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. This situation commonly arises when a business is the defendant in a lawsuit, or has guaranteed the payment of a debt incurred by a third party.
As an example of a contingency, 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.
As another example, 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.
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:
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.
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.