A signed contract, an unresolved lawsuit and a possible insurance payment create different accounting questions at the reporting date. A contingency is an existing situation whose potential gain or loss depends on the resolution of uncertainty.
An executory contract remains unperformed by both parties, such as an order for goods awaiting delivery and payment. Contingencies require attention to existing conditions; general exposure to future fires or future operating losses does not establish an accrued liability.
Under United States generally accepted accounting principles (U.S. GAAP), an ordinary loss contingency requires recognition when a loss existing at the reporting date is probable and reasonably estimable. Both conditions apply to the evidence supporting the specific loss.
- Probable: The future event confirming the loss is likely to occur; the standard establishes no numerical percentage cutoff.
- Reasonably possible: The chance exceeds a slight possibility but does not reach the probable category.
- Remote: The chance that the event will occur is slight.
The following matrix assumes material exposures:
Common mistakes
- Inventing a midpoint. Lydren's no-best-estimate range requires $240,000, while $420,000 needs separate evidentiary support.
- Recording the full target. Varden needs $160,000 additional expense; another $240,000 entry would create an unsupported $320,000 balance.
- Expensing claims twice. Norvale's $55,000 settlements reduce the warranty liability; current warranty expense remains $92,000.
Bottom line
- An ordinary loss contingency is accrued when an existing loss is probable and reasonably estimable.
- Use the supported best estimate within a range, or the minimum when no amount is better supported; calculate additional exposure beyond the accrual separately.
- Probable unestimable and reasonably possible losses generally require disclosure; ordinary remote exposures generally require neither recognition nor disclosure.
- Adjust the existing liability to its required balance, and charge settlements against that liability rather than recording the same expense again.
Exam shortcut
Mark three different amounts before calculating: total possible loss, required ending liability and liability already recorded. Subtract the recorded balance only when finding the adjusting entry. Circle phrases such as "no better estimate," "best estimate," "after deductibles" and "at delivery." Each phrase selects a measurement input that a tempting answer may ignore. Build warranty movements in four columns: opening balance, new accruals, estimate revisions and settlements.
The full lesson (about 6,860 words, 46 min read) adds 4 worked examples, all 7 common mistakes, a self-check, free in the app.
Learning objectives
- III.B1
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