ESTIMATED LIABILITIES, lOSS CONTINGENCIES, AND COMMITMENTS
Estimated liabilities The term “estimated liabilities” refers to liabilities that appear in financial statements at estimated dollar amounts, Let us again consider the example of the automaker’s liability to honor its new car warranties. A manufacturer’s liability for warranty work is recorded by an entry debiting Warranty Expense and crediting Liability for Warranty Claims. The matching principle requires that the expense of performing warranty work be recognized in the period in which the products are sold in order to offset this expense against the related sales revenue. The warranty may extend several years into the future, the dollar amount of this liability (and expense) must be estimated. Rather than estimate when warranty work will be performed, accountants traditionally have classified the liability for warranty claims as a current liability.By definition, estimated liabilities involve some degree of uncertainty.
However, (1) the liabilities are known to exist, and (2) the uncertainty as to dollar amount is not so great as to prevent the company from ‘making a reasonable estimate and recording the liability Define loss contingencies and explain their presentation in financial statements. If this oil tanker spilled its , cargo on the way to theAlaskan Pipeline. the oil company would likely incur significant legal and clean-up costs. However, the actual amount the company would have to pay would be difficult. if not impossible. to estimate at the time of the spill
Loss contingencies are similar to estimated liabilities but may involve much more uncertainty. A loss contingency is a possible loss (or expense),’ stemming from past events. that is expected to be resolved in the future. ‘ Central to the definition of a loss contingency is the element of uncertainty-uncertainty as to the amount of loss and, in some cases, uncertainty as to whether or not any loss actually has been incurred. A common example of a loss contingency is a lawsuit pending against a company. The lawsuit is based on:past events, but until the suit is resolved, uncertainty exists as to the amount (if any) of the company’s liability. Loss contingencies differ from estimated liabilities in two ways.
First, a loss contingency’s may involve a greater degree of uncertainty. Often the uncertainty extends to whether or not any loss ‘or expense actually has been incurred. Iri contrast, the toss or expense relating to an estimated liability is known to exist. . Second, the concept of a loss contingency extends not only to possible liabilities, but also to possible impairments of assets. Assume, for example, that a bank has made large loans to a foreign country now experiencing political instability. Uncertainty exists as to the amount of loss, if any, associated with this loan. From the bank’s point of view, this, loan is an asset that may be impaired, not a liability. Loss Contingencies In Financial Statements The manner in which loss contingencies are presented in financial statements depends on the degree of uncertainty involved.
Loss contingencies are recorded in the accounting records only when both of the following criteria are met:
(1) It is probable that a loss has been incurred, and
(2) the amount of loss can be reasonably estimated.
An example of a loss contingency that usually meets, these criteria and is recorded in the accounts is the obligation a company has for product warranties and defects. When these criteria are 1I0t met, loss contingencies still are disclosed in financial statements if there is a reasonable possibility that a material loss has been incurred. -Pending lawsuits, for example, usually are disclosed in notes accompanying the financial statements, but the loss, if any, is not recorded in the accounting records until the lawsuit is settled. Companies need not disclose loss contingencies if the risk of a material loss having occurred is considered remote. Notice the judgmental nature of the criteria used in accounting for loss contingencies.
These criteria involve assessments as to whether the risk of material loss is “probable,” “reasonably possible,” or “remote.” Thus the professional judgments of the. company’s management, accountants, legal counsel, and auditors are the deciding. factor in accounting for loss contingencies. When loss contingencies are disclosed in notes to the financial statements, the note should describe the nature of the contingency and, if possible, provide an estimate of the amount of possible loss. If a reasonable estimate of the amount of possible loss cannot be made, the disclosure should include the range of possible loss or a statement that an estimate cannot be made. The following note is typical of the disclosure of the loss contingency arising from pending litigation:
Note 8: Contingencies
In October of 2001, the Company was named as defendant in a $408, million patent infringement lawsuit. The Company denies all charges and is preparing its defense against them. It is not possible at this time to determine the ultimate legal or financial responsibility that may arise as a result of this litigation. Sometimes a portion of a. loss contingency qualifies for immediate recognition, whereas the remainder only meets the criteria for disclosure. Assume, for example, that a company is required by the Superfund Act to clean up an environmental hazard over a two-year period. The company cannot predict the total cost of the project but considers it probable that it will lose at least $1 million. The company’ should recognize a $1 million expected loss and record it as a liability. In addition, it should disclose in the notes to the financial statements that the actual cost ultimately may exceed the recorded amount.