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Definition of Contingencies
The US Financing Accounting Standards Board (FASB) Statement of Financial Accounting Standard No. 5 (SFAS No. 5 of 1975) and the more recent General Accepted Accounting Principles (GAAP) ASC 450 defines contingency as an existing condition, situation, or set of circumstances that involves uncertainty as to possible gains or loss. The uncertainty resolves when one or more future events occur or fail to occur.
ASC 450 categorizes uncertainties into three:
- Probable, where the future event remains most likely to occur
- Reasonably possible, where the future event occurring is realistic, but neither likely nor remote
- Remote, where the chance of the future event occurring is slight.
Cost accounting standards - contingencies as per ASC 450 stipulates disclosure or accrual of only such contingencies where the uncertainty of the future event falls into the “probable" category, when the asset is impaired or the liability incurred on the date of financial statement, and when the amount is possible to estimate the liability. If a loss is probable but estimating the amount is not possible, accounting standards stipulate mentioning the contingency in a note. Accounting standards do not stipulate making contingencies if probability of loss is remote.
For instance, accounting standards do not allow catering to contingencies for general business risks such as losses owing to natural calamities as the event has not taken place, but allow for contingencies for lawsuits owing to product failure, as the product is already in existence.
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Some examples of contingencies include:
- Allowances for noncollectable accounts
- Provision to honor repurchase agreements
- Estimated liabilities for warranties
- Estimated losses on lawsuits
- Estimated losses related to pollution caused by company operations
- Obligations under standby letters of guarantees
- Provision for expropriation of assets
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How Much to Provide
One important consideration in cost accounting standards and contingencies is determining how much to set aside for contingencies.
Standards stipulate making provisions for the best estimate for the contingency, and if the best estimate is in a range, the minimum amount in the range is used. Cost accounting standards also specify making provisions for additional or reduced contingencies for the same head, if in the future the amount of uncertainty for the same contingency changes, or if revised estimates become available.
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When to Disclose
Cost accounting rules stipulate making the accrual for contingency in the earliest period in which the estimate for amount of the possible loss takes place.
Events such as bankruptcy or expropriation that takes place after preparation of the balance sheet but before issuance of the financial statements, require disclosure as “Note disclosures" or “pro forma financial statements" containing supplemental information.
Adherence to cost accounting standards - contingencies make financial statements fair and accurate, and help investors form realistic expectations. Provision of contingencies mitigate the shock of fall in share prices when the contingent liability results in an actual loss.
In cost accounting standards, contingencies, however, serve only as guidelines and stipulate the reporting format, and the issue of catering to contingencies depends on the company’s interpretation of what constitutes uncertainty and potential liability.
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Accounting Financial & Tax. “Accounting Standard for Contingencies [An Overview]." http://accounting-financial-tax.com/2009/11/accounting-standard-for-contingencies-an-overview/. Retrieved 12 March 2011.
Image Credit: flickr.com/Crispin Semmens