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Contingencies

The document discusses contingencies in accounting, which involve uncertainties regarding obligations to transfer cash or assets. It differentiates between gain contingencies, which are potential benefits that are not recorded unless highly probable, and loss contingencies, which may require accrual if a liability is probable and estimable. The document also outlines the likelihood of loss and the accounting treatment for various types of contingencies.

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14 views4 pages

Contingencies

The document discusses contingencies in accounting, which involve uncertainties regarding obligations to transfer cash or assets. It differentiates between gain contingencies, which are potential benefits that are not recorded unless highly probable, and loss contingencies, which may require accrual if a liability is probable and estimable. The document also outlines the likelihood of loss and the accounting treatment for various types of contingencies.

Uploaded by

omondiv394
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CONTINGENCIES

Companies often are involved in a situation, where uncertainty exists about whether an
obligation to transfer cash or other assets has arisen and/or the amount that will be required to
settle the obligation.

For Example:

1. Company A may be a defendant in a law suit and any payment is contingent upon the
outcome of a settlement or an administrative or court proceeding
2. Toyota Kenya provides a warranty for a car it sells and any payments are contingent on
the number of cars that qualify for benefits under the warranty.
3. Kenindia Insurance company act as a guarantor on a loan for another entity and any
payment is contingent on whether the other entity defaults.

Broadly, these situations are known as contingencies. A contingency is ‘an existing condition,
situation or set of circumstances involving uncertainty or the possible gain (gain contingency) or
loss (loss contingency) to an enterprise that will ultimately be resolved when one or more
future events occur or fail to occur.

Gain contingencies

Gain contingencies are claims or rights to receive assets (or have a liability reduced) whose
existence is uncertain but which may become valid eventually.

The typical gain contingencies are:

1. Possible receipts of monies from gifts, donations bonuses and so on.


2. Possible refunds from the government in tax disputes.
3. Pending court cases with a probable favourable outcome.
4. Tax loss carry forwards. Under this provision, a company pays no income tax for a year
in which it incurs a net operating loss.

Companies follow a conservative policy in this area. Except for tax loss carry forwards, they do
not record gain contingencies. A company discloses gain contingencies in the notes, only when
a high probability exists for realizing them. As a result, it is unusual to find information about
contingent gains in the financial statements and the accompanying notes.
An example of a gain contingency disclosure is given below:

Thika Industries Ltd.

Note 13. Legal matters. In the first quarter of 2019 the Milimani Commercial Court, Nairobi,
awarded the company shs. 5 million judgement against S. Mehta Fabricators. The judgement
relates, to an agreement under which S. Mehta Fabricators were to help automate the
production plant in Thika. The company has not recorded any income relating to this judgement
because S. Mehta Fabricators have filed an appeal.

Loss contingencies

Loss contingencies involve possible losses. A liability incurred as a result of a loss contingency is
by definition a contingent liability. Contingent liabilities depend on the occurrence of one or
more future events to confirm the amount payable, the payee, the date payable or its
existence. That is, these factors depend on a contingency.

Likelihood of loss

When a loss contingency exists, the likelihood that the future event or events will confirm the
incurrence of a liability can range from probable to remote. The FASB uses the terms probable,
reasonably possible and emote to identify three areas within that range and assigns the
following meanings:

Probable: The future event or events are likely to occur

Reasonably possible: The chance of the future event or events occurring is more than remote
but less than likely.

Remote: The chance of the future event or events occurring is slight.

Companies should accrue on estimated loss from a loss contingency by a charge to expense and
a liability recorded only if both of the following two conditions are met:

1) Information available prior to the issuance of the financial settlements indicate that it is
probable that a liability has been incurred at the date of the financial statements.
2) The amount of the loss can be reasonably estimated.

To record a liability, a company does not need to know the exact payee nor the exact date
payable. What a company must know is whether it is probable that it incurred a liability. To
meet the second criterion, a company needs to be able to reasonably determine an amount for
the liability. To determine a reasonable estimate of the liability, a company may use its own
experience, experience of other companies in the industry, engineering or research studies,
legal advice or educated guesses by qualified personnel.

The illustration below shows an accrual recorded for a loss contingency, from the annual report
of Luanda Oil Refining Company.

Note 5: Contingencies. During the period from November 13 to December 23, a change in an
additive component purchased from one of its suppliers caused certain oil refined and shipped
not to meet the company’s low-temperature performance requirements. The company has
recalled this product and has arranged for reimbursement to its customers and the ultimate
consumers of all costs associated with the product. Estimated cost of the recall program, net of
estimated third party reimbursement, in the amount of $3,500,000 has been charged to current
operations.

Examples of loss contingencies and the general accounting treatment are given below:

Usually Accrued

Loss related to:

1. Collectibility of receivables.
2. Obligations related to product warranties and product defects.
3. Premiums offered to customers.

Not accrued

Loss related to:

1. Risk of loss or damage of enterprise property by fire, explosion or other hazards.


2. General or unspecified business risks.
3. Risk of loss or damage from catastrophes, assumed by property and casualty insurance
companies, including reinsurance companies.

Maybe accrued if probable or reasonably possible

Loss related to:

1. Threat of an expropriation of asset


2. Pending or threatened litigation.
3. Actual or possible claims and assessments
4. Guarantees of indebtedness of others
5. Obligations of commercial banks under ‘Stand by letters of credit’
A question that might be raised in this area of contingencies is: how are the terms “probable”,
“reasonably possible” and “remote” related to contingent liabilities?
The terms probable, reasonably possible, and remote are used in FASB Statement No. 5 and IAS
No. 37 to denote the chances of a future event occurring, the result of which is a gain or loss to
the enterprise. If it is probable that a loss has been incurred at the date of the financial
statements, then the liability (if reasonably estimable) should be recorded.
If it is reasonably possible that a loss has been incurred at the date of the financial statements,
then the liability should be disclosed via a footnote. The footnote should disclose (1) the nature
of the contingency and (2) an estimate of the possible loss or range of loss or a statement that
an estimate cannot be made.
If the incurrence of a loss is remote, then no liability need be recorded or disclosed (except for
guarantees of indebtedness of others, which are disclosed, even when the loss is remote).

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