Contingencies and Commitments

Question 1

What is a contingency?

Answer 1

it is an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss that will ultimately be determined when a future event occurs or fails to occur; the resolution may result in the acquisition of an asset, the reduction of a liability, the loss or impairment of an asset, or the incurrence of a liability

Question 2

Recognition and measurement of gain contingencies

Answer 2

these are claims or rights to receive assets whose existence is uncertain but may become valid upon the occurrence of future events; gain contingencies are not recognized in the financial statements because to do so may cause recognition of revenue prior to its realization; an entity should disclose a contingency that might result in a gain in the notes to the financial statements, but should be careful to avoid misleading implications about the likelihood of realization

Question 3

Recognition and measurement of loss contingencies

Answer 3

the recognition of contingent losses in the financial statements depends on the likelihood that future events will confirm the contingent loss; GAAP classifies the likelihood of contingent losses as follows:

probable = likely to occur

reasonably possible = more than remote, but less than likely

remote = slight chance of occurring

provision for a loss contingency should be accrued by a charge to income, providing that both of the following conditions exist:

it is probable that as of the date of the financial statements an asset has been impaired or a liability incurred, based on information available prior to the issuance of the financial statements

the amount of loss can be reasonably estimated; in the event that a range of probable losses is given, GAAP requires that the best estimate of the loss be accrued; if no amount in the range is a better estimate than any other amount within the range, the minimum amount in the range should be accrued, and a note disclosing the possibility of an additional loss should be presented

in the event that both of the conditions above are not met, a financial statement disclosure shall be made when there is at least a reasonable possibility that a loss or an additional loss may have been incurred; the disclosure should include the nature of the contingency and an estimate of the possible loss or range of loss or a statement that an estimate cannot be made

generally, no disclosure is necessary for a remote loss contingency; however, disclosure (nature, amount of guarantee, and any expected recovery) should be made for “guarantee-type” remote loss contingencies, such as debts of others guaranteed (officers/related parties), obligations of commercial banks under standby letters of credit, and guarantees to repurchase receivables (or related property) that have been sold or assigned

Question 4

T/F: premiums and warranties are loss contingencies that are generally accrued by an entity as the expected amounts are probable and can be reasonably estimated

Answer 4

True

premiums are offers to customers for the purpose of stimulating sales; they are offered in return for coupons, box tops, labels, etc.; the cost of the premium is charged to sales in the period(s) that benefit from the premium offer; generally, all premiums will not be redeemed in the same period; therefore, the number of outstanding premium offers must be estimated accurately to reflect the current liability at the end of each period

total estimated coupon redemptions = total number of coupons issued * estimated redemption rate

warranties are a seller’s promise to “correct” any product defects; sellers offering warranties must create a liability account if the cost of the warranty can be reasonably estimated; the entire liability for the warranty should be accrued in the year of sale to “match” the cost with the corresponding revenue; the accrual should take place even if part of the warranty expenditure will be incurred in a later year