In this video, we walk through 5 FAR practice questions covering how to calculate amounts of contingencies. These questions are from FAR content area 3 on the AICPA CPA exam blueprints: Select Transactions.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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How to Calculate Amounts of Contingencies
Contingencies arise when a company faces uncertain outcomes that depend on future events. These contingencies can be related to lawsuits, warranties, promotions, or other obligations. Properly calculating and recording contingencies ensures compliance with accounting standards and presents an accurate picture of a company’s financial position. This guide breaks down how to calculate contingencies, including examples for clarity.
Understanding Contingent Liabilities
A contingent liability is recorded when two conditions are met:
- The loss is probable (likely to occur).
- The amount of the loss can be reasonably estimated.
If the loss is reasonably possible (less likely than probable but still possible), it is disclosed in the notes to the financial statements but not accrued. If the loss is remote (highly unlikely), no action is typically required, except for rare exceptions like guarantees.
Handling Ranges of Estimates for Probable Liabilities
When a liability is probable and a range of amounts is provided:
- No best estimate in the range: Accrue the lowest amount in the range.
- A best estimate in the range: Accrue the best estimate provided.
Example 1:
A company is sued, and its attorneys believe it is probable that the company will lose. They estimate damages will fall between $500,000 and $800,000, with no amount more likely than another.
- Action: The company accrues $500,000, the lowest amount in the range.
Example 2:
Another lawsuit is probable, with estimated damages of $300,000 to $700,000. The attorneys believe $400,000 is the most likely outcome.
- Action: The company accrues $400,000, the best estimate.
Contingent Gains
Contingent gains are treated differently. These are only recognized in financial statements when they are realized or become virtually certain. If the gain is probable but not yet realized, it is disclosed in the notes.
Example:
A company expects to win a lawsuit with an estimated gain of $1,000,000, and the attorneys consider the outcome probable.
- Action: The company discloses the potential gain in the notes but does not recognize it in the financial statements.
Warranty Obligations
Warranties are a common source of contingent liabilities. These are typically based on historical data about the percentage of products expected to need repair or replacement and the average cost of those repairs.
Example:
A company sells 100,000 units of a product with an estimated warranty cost of 5% of sales. Each warranty repair costs an average of $20. During the year, the company incurs $80,000 in actual warranty costs.
- Estimated warranty liability:
100,000 units × 5% × $20 = $100,000 - Remaining liability:
$100,000 (estimated) – $80,000 (actual costs incurred) = $20,000
The company accrues a $20,000 warranty liability at year-end.
Promotional Contingencies
Promotions, such as coupons or rebates, create contingent liabilities based on the expected redemption rate and cost to fulfill.
Example:
A toothpaste company issues 2 million coupons for a free toothbrush worth $2.50 (5 coupons required for redemption). Historical data shows 70% of coupons are redeemed. By year-end, 800,000 coupons have already been redeemed.
- Total expected redemptions:
2,000,000 × 70% = 1,400,000 coupons - Remaining coupons to be redeemed:
1,400,000 – 800,000 = 600,000 coupons - Convert coupons to toothbrushes:
600,000 ÷ 5 = 120,000 toothbrushes - Liability:
120,000 toothbrushes × $2.50 = $300,000
The company accrues a $300,000 liability at year-end.
Key Takeaways for Calculating Contingencies
- Probable liabilities: Accrue the best estimate or, if none, the lowest amount in a range.
- Reasonably possible liabilities: Disclose the range in the notes but do not accrue.
- Contingent gains: Recognize only when realized or virtually certain; otherwise, disclose.
- Warranties and promotions: Use historical data to estimate costs and adjust for actual outcomes.
By applying these principles, organizations can ensure accurate accounting for uncertainties and present clear, transparent financial statements.
