The term disclosing of loss contingencies refers to the reporting of potential liabilities that are both probable and can be estimated. A loss contingency is one that will be incurred by a company if a future event is triggered. Such contingencies are classified on the balance sheet as a current liability if they are both probable and can be reasonably estimated.
Current liabilities are defined as debts that must be paid within one year or one operating cycle, whichever is longer. In order to be classified as contingent, the debt obligation depends on one or more future events to confirm the amount owed.
If the likelihood of the future event is probable, and the financial obligation can be reasonably estimated, the company should accrue the expense and place the current liability on their balance sheet. If the likelihood of the event meets only one of the two standards (probable or reasonably estimated, but not both), the company is required to include a note in their financial statements.
GAAP requires companies to confirm the likelihood of the future event using the following terms and definitions as guidance:
If there is a range of possible financial losses, the one representing the most likely outcome should be accrued. If all of the possible financial losses appear to be equally likely, the minimum financial loss should be recorded, but the potential for additional losses needs to be disclosed. Examples of loss contingencies include pending lawsuits, penalties and fines in litigation, and other monetary claims against the company.
Company A is being sued by Company XYZ, which claims the transformers they received were defective. Company XYZ is looking to recover not only the cost of the transformers, but the cost to remove and reinstall new units. While Company A believes the units were used incorrectly, they have good reason to believe Company XYZ will be successful in their claim. Company XYZ is seeking $1,200,000 in this lawsuit.
Since the loss is both probable and reasonably estimated, Company A has decided to accrue the expense and disclose the loss contingency. The following journal entry was recorded by Company A:
|Product Defect Expense||$1,200,000|