Financial contingencies are an issue that you must know how to properly deal with in the accounting and financial reporting of your small business. There are various legal requirements for financial reporting of contingencies, based on the probability of the contingency becoming a reality, and on whether the dollar amount of the contingency can be estimated with reasonable accuracy.
Financial contingencies exist for a business when, at the time of a financial statement, there is an existing yet unsettled circumstance that may cause the company to experience a financial gain or loss at some point in the future. Whether the company eventually realizes the gain or loss is contingent — meaning that it is dependent on outcomes or events that have not yet occurred or may not occur.
An example of a typical financial contingency for a business is that of a company that is being sued for copyright or patent infringement by another company. As long as the lawsuit has not been settled, the company being sued only has a potential liability, contingent on the outcome of the lawsuit. How the company records the financial contingency in their accounting and financial statements depends on the assessed probability of winning or losing the lawsuit, and the amount of damages being sought by the company bringing suit.
Financial contingencies may be either contingent gains or contingent losses. In the example of the lawsuit given above, the company being sued is considered to have a contingent loss. An example of a contingent gain might be a tax review that is considered likely to result in a judgment in the company’s favour, that will benefit the company in the form of a tax refund or tax credit.
Properly Reporting Financial Contingencies
The two factors that determine how a company must report a financial contingency are the probability of the future event actually coming to pass, and how accurately the amount of the contingency can be determined or estimated.
In determining the proper accounting for a financial contingency, the general rule is that you only record an accounting journal entry for gains or losses that are probable, and for which the contingent amount can be estimated with reasonable accuracy. If the best possible estimate of the contingency amount lies within a range of estimates, with no single estimate clearly better, then the contingency amount recorded should be the lowest estimate. For example, if your company is facing a lawsuit it will likely lose, and the judgment assessed may range from $100,000 to $300,000, then the contingent liability should be recorded as a reduction of net income by $100,000 and an accrued liability of $100,000.
The determination of the probability of a contingency is a subjective one, but should be a reasonable assessment. If the contingency is considered remote (very unlikely) then there is no required report of it. If a contingency is considered possible, but less than probable, or if the amount of the contingency cannot be estimated with any reasonable accuracy, then the contingency doesn’t require an accounting journal entry — only a disclosure note accompanying financial statements.