Financial contingencies are an issue you must understand and properly account for in your small business financial reports. There are various legal requirements for financial reporting of contingencies, based on the probability of the contingency becoming a reality, and on whether you can estimate the dollar with reasonable accuracy.
What is a Contingency in Accounting?
So what exactly are contingencies? Financial contingencies exist for your 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 you eventually realize the gain or loss is contingent — meaning that it’s dependent on outcomes or events that haven’t yet occurred or may not occur at all.
Say another company is suing you, claiming you broke patent laws by selling a product that is similar to theirs. Until you receive a verdict, your company has potential liability, contingent on the outcome of the lawsuit. How your company records the financial contingency in the accounting and financial statements depends on the probability of winning or losing the lawsuit and the amount of damages the company that brought the suit is requesting.
Financial contingencies may be either contingent gains or contingent losses. In the above example of the lawsuit, your company has a contingent loss. An example of a contingent gain might be a tax review you reasonably expect to result in a judgment in your company’s favour in the form of a tax refund or tax credit.
Properly Reporting Financial Contingencies
So how do you report these contingencies? The two contingency factors that determine how your company must report a financial contingency are the probability of the future event actually coming to pass, and how accurately you can determine an estimate of the amount of the contingency.
If the best possible estimate of the contingency amount lies within a range of estimates, with no single estimate clearly better, then you should record the lowest estimate. For example, if your company is facing a lawsuit it seems likely to lose, and the judgment may range from $100,000 to $300,000, then the contingent liability to record as a reduction of net income is $100,000.
The determination of the probability of a contingency is a subjective one, but it’s a good idea to make the best estimate you can. If you consider the contingency as a highly unlikely outcome, then you don’t have to report it. When a contingency is possible, but less than probable, or you can’t estimate the amount of the contingency with any reasonable accuracy, then the contingency doesn’t require an accounting journal entry — only a disclosure note accompanying financial statements.
Keeping a close eye on your finances is an important part of running your business, and budgeting for contingencies is just one part of that. Accounting software can help you keep track of all your income and expenses. 4.3 million customers use QuickBooks. Join them today to help your business thrive for free.