The only time a contingent asset can be recognized in the statement of financial position is when it is VIRTUALLY CERTAIN that the inflow of benefits will happen. Another important aspect is the ability to measure the gain with reasonable accuracy. Even if the probability of the event is high, the gain should not be recognized unless it can be quantified reliably.
Part 2: Your Current Nest Egg
Calculating depreciation using an estimated useful life or amounts accrued for services received are not contingencies. For our purposes, assume that Sierra Sports has a line of soccer goals that sell for $800, and the company anticipates selling 500 goals this year (2019). Past experience for the goals that the company has sold is that 5% of them will need to be repaired under their three-year warranty program, and the cost of the average repair is $200. To simplify our example, we concentrate strictly on the journal entries for the warranty expense recognition and the application of the warranty repair pool. If the company sells 500 goals in 2019 and 5% need to be repaired, then 25 goals will be repaired at an average cost of $200.
Reasonably Possible Contingencies
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The answer to whether or not uncertainties must be reported comes from Financial Accounting Standards Board (FASB) pronouncements. Essentially, the ruling serves as reliable evidence that the loss was probable and estimable. Companies are reluctant to provide these disclosures because they may simply invite investigation or litigation.
Here, companies must describe the nature of the contingency, including the underlying events or conditions that could lead to a gain. For instance, if a company is involved in litigation that could result in a favorable settlement, the notes should outline the case’s background, gain contingency accounting the current status, and the potential financial implications. This level of detail helps stakeholders assess the likelihood and magnitude of the potential gain. Transparency in financial reporting is paramount, and this extends to the disclosure of gain contingencies.
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This often requires detailed financial analysis and sometimes the involvement of external experts. For instance, in the case of a potential settlement, the exact amount must be determinable before it can be recognized in the financial statements. In financial reporting, gain contingencies represent potential economic benefits that may arise from uncertain future events.
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- When deciding upon the appropriate accounting for a contingency, the basic concept is that you should only record a loss that is probable, and for which the amount of the loss can be reasonably estimated.
- The firm should also disclose—using a note—the possible additional loss that may have to be recognized when the determination date is reached.
- 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.
- Do not make a retroactive adjustment to an earlier period to record a loss contingency.
Entities often make commitments that are future obligations that do not yet qualify as liabilities that must be reported. For accounting purposes, they are only described in the notes to financial statements. Contingencies are potential liabilities that might result because of a past event. Loss contingencies are recognized when their likelihood is probable and this loss is subject to a reasonable estimation. Reasonably possible losses are only described in the notes and remote contingencies can be omitted entirely from financial statements. Estimations of such losses often prove to be incorrect and normally are simply fixed in the period discovered.
The average cost of $200 × 25 goals gives an anticipated future repair cost of $5,000 for 2019. Assume for the sake of our example that in 2020 Sierra Sports made repairs that cost $2,800. Following are the necessary journal entries to record the expense in 2019 and the repairs in 2020.