Question

Discuss the connection between current liabilities and contingencies.

Answer 1

Current liabilities are obligations whose liquidation is expected to require the use of existing current assets or the creation of other current liabilities within one year or an operating cycle, whichever is longer. An operating cycle is the time normally required for a company to convert cash into inventory, sell the inventory, and collect the resulting receivables.

Conceptually, a company should record all liabilities at the present value of the future outlays they will require, and should disclose the liabilities in a way that provides useful information about their liquidity. However, most current liabilities are measured, recorded, and reported at their maturity or face value. Usually the difference between maturity value and present value is not material.

According to GAAP, a contingency is an existing condition, situation, or set of circumstances involving uncertainty that will ultimately be resolved when one or more events occur or fail to occur. This definition has three primary characteristics: (a) an existing condition, (b) uncertainty as to the ultimate effect of this condition, and (c) the resolution of the uncertainty based on one or more future events. The FASB used three terms describing the likelihood that a loss contingency will be confirmed: (a) probable - the future event (or events) is likely to occur, (b) reasonably possible - the chance of the future event occurring is more than remote but less than likely, (c) remote - the chance of the future event occurring is slight.

A company accrues an estimated loss from a loss contingency in its accounts and reports the loss in its financial statements as a reduction of income and as a liability (or reduction of an asset) if (a) it is probable that a loss has occurred, and that a future event or events will confirm the loss, and (b) the amount of the loss can be reasonably estimated. It is not necessary to know the exact payee or the exact date of payment. If the two conditions have not been met, but it is reasonably possible that a loss may have been incurred, the company must disclose that loss contingency in a note to its financial statements. Disclosure must indicate the nature of the contingency and give an estimate of the possible loss or range of loss, or state that such an estimate cannot be made. Certain contingencies where the possibility of loss is only remote are also disclosed in the notes to the financial statements.