Accounting for Contingent Assets and Contingent Liabilities
Contingency is an uncertain event that may or may not occur in the future. It is hard to predict the possibility of an event occurrence. It may depend on another even to determine the likelihood. However, there are some indications that show the possibility of occurrence. The events are not under the control of the company, so the company cannot decide on the occurrence of the event.
Contingent assets are the possible future assets which the company may or may not be able to take advantage of, it depends on any specific event that is not under company control. Assets are the resource that the company expects to generate benefits from.
As the assets are not yet certain and company does not own them yet. The accounting standard does not allow the company to record the contingent assets as it purely depends on the management decision. There is not enough proof to support the recording. The company may play around by making fake estimations to record assets. Their intention is to overstate assets to window-dressing financial statements. So we cannot record the assets into the financial statement.
However, we should disclose such kind of information in the financial statement note. It tells the reader that there is a possible future economic benefit that may be flowing into the company in the future. The disclosure needs to describe the actual nature of contingent assets and it will let the reader make their own judgment.
Contingent assets will be recorded into the balance sheet when there is a certain of the future cash flow into the company. By the time of certainty, the accountant can record the transaction. It mostly happens when the assets’ future economic benefits are not measured reliably. So we cannot record it into the financial statement. But when we can measure it reliably, it is time to record it into the balance sheet.
When the company’s future cash flow can measure reliably, it means the item meets the definition of assets. It is the assets, so it needs to record on the balance sheet as normal assets.
Company ABC has sued another company who misuse their own copyright material. Based on the lawyer, we may win the lawsuit and get a huge compensation. It is possible that the asset (cash) will flow into the company, but it is not certain that the company will win the lawsuit. The company cannot record anything base on the uncertainty, we have to wait until the lawsuit is settled. We can only disclose this scenario in the financial note to inform the reader about the contingent assets.
Contingent Liabilities are the possible future liabilities that may or may not happen due to the independent event not under company control. Similar to contingent assets, contingent liabilities are not certain yet. The company will have future obligations when the contingent liabilities really incur.
Opposite from contingent assets, contingent liabilities are recorded into balance sheet if they are highly likely and the amount can be estimated. It prevents the company from ignoring the possibility of contingent liabilities. It follows the conservative nature of the financial statement, the liabilities will be recorded even if it is not certain yet. Management must access the likelihood and estimated amount.
If both conditions do not exist, the contingent liabilities must record in the financial note. If the management cannot measure the amount reliably and likelihood, it is not required to record the liability.
Company is getting a laws suite from the client regarding products’ safety. Due to the accident, the company is highly likely to pay some compensation to the client. Base on the lawsuit, the company will need to pay $ 1 million if they lose the lawsuit.
As the loss is highly likely to happen and the amount can be estimated. So the company needs to record the contingent liability and expense.
The transaction will increase the expense on the income statement. The expense will reduce the company’s profit and contingent liability will be present on the balance sheet.
Apple Inc provides a warranty over the new MacBook for 12 months. We know that the customers are going to bring back the MacBook and claim a warranty due to various issues. Based on the historical data, 5% of the product will be broken within 12 months and claim the warranty.
So the company needs to estimate the warranty expense and record it into the financial statement. The journal entry is debiting warranty expense and credit contingent liability.
The journal will increase the warranty expense on the income statement and contingent liability.