Contingencies and commitments

Q: How does US GAAP define the three levels of probability for contingencies?

US GAAP uses Probable (likely to occur), Reasonably Possible (more than remote but less than likely), and Remote (slight chance of occurring).

Q: What two conditions must be met to accrue a loss contingency?

A loss must be accrued if it is probable that a liability has been incurred at the balance sheet date and the amount of the loss can be reasonably estimated .

Q: How should a company account for a loss contingency that is probable but cannot be reasonably estimated?

The company should not accrue the loss; instead, it must disclose the nature of the contingency in the financial statement footnotes.

Q: What is the accounting treatment for a loss contingency categorized as "reasonably possible"?

A reasonably possible loss contingency must be disclosed in the footnotes, regardless of whether the amount can be estimated.

Q: Under US GAAP, what amount is accrued when a probable loss is estimated within a range and no amount is better than any other?

The minimum amount in the range should be accrued.

Q: What is the "Golden Rule" for gain contingencies?

Never accrue a gain contingency ; gains are only recorded when they are realized.

Q: How are future commitments, like lease agreements or purchase obligations, generally reported?

Significant commitments are disclosed in the footnotes, including their nature and the total payments required for the upcoming years.

Financial Accounting and Reporting (FAR) · US CPA · 5 min read

Welcome to Area III: Contingencies and Commitments!

In the world of accounting, we usually like things to be certain. We like receipts, bank statements, and signed contracts. But what happens when we don't know for sure if something will happen? What if a company is being sued, or what if they offer a warranty on a product? That is where Contingencies come in.

Think of a contingency as a "maybe." In this chapter, we will learn how to handle these "maybes" so that the financial statements remain honest and helpful for investors. Don't worry if this seems a bit abstract at first—once you see the "Probability Ladder," it will all click!

1. Loss Contingencies: The "What If" Expenses

A loss contingency is an existing condition or situation involving uncertainty as to a possible loss. We use two main criteria to decide how to handle them: Probability (how likely is it?) and Estimability (can we put a dollar amount on it?).

The Probability Ladder

US GAAP breaks down the likelihood of a loss into three categories:

Probable: The future event is likely to occur.
Reasonably Possible: The chance of the event occurring is more than remote but less than likely.
Remote: The chance of the event occurring is slight.

How to Account for Loss Contingencies

Depending on where the "maybe" falls on the ladder, we do one of three things: Accrue (record it in the books), Disclose (write a note about it), or Ignore it.

Step 1: Is it Probable and can you Estimate the amount?

If YES to both: You must Accrue the loss. This means you record a loss on the Income Statement and a liability on the Balance Sheet.
Journal Entry:
Debit: Estimated Loss
Credit: Estimated Liability

Step 2: Is it Probable but you CANNOT estimate the amount?

You cannot record a number you don't have! So, you simply Disclose it in the footnotes of the financial statements.

Step 3: Is it Reasonably Possible?

Whether you can estimate it or not, you must Disclose it. No journal entry is needed here.

Step 4: Is it Remote?

Generally, you do Nothing. You don't record it, and you don't even have to mention it.

Quick Review: The Treatment Matrix

Probable + Estimable = Accrue & Disclose
Probable + NOT Estimable = Disclose only
Reasonably Possible = Disclose only
Remote = Ignore (usually)

What if there is a Range of Estimates?

Sometimes you know you're going to lose money, but you only have a range (e.g., between \$10,000 and \$50,000). Under US GAAP, if no amount in the range is a better estimate than any other, you must accrue the minimum amount in the range.

Example: A company is sued. Their lawyers say they will probably lose between $ \$100,000 $ and $ \$500,000 $. If no amount is "more likely," the company records a loss of $ \$100,000 $ and discloses the possibility of the additional $ \$400,000 $.

Key Takeaway: We are conservative. We record losses when they are likely and we can measure them, but we don't guess high—we use the minimum of a range if we aren't sure.

2. Gain Contingencies: Looking on the Bright Side?

A gain contingency is a "maybe" that results in a profit (like a company suing someone else). In accounting, we follow the Conservatism Principle. This means we are very quick to record losses, but very slow to record gains.

The Golden Rule for Gains

Never accrue a gain contingency! We do not record a journal entry for a gain that hasn't happened yet, no matter how "probable" it is.

