Question

The commingling of legal and contingent liabilities exists under current GAAP accounting. Discuss potential problems this creates and propose alternatives to address them.

Textbook: Accounting Theory: Conceptual Issues in a Political and Economic Envirnoment (9th edition) by Wolk, Dodd & Rozycki

Answer 1

A contingent liability is a potential cost a company may or may not incur in the future. A contingent liability could be a guarantee on a debt to another entity, a lawsuit, a government probe, or even a product warranty. Any of these circumstances could cost a company money, but the amount of that cost is unknown. It could be zero, or it could be billions.

There are somes problems relating to contingent liabilities Accounting & recording by companies

Because of subjective accounting rules, investors should make their own determination of a company's contingent liabilities.

A contingent liability that is both probable and the amount can be estimated is recorded as 1) an expense or loss on the income statement, and 2) a liability on the balance sheet. As a result, a contingent liability is also referred to as a loss contingency.

If a contingent liability is deemed probable, it must be directly reported in the financial statements. Nevertheless, generally accepted accounting principles, or GAAP, only require contingencies be recorded as unspecified expenses. Any details are contained within disclosures in the footnotes.

Contingent liabilities have gained prominence in the analysis of public finance. Indeed, history is full of episodes in which the financial position of the public sector is substantially altered-or its true nature uncovered-as a result of government bailouts of financial or nonfinancial entities, in both the private and the public sector. The paper discusses theoretical and practical issues raised by contingent liabilities, including the rationale for taking them on, how to safeguard against the fiscal risks associated with them, how to account and budget for them, and how to disclose them. Country experiences are used to illustrate ways these issues are addressed in practice and challenges faced. The paper also points to good practices related to the mitigation, management and disclosure of risks from contingent liabilities.

As Per GAAP, contingent liabilities can be broken down into three categories based on the likelihood of those liabilities actually occurring. They are:

·         High probability. Record a contingent liability when it is probable that the loss will occur, and you can reasonably estimate the amount of the loss. If you can only estimate a range of possible amounts, then record that amount in the range that appears to be a better estimate than any other amount; if no amount is better, then record the lowest amount in the range. “Probable” means that the future event is likely to occur. You should also describe the liability in the footnotes that accompany the financial statements.

·         Medium probability. Disclose the existence of the contingent liability in the notes accompanying the financial statements if the liability is reasonably possible but not probable, or if the liability is probable, but you cannot estimate the amount. “Reasonably possible” means that the chance of the event occurring is more than remote but less than likely.

·         Low probability. Do not record or disclose the contingent liability if the probability of its occurrence is remote.

The accounting rules for the treatment of a contingent liability are quite liberal - there is no need to record a liability unless the risk of loss is quite high. Thus, you should review the disclosures accompanying a company's financial statements to see if there are additional risks that have not yet been recognized. These disclosures should be considered advance warning of amounts that may later appear as formal liabilities in the financial statements.

When we record a liability in the accounting records, this does not mean that we are also setting aside funds to pay for the liability when it must eventually be paid – recording a contingent liability has no impact on cash flow.