A contingency arises when there is a situation for which the outcome is uncertain, and which should be resolved in the future, possibly creating a loss. The accounting for a contingency is essentially to recognize only those losses that are probable and for which a loss amount can be reasonably estimated.
Examples of contingent loss situations are:
- Injuries that may be caused by a company’s products, such as when it is discovered that lead-based paint has been used on toys sold by the business
- The threat of asset expropriation by a foreign government, where compensation will be less than the carrying amount of the assets that will probably be expropriated
- A threatened lawsuit
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. If the best estimate of the amount of the loss is within a range, accrue whichever amount appears to be a better estimate than the other estimates in the range. If there is no “better estimate” in the range, accrue a loss for the minimum amount in the range.
If it is not possible to arrive at a reasonable estimate of the loss associated with an event, only disclose the existence of the contingency in the notes accompanying the financial statements. Or, if it is not probable that a loss will be incurred, even if it is possible to estimate the amount of a loss, only disclose the circumstances of the contingency, without accruing a loss.
Examples of Contingencies
- Armadillo Industries has been notified by the local zoning commission that it must remediate abandoned property on which chemicals had been stored in the past. Armadillo has hired a consulting firm to estimate the cost of remediation, which has been documented at $10 million. Since the amount of the loss has been reasonably estimated and it is probable that the loss will occur, the company can record the $10 million as a contingent loss. If the zoning commission had not indicated the company’s liability, it may have been more appropriate to only mention the loss in the disclosures accompanying the financial statements.
- Armadillo Industries has been notified that a third party may begin legal proceedings against it, based on a situation involving environmental damage to a site once owned by Armadillo. Based on the experience of other companies who have been subjected to this type of litigation, it is probable that Armadillo will have to pay $8 million to settle the litigation. A separate aspect of the litigation is still open to considerable interpretation, but could potentially require an additional $12 million to settle. Given the current situation, Armadillo should accrue a loss in the amount of $8 million for that portion of the situation for which the outcome is probable, and for which the amount of the loss can be reasonably estimated.
If the conditions for recording a loss contingency are initially not met, but then are met during a later accounting period, the loss should be accrued in the later period. Do not make a retroactive adjustment to an earlier period to record a loss contingency.
The recognition of a gain contingency is not allowed, since doing so might result in the recognition of revenue before the contingent event has been settled.