
We might have a note to the financial statements saying, hey,
subsequent to year end, this issue arose.
And we'll have this potential future cost associated with it, but
we would not adjust the financial statements.
Let's think about a specific case such as a warranty liability,
which you might view as an estimated liability or a contingent liability.
When goods are sold, an estimate of the amount of the warranty cost to be
incurred on the goods should be recorded as an expense,
with an offsetting credit to a warranty liability account.
As the warranty work is performed, we're going to be crediting cash and
debiting the warranty liability account.
This follows the matching principle such that we're recording expenses in
the period of sale, the actual work might be done in a subsequent year.
Here's an example, Zeff Company had a beginning-of-year warranty liability
account balance of 25,000.
During the year, Zeff sold $3 million 500,000 of goods and
estimated that we would incur warranty costs equal to 2% of sales.
It's just an estimate, but we actually did 80,000 in warranty work during the year.
Let's look at a T account to analyze the effect of what's occurred for Zeff.
First of all,
there's the $25,000 beginning balance on the warranty liability account.
We did sales of 3 million 5, and we provided 2% of sales or
$70,000 as an additional accrual.
So we have 95,000 in credits.
As we did the work, credit cash to pay vendors and so forth for parts or
whatever, for the warranty work.
We're gonna offset that by debiting the warranty liability $80,000.
And that'll give rise to a $15,000 ending balance for
the estimated remaining liability at the end of the period.
Here's the journal entries.
There is the sales, debit, cash, credit sales, 3 million 5.
Simultaneous with recording the sales, we'll debit warranty expense and
credit warranty liability, that's 2% of sales.
And as the work is done throughout the period, we'll credit cash and
debit the warranty liability amount.
There are other costs that are similar to warranties.
These would include coupons, prizes,
rebates, airlines with their advantage miles programs and so forth,
free hotel stays, free rentals, other items associated with sales activities.
All of these represent items that are deemed to be probable and
subject to reasonable estimations.
They're estimated liabilities that broadly fall under the umbrella of contingent
liabilities susceptible to accrual.