Financial Accounting: In an Economic Context

CONTINGENCIES AND CONTINGENT LIABILITIES

As defined by the FASB, “a contingency is an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occurs or fails to occur.”⁶ A common example is an existing lawsuit that will be settled in the future by the decision of a court. If the possible future outcome represents an increase of assets or a decrease of liabilities, the existing condition is considered a gain contingency. If the possible outcome represents a decrease in assets or an increase in liabilities, the condition is considered a loss contingency.

5. A popular method of compensating executives involves the use of stock options, which is covered in Chapter 12.

6. Financial Accounting Standards Board (FASB), “Accounting for Contingencies,” Statement of Financial Accounting Standards No. 5 (Stamford, Conn.: FASB, 1987), par. 1.

Before discussing the methods used to account for contingencies, study the following scenario carefully. It is designed to illustrate some of the economic issues involved in reporting contingencies.

Contingent Liabilities: A Scenario

Suppose that Harry Jones, the accountant for Chemical Enterprises, is preparing the financial statements as of December 31, 2011. Chemical Enterprises is in need of cash and plans to submit the financial statements to First National Bank with an application for a sizable loan. First National has ...