Question

Respond to the following in a minimum of 175 words:

There are 3 contingent liability categories specified in generally acceptable accounting principles (GAAP): probable, possible, and remote. In general, probable contingencies are more likely to occur and can be reasonably appraised. Possible contingencies are less likely to occur, but could still occur. Remote contingencies are not likely to occur.

• Discuss the 2 primary differences between assets on the balance sheet.
• Discuss reporting requirements for contingencies.
• Explain 2 contingent liability examples.

Answer 1

Answer :

Question 1. Discuss the 2 primary differences between assets on the balance sheet.

Answer : Current Assets and Noncurrent Assets :

A company’s resources can be divided into two categories: current assets and noncurrent assets. The primary determinant between current and noncurrent assets is the anticipated timeline of their use. Current and noncurrent assets are listed on the balance sheet. They appear as separate categories before being summed and reconciled against liabilities and equities.

• Current assets are assets that are expected to be converted to cash within a year.
• Noncurrent assets are those that are considered long-term, where their full value won't be recognized until at least a year.
• Current assets include items such as accounts receivable and inventory, while noncurrent assets are land and goodwill.
• Noncurrent liabilities are financial obligations that are not due within a year, such as long-term debt.
• The key difference between current and noncurrent assets and liabilities, which are all listed on the balance sheet, is their timeline for use or payment.

Current Assets

Current assets represent the value of all assets that can reasonably expect to be converted into cash within one year. Current assets are separated from other resources because a company relies on its current assets to fund ongoing operations and pay current expenses.

Examples of current assets include:

• Cash and cash equivalents
• Accounts receivable
• Prepaid expenses
• Inventory
• Marketable securities

Noncurrent Assets

Noncurrent assets are a company’s long-term investments where the full value will not be realized within the accounting year. Non-current assets can be considered anything not classified as current.

Examples of non-current assets include:

• Land
• Property, plant, and equipment (PP&E)
• Trademarks
• Long-term investments
• Goodwill

Since noncurrent assets have a useful life for a very long time, companies spread their costs over several years. This process helps avoid huge losses during the years when capital expansions occur. Both fixed assets, such as PP&E, and intangible assets, like trademarks, fall under noncurrent assets.

Question 2. Discuss reporting requirements for contingencies

Answer :

Contingency: A possibility; something which may or may not happen. This also can mean a chance occurrence, especially in, unexpected expenses

Reporting requirements on Gain Contingency : Gain contingencies, or the possible occurrences of a gain on a claim or obligation that involves the entity, are reported when realized (earned). If a specific event that can cause the gain occurs, and the gain is realized, then the gain is disclosed. If the gain is probable and quantifiable, the gain is not accrued for financial reporting purposes, but it can be disclosed in the notes to financial statements. If the gain is not probable or its amount cannot be reasonably estimated, but its effect could materially affect financial statements, a note disclosing the nature of the gain is also disclosed in the notes. Care should be taken that misleading language is not used regarding the potential for the gain to be realized. The disclosure of gain contingencies is affected by the materiality concept and the conservatism constraint.

Materiality

Materiality is a concept or convention within auditing and accounting that relates to the importance/significance of an amount, transaction, or discrepancy. For example, an auditor expresses an opinion on whether financial statements are prepared, in all material aspects, in conformity with generally accepted accounting principles (GAAP). Professional judgment is required to determine what is material and what isn’t. Generally, if the omission or misstatement of information can influence the economic decision of financial statement users, the missing or incorrect information is considered material. Thus, if a gain contingency, that remains unrealized, affects the economic decision of statement users, it should be disclosed in the notes.

Conservatism

Most accounting principles follow the conservative constraint, which encourages the immediate disclosure of losses and expenses on the income statement. This constraint also encourages the omission of revenues and gains until those gains are realized. Thus, for a gain contingency, only a realized gain is accrued for and disclosed on the income statement. A material gain contingency that is both probable and reasonably estimated can be disclosed in the notes to financial statements.

Definition of Loss Contingencies

A loss contingency is incurred by the entity based on the outcome of a future event, such as litigation. Due to conservative accounting principles, loss contingencies are reported on the balance sheet and footnotes on the financial statements, if they are probable and their quantity can be reasonably estimated. A footnote can also be included to describe the nature and intent of the loss. The likelihood of the loss is described as probable, reasonably possible, or remote. The ability to estimate a loss is described as known, reasonably estimable, or not reasonably estimable.

Contingent Liabilities for Losses

Loss contingencies can refer to contingent liabilities that may arise from discounted notes receivable, income tax disputes, or penalties that may be assessed because of some past action or failure of another party to pay a debt that a company has guaranteed. Unlike gain contingencies, losses are reported immediately as long as they are probable and reasonably estimated. They do not have to be realized in order to report them on the balance sheet. At least a minimum amount of the loss expected to be incurred is accrued. For losses that are material, but may not occur and their amounts cannot be estimated, a note to the financial statements disclosing the loss contingency is reported.

Example of a Disclosed Loss Contingency

A jury awarded $5.2 million to a former employee of the Company for an alleged breach of contract and wrongful termination of employment. The Company has appealed the judgment on the basis of errors in the judge’s instructions to the jury and insufficiency of evidence to support the amount of the jury’s award. The Company is vigorously pursuing the appeal. The Company and its subsidiaries are also involved in other litigation arising in the ordinary course of business. Since it presently is not possible to determine the outcome of these matters, no provision has been made in the financial statements for their ultimate resolution. The resolution of the appeal of the jury award could have a significant effect on the Company’s earnings in the year that a determination is made. However, in management ‘s opinion, the final resolution of all legal matters will not have a material adverse effect on the Company’s financial position.

Question 3. Explain 2 contingent liability examples.

Answer : A contingent liability is a potential liability...it depends on a future event occurring or not occurring. For example, if a parent guarantees a daughter's first car loan, the parent has a contingent liability. If the daughter makes her car payments and pays off the loan, the parent will have no liability. If the daughter fails to make the payments, the parent will have a liability.

If a company is sued by a former employee for $500,000 for age discrimination, the company has a contingent liability. If the company is found guilty, it will have a liability. However, if the company is not found guilty, the company will not have an actual liability.

In accounting, a contingent liability and the related contingent loss are recorded with a journal entry only if the contingency is both probable and the amount can be estimated.

If a contingent liability is only possible (not probable), or if the amount cannot be estimated, a journal entry is not required. However, a disclosure is required. When a contingent liability is remote (such as a nuisance suit), then neither a journal nor a disclosure is required.

2nd Example of a Contingent Liability:

Assume that a company is facing a lawsuit from a rival firm for patent infringement. The company's legal department thinks that the rival firm has a strong case, and the business estimates a $2 million loss if the firm loses the case. Because the liability is both probable and easy to estimate, the firm posts an accounting entry on the balance sheet to debit (increase) legal expenses for $2 million and to credit (increase) accrued expense for $2 million.

The accrual account permits the firm to immediately post an expense without the need for an immediate cash payment. If the lawsuit results in a loss, a debit is applied to the accrued account (deduction) and cash is credited (reduced) by $2 million.