Lesson 17 Flashcards
Define contingency
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.
What is a gain contingency?
are claims or rights to receive assets (or have a liability reduced) whose existence is uncertain but which may become valid eventually.
What are 4 typical gain contingencies?
- possible receipts of monies from gifts, donations, asset sales, etc.
- possible refunds from the government in tax disputes
- pending court cases with a probable favorable outcome
- tax loss carryforwards
Do companies record a gain contingency?
No, they only disclose the gain contingency in the notes only when a high probability exists for realizing them.
What is a loss contingency?
involve possible losses.
If a liability incurred as a result of a loss contingency, what is that called?
Contingent liabilities
Define contingent liabilities
is a potential liability that may occur in the future. example - pending lawsuits, honoring product warranties.
In order to record a loss contingency, what 2 conditions must be met?
- 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.
- the amount of the loss can be reasonably estimated.
To record a liability the company doesn’t need to know the exact payee or the exact date, but what must a company know?
that it is probable that it incurred a liability
What are 4 common loss contingencies?
- litigation, claims, and assessments
- guarantee and warranty costs
- consideration payable (premiums and coupons)
- environmental liabilities
What 3 factors must companies consider when determining whether to record a liability?
- The time period in which the underlying cause of action occured
- the probability of an unfavorable outcome
- the ability to make a reasonable estimate of the amount of loss.
In order to record the loss and a liability on the financial statements, what must have occurred?
The cause of litigation on or before the date of the financial statements.
With respect to unfilled suits and unasserted claims and assessments, a company must determine what 2 things?
- the degree of probability that a suit may be filed or a claim or assessment may be asserted
- the probability of an unfavorable outcome
Define warranty
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.
Define assurance type warranty
a warranty that the product meets agreed upon specifications in the contract at the time the product is sold
define service type warranty
a warranty that provides an additional service beyond the assurance type warranty
What warranty is sold separately from the product?
service type warranty
define consideration payable
they indicate discounts, rebates, free products,
define premium (in regards to consideration payable)
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.
Contingent liability is based on what?
on an existing condition, but involved uncertainty about a future event.
if the future event of a contingent liability occurs what happens?
The contingent liability becomes a definite liability and have to accrue it
When is a contingent liability recorded?
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.
Which of the following is an example of a contingent liability?
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.
Which term is associated with recording a contingent liability?
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.
What is the proper way to report some gain contingencies?
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.
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?
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.
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?
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.
