Financial Accounting

Learn the toughest concepts covered in your Financial Accounting class with step-by-step video tutorials and practice problems.

9. Current Liabilities

Contingent Liabilities


Contingent Liabilities and Gains

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All right now, let's talk about contingencies which are based on events that may or may not happen. Let's see how we deal with this in an accounting standpoint. So contingencies relate to situations that are uncertain. Okay. And this could relate to contingent gains gains is contingent gains and contingent losses. However, let's start here with contingent gains because this is the chance that we might make some money in the future. Hey, we have a chance that we're gonna make some money. Well, we like to be concern when we do our accounting, we don't want to say, hey, there's a chance we're gonna make some money. Let's take that revenue right now. No, we can't do that. What we do with gains is we wait until they actually happen with the contingent gain. If there's some uncertain event, let's say maybe we're in the middle of a lawsuit and we think we're gonna win the lawsuit and get some money. Well, we can't right now say, I think we're gonna win. So let's take the game right now, we don't do that. Convention gains are never recorded. Okay. And I want to talk about that quickly because it's easy, it's easy to remember, we don't we're conservative when we do accounting. So we never record a contingent gain until it actually happens and it's realized and then we're gonna take that gain at that point. Okay. So it's an uncertain result that might result in a gain. Well, we don't deal with that. We don't make any sort of journal entry for that. However, contingent liabilities if there's a chance that we're gonna lose some money while we were there is, there's a situation where we're gonna accrue a liability. We're actually gonna have a liability on our balance sheet for the chance that we're gonna lose some money in the future. Because we're conservative. We don't want to be so so proactive about taking gains but were proactive about losses that might occur because that's very important to an investor, right? An investor, if they see that, hey, there's a chance we're gonna lose a lawsuit and lose a bunch of money. Well, that's important information that they might want to know about. Okay, so uncertainties that result in the loss could result in a contingent liability. Okay. However, they're not always gonna be a liability. There could be situations where, instead of just instead of accruing a liability, we might disclose in the footnotes, which is after we show all our balance sheet, income statement retained earnings statement of cash flows. There's pages and pages in the financial statements of footnotes where we describe in one words, a bunch of information that could be relevant to the investors. Okay, so in the footnotes, there might be a note, hey, we're in the middle of a lawsuit and there's a chance that we might lose some money. However, the chance wasn't big enough to accrue liability. Okay. And there could be other situations where the chance of this happening is so small that we're not going to record anything about it. Okay, so let's talk about the criteria because this is very definite criteria. And these problems end up being really easy because they have to use very specific vocabulary in the problems when they give it to you, whether you're going to record a liability or a disclosure or do nothing at all. So we have two criteria here. The first one is the likelihood of payment. So the likelihood that you're gonna have to pay out some money, the most common is with a lawsuit and you're gonna end up losing the lawsuit and having to pay some money out. So what's the likelihood of the payment? But we've got three different categories. We've got probable. It's probable that we're going to pay out money and that's when it's likely to occur. Right? It's probable it's likely to occur, then there's reasonably possible. And that's somewhere in the middle between probable and remote. Were remote. Is that the chance is slight? It's a remote chance. Right? So we have these very definitive words and you're gonna see when you have problems about contingent liabilities, they're going to use this very specific vocabulary. Probable, reasonably possible. And remote. Okay. So that's the likelihood of payment But then there's also the ability to estimate the amount of the payment. Okay, so we might know that we're going to pay out some money but we might not be sure how much that money is yet. Right. Maybe the lawsuit, there's a chance we'll end up paying out $1 million, but it could actually only be like $200,000 or some different amount of money. Well, that's why we have this estimating quality as well. So we're either gonna know the amount that we're gonna have to pay out or reasonably estimate that amount or we're not gonna be able to estimate it at all. Right. So those are the two categories if we know or could reasonably estimate or if we can't estimate at all. Okay. So let's see what happens with these two criteria in the different categories. So the most the time that we accrue liability, there's only one time we accrue a liability and that's when the payment is probable. So there's a high chance that we're gonna pay out, like lose this lawsuit and we're gonna have to pay out some money. So if it's probable and we can reasonably estimate or we know the amount we're gonna accrue a liability. Okay? So if we know it's probable that we're gonna have to pay out $1 million well, we're gonna have a liability, we're gonna take legal expense for a million and we're gonna have a liability on our balance sheet for that million dollars that we're accruing. Now, not only do we accrual liability, but we disclose it in the footnotes, we give a little more information, we're gonna have this liability, this contingent liability and then we're gonna say in the footnotes a little more information about it. Now this is pretty easy. This this is why these problems are so easy because this is the only situation where we accrued liability is when it's probable and at least reasonably possible to estimate the amount. If we can't reasonably estimate but we know we're gonna have some payout. Well we're gonna disclose it in the footnotes okay? We still disclose it in the footnotes when it's probable but we can't reasonably estimate the amount. Okay? Now when it's reasonably possible. So this is somewhere in the middle between probable and remote that we're gonna lose the lawsuit or something. We're not entirely sure yet. Well reasonably possible. And if we know or don't know in both cases, if we can estimate or not estimate it's just the disclosure. So we disclosed in the footnotes. And that's in both cases. So it doesn't matter if we can estimate it or not. We're gonna give the the users of the financial statements the information that we do know. Okay. And then if the if the payment is remote so maybe it's a lawsuit that just started and there's gonna be a long legal battle and we don't really know what's gonna happen. Well we don't have to say anything. We don't do anything in that case. Okay. So the big thing here is to be able to basically memorize these terms. And just the main thing to remember is if it's probable and reasonably possible that we're gonna be able that this is gonna happen. Well, that's when we accrue liability. Okay? So this is the only case where we accrue liability is in this box up here. Otherwise it's disclosures and when you think, hey, it's remote, it's a remote chance that's gonna happen. Well, it's why would we accrue something that we don't actually expect to happen? Okay. That's why we do nothing in that case. All right. So let's do a quick practice problem about contingent liabilities and you'll see how discreet they are with this vocabulary that they use it explicitly. Alright, Let's go ahead and pause here and then we'll do a practice problem.

Sumsang designs and sells smartphones for personal and commercial use. During the current year, the product engineers notified management of a flaw in the design that could cause the latest model to spontaneously combust. After a further investigation, it was noted that a product recall was probable, with an estimated cost to the company of $2,500,000. What influence might this information have on the current year financial statements?