If the gain is Probable or Reasonably Possible: You may Disclose it in the notes, but be careful not to sound too optimistic or misleading.
If the gain is Remote: Ignore it entirely.

Did you know? This is a classic "trick" question on the CPA exam. They will tell you a gain is "virtually certain" and give you a dollar amount. Don't fall for it! You still don't record it until the money is actually realized.

Key Takeaway: Losses are recorded early; gains are recorded only when they actually happen.

3. Commitments: Looking into the Future

A Commitment is a legal obligation to perform in the future. While contingencies are about "what ifs," commitments are usually about "what will be."

Common Examples:

Unconditional purchase obligations: Agreements to buy a certain amount of inventory or services at a set price.
Lease agreements: Long-term commitments to pay for the use of property.

How to handle Commitments

Most commitments are not recorded as liabilities on the balance sheet immediately. Instead, they are Disclosed in the footnotes. You must describe the nature of the commitment and the amounts involved for the next several years.

Memory Aid: DOG
Even if a loss is Remote, you usually still have to disclose guarantees for the "DOG":
D - Debts of others guaranteed
O - Obligations of banks (letters of credit)
G - Guarantees to purchase items

Key Takeaway: Significant future commitments must be explained to the readers of the financial statements so they aren't surprised by large cash outflows later.

4. Common Mistakes to Avoid

Mistake #1: Using the Midpoint. Some students want to take the average of a range of losses. Remember, for US GAAP, use the Minimum. (The midpoint is used in IFRS, which is not what we are testing here!).

Mistake #2: Accruing Gains. It's tempting to record a gain if the lawyer says "You're 99% sure to win." Don't do it. Just disclose it.

Mistake #3: Forgetting Disclosure. Even if you record a journal entry (accrue) for a loss, you still have to write a footnote explaining it!

Summary Review

To master this chapter, ask yourself these two questions for every scenario:

Is it a Gain or a Loss? (If Gain: Disclose only. If Loss: Keep going).
How likely is it and do I have a number? (Probable + Estimable = Accrue).

You've got this! Contingencies are just about being careful and making sure investors aren't blindsided by future events.

Quick check

Can you answer these now?

Open each question to check the key ideas from this chapter.

What is a contingency in financial accounting?

A contingency is an existing condition involving uncertainty about a potential gain or loss that will be resolved when one or more future events occur or fail to occur.

How does US GAAP define the three levels of probability for contingencies?

US GAAP uses Probable (likely to occur), Reasonably Possible (more than remote but less than likely), and Remote (slight chance of occurring).

What two conditions must be met to accrue a loss contingency?

A loss must be accrued if it is probable that a liability has been incurred at the balance sheet date and the amount of the loss can be reasonably estimated.

What is the standard journal entry for recording an accrued loss contingency?

Debit: Estimated Loss (Expense) and Credit: Estimated Liability.

How should a company account for a loss contingency that is probable but cannot be reasonably estimated?

The company should not accrue the loss; instead, it must disclose the nature of the contingency in the financial statement footnotes.

What is the accounting treatment for a loss contingency categorized as "reasonably possible"?

A reasonably possible loss contingency must be disclosed in the footnotes, regardless of whether the amount can be estimated.

Under US GAAP, what amount is accrued when a probable loss is estimated within a range and no amount is better than any other?

The minimum amount in the range should be accrued.

What is the "Golden Rule" for gain contingencies?

Never accrue a gain contingency; gains are only recorded when they are realized.

When is it appropriate to disclose a gain contingency?

A gain contingency may be disclosed in the footnotes if it is probable or reasonably possible, provided the disclosure is not misleading.

How are future commitments, like lease agreements or purchase obligations, generally reported?

Significant commitments are disclosed in the footnotes, including their nature and the total payments required for the upcoming years.

What does the "DOG" acronym represent regarding remote loss contingencies?

It stands for Debts of others guaranteed, Obligations of banks, and Guarantees to purchase, all of which must be disclosed even if the loss is remote.

What is a common mistake when choosing an amount from a range of loss estimates under US GAAP?

Choosing the midpoint or the maximum; US GAAP requires using the minimum when no amount is more likely.

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