Lesson 17

Question 1

Define contingency

Answer 1

It is an existing condition, situation, or set of circumstances involving uncertainty as to 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.

Question 2

What is a gain contingency?

Answer 2

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

Question 3

What are 4 typical gain contingencies?

Answer 3

1. possible receipts of monies from gifts, donations, asset sales, etc.
2. possible refunds from the government in tax disputes
3. pending court cases with a probable favorable outcome
4. tax loss carryforwards

Question 4

Do companies record a gain contingency?

Answer 4

No, they only disclose the gain contingency in the notes only when a high probability exists for realizing them.

Question 5

What is a loss contingency?

Answer 5

involve possible losses.

Question 6

If a liability incurred as a result of a loss contingency, what is that called?

Answer 6

Contingent liabilities

Question 7

Define contingent liabilities

Answer 7

is a potential liability that may occur in the future. example - pending lawsuits, honoring product warranties.

Question 8

In order to record a loss contingency, what 2 conditions must be met?

Answer 8

1. information available prior to the issuance of the financial statements indicates 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.

Question 9

To record a liability the company doesn’t need to know the exact payee or the exact date, but what must a company know?

Answer 9

that it is probable that it incurred a liability

Question 10

What are 4 common loss contingencies?

Answer 10

1. litigation, claims, and assessments
2. guarantee and warranty costs
3. consideration payable (premiums and coupons)
4. environmental liabilities

Question 11

What 3 factors must companies consider when determining whether to record a liability?

Answer 11

1. The time period in which the underlying cause of action occured
2. the probability of an unfavorable outcome
3. the ability to make a reasonable estimate of the amount of loss.

Question 12

In order to record the loss and a liability on the financial statements, what must have occurred?

Answer 12

The cause of litigation on or before the date of the financial statements.

Question 13

With respect to unfilled suits and unasserted claims and assessments, a company must determine what 2 things?

Answer 13

1. the degree of probability that a suit may be filed or a claim or assessment may be asserted
2. the probability of an unfavorable outcome

Question 14

Define warranty

Answer 14

it is a promise made by a seller to a buyer to make good on a deficiency of quantity, quality, or performance in a product.

Question 15

Define assurance type warranty

Answer 15

a warranty that the product meets agreed upon specifications in the contract at the time the product is sold

Question 16

define service type warranty

Answer 16

a warranty that provides an additional service beyond the assurance type warranty

Question 17

What warranty is sold separately from the product?

Answer 17

service type warranty

Question 18

define consideration payable

Answer 18

they indicate discounts, rebates, free products,

Question 19

define premium (in regards to consideration payable)

Answer 19

It may be silverware, dishes, a small appliance, a toy or free transportation given to customers in exchange for box tops, certificates, coupons, labels, or wrappers.

Question 20

Contingent liability is based on what?

Answer 20

on an existing condition, but involved uncertainty about a future event.

Question 21

if the future event of a contingent liability occurs what happens?

Answer 21

The contingent liability becomes a definite liability and have to accrue it

Question 22

When is a contingent liability recorded?

Answer 22

When the future events are probable to occur and the amount can be reasonably estimated
Correct. In order to record a contingent liability, both of the following conditions must be met: (1) it is probable (not possible) that the liability has been incurred, and (2) the amount of the liability can be reasonably estimated.

Question 23

Which of the following is an example of a contingent liability?

Answer 23

Obligations related to product warranties
Correct. Receipts from litigation settlements, favorable court outcomes and tax loss carry forwards are all gain contingencies. Following the principle of conservativeness, companies disclose the gain contingencies in the notes, but they are not reported on the financial statements. Loss contingencies, on the other hand, if they are probable and reasonably estimated, are reported on the financial statements.

Question 24

Which term is associated with recording a contingent liability?

Answer 24

Probable
Correct. In order to record a contingent liability, both of the following conditions must be met: (1) it is probable (not possible, likely, or remote) that the liability has been incurred, and (2) the amount of the liability can be reasonably estimated.

Question 25

What is the proper way to report some gain contingencies?

Answer 25

As a disclosure only
Correct. Following the principle of conservativeness, companies disclose the gain contingencies in the notes, but they do not report these contingencies on the financial statements.

Question 26

Information available prior to the issuance of the financial statements indicates that it is probable that, at the date of the financial statements, a liability has been incurred for obligations related to product warranties. The amount of the loss involved can be reasonably estimated.

Based on the above facts, how should the company report the estimated loss contingency?

Answer 26

Accrued and disclosed
Correct. If information is known prior to the issuance of the financial statements and the obligation is probable and reasonably estimated, it must be accrued and reported on the financial statements and a contingent liability.

Question 27

Sandy Shoes Foot Inc. is involved in litigation regarding a faulty product sold in a prior year. The company has consulted with its attorney and determined that it is possible that they may lose the case. The attorney estimated that there is a 40% chance of losing. If this is the case, their attorney estimated that the amount of any payment would be $800,000.

How should this contingent liability be recorded?

Answer 27

No journal entry is needed.
Correct. Loss contingencies, if probable and reasonably estimated, must be accrued and reported on the balance sheet. In this case, however, the attorney has made an estimate that the liability is only possible, not probable. Therefore, the liability is not accrued, but only reported in the notes to the financial statements. Since the liability is not accrued, no journal entry is required.