In this instance, Sierra could estimate warranty claims at 10% of its soccer goal sales. The measurement requirement refers to the company’s ability to reasonably estimate the amount of loss. Even though a reasonable estimate is the company’s best guess, it should not be a frivolous number. For a financial figure to be reasonably estimated, it could be based on past experience or industry standards (see (Figure)).
If the warranties are honored, the company should know how much each screw costs, labor cost required, time commitment, and any overhead costs incurred. This amount could be a reasonable estimate for the parts repair cost per soccer goal. 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. When both of these criteria are met, the expected impact of the loss contingency is recorded. They believe that a loss is probable and that $800,000 is a reasonable estimation of the amount that will eventually have to be paid as a result of the damage done to the environment.
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 https://accounting-services.net/gain-contingency-accountingtools/ 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.
These materials were downloaded from PwC’s Viewpoint (viewpoint.pwc.com) under license. Adequate disclosure shall be made of a contingency that might result in a gain, but care shall be exercised to avoid misleading implications as to the likelihood of realization. The supplier had breached a contract, leading to significant losses for Company XYZ.
For example, Sierra Sports has a one-year warranty on part repairs and replacements for a soccer goal they sell. Sierra Sports notices that some of its soccer goals have rusted screws that require replacement, but they have already sold goals with this problem to customers. There is a probability that someone who purchased the soccer goal may bring it in to have the screws replaced. Not only does the contingent liability meet the probability requirement, it also meets the measurement requirement.
Just Say No…to Recording a Gain Contingency under ASC 450 (old FAS
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. If the contingency is reasonably possible, it could occur but is not probable.
Unlike loss contingencies, gain contingencies should not be accrued as doing so would result in recognizing revenue before it is realized. Disclosure should be made in the financial statements when the probability is high that a gain contingency will be recognized. If the contingent liability is probable and inestimable, it is likely to occur but cannot be reasonably estimated. In this case, a note disclosure is required in financial statements, but a journal entry and financial recognition should not occur until a reasonable estimate is possible. Assume that Sierra Sports is sued by one of the customers who purchased the faulty soccer goals.
- Since this warranty expense allocation will probably be carried on for many years, adjustments in the estimated warranty expenses can be made to reflect actual experiences.
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- Such amounts were not reported in good faith; officials have been grossly negligent in reporting the financial information.
- Adequate disclosure shall be made of a contingency that might result in a gain, but care shall be exercised to avoid misleading implications as to the likelihood of realization.
- This amount could be a reasonable estimate for the parts repair cost per soccer goal.
An entity may choose how to classify business interruption insurance recoveries in the statement of operations, as long as that classification is not contrary to existing generally accepted accounting principles (GAAP). If some amount within the range of loss appears at the time to be a better estimate than any other amount within the range, that amount shall be accrued. When no amount within the range is a better estimate than any other amount, however, the minimum amount in the range should be accrued.
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. These are questions businesses must ask themselves when exploring contingencies and their effect on liabilities. Zebra Inc. is a small, regional design company that specializes in mesmerizing black and white images. Lion Co. is a large, well-established international design company that takes what it wants when it wants.
Exercise Set A
“Probable” is described in Statement Number Five as likely to occur and “remote” is a situation where the chance of occurrence is slight. “Reasonably possible” is defined in vague terms as existing when “the chance of the future event or events occurring is more than remote but less than likely” (paragraph 3). The professional judgment of the accountants and auditors is left to determine the exact placement of the likelihood of losses within these categories. In our case, we make assumptions about Sierra Sports and build our discussion on the estimated experiences. For example, assume that a business places an order with a truck company for the purchase of a large truck. The business has made a commitment to pay for this new vehicle but only after it has been delivered.
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Since this condition does not meet the requirement of likelihood, it should not be journalized or financially represented within the financial statements. Rather, it is disclosed in the notes only with any available details, financial or otherwise. 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. Positive contingencies do not require or allow the same types of adjustments to the company’s financial statements as do negative contingencies, since accounting standards do not permit positive contingencies to be recorded. From a journal entry perspective, restatement of a previously reported income statement balance is accomplished by adjusting retained earnings. Revenues and expenses (as well as gains, losses, and any dividend paid figures) are closed into retained earnings at the end of each year.
These lawsuits have not yet been filed or are in the very early stages of the litigation process. Since there is a past precedent for lawsuits of this nature but no establishment of guilt or formal arrangement of damages or timeline, the likelihood of occurrence is reasonably possible. Since the outcome is possible, the contingent liability is disclosed in Sierra Sports’ financial statement notes. A contingency occurs when a current situation has an outcome that is unknown or uncertain and will not be resolved until a future point in time.
Pending litigation involves legal claims against the business that may be resolved at a future point in time. The outcome of the lawsuit has yet to be determined but could have negative future impact on the business. A contingency that might result in a gain usually should not be reflected in the financial statements because to do so might be to recognize revenue before its realization. It is essential for companies to regularly assess the likelihood of realizing gain contingencies and adjust their financial statements accordingly to reflect the most accurate and conservative picture of their financial position. It ensures that financial statements provide users with reliable information for decision-making. In addition, Lion should disclose the contingency, if material, in its year-end financial statements along with the range of potential loss (i.e. $4.5 million to $8.5 million).