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.
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- The outcome of the lawsuit has yet to be determined but could have negative future impact on the business.
- In accounting, the recognition of revenue or gains is generally based on the realization principle, meaning that revenue is recognized when it is realized or realizable and earned.
A gain contingency is an uncertain situation that will be resolved in the future, possibly resulting in a gain. The accounting standards do not allow the recognition of a gain contingency prior to settlement of the underlying event. Doing so might result in the excessively early recognition of revenue (which violates the conservatism principle). Instead, one must wait for the underlying uncertainty to be settled before a gain can be recognized. As you’ve learned, not only are warranty expense and warranty liability journalized, but they are also recognized on the income statement and balance sheet. The following examples show recognition of Warranty Expense on the income statement (Figure) and Warranty Liability on the balance sheet (Figure) for Sierra Sports.
About GAAPology
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.
- Review each of the transactions and prepare any necessary journal entries for each situation.
- 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).
- Finally, how a loss contingency is measured varies between the two options as well.
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.
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Zebra filed a $10 million lawsuit against Lion for predatory business practices, alleging Lion stole several of Zebra’s designs without its permission. At the end of the year, the lawyers for both companies believe Zebra will win the lawsuit, putting its chances of success of between 75-80%. Furthermore, Lion’s lawyers believe Lion will settle the lawsuit in the coming year, paying between $4.5 million and $8.5 million.
4 Contingencies
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.
Financial Accounting
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 https://accounting-services.net/gain-contingency-accountingtools/ 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)).
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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.
On the Radar: Contingencies, loss recoveries, and guarantees
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 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.
“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.
