Current Liabilities, CHAPTER 13

Provisions, and Contingencies

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Describe the nature, valuation, 3. Explain the accounting for
and reporting of current loss and gain contingencies.
liabilities. 4. Indicate how to present and
2. Explain the accounting for analyze liability-related
different types of provisions. information.

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 LEARNING OBJECTIVE 2
Provisions Explain the accounting for
different types of provisions.

A provision is a liability of uncertain timing or amount.

Reported either as current or non-current liability.

Common types are

► Obligations related to litigation.
► Warrantees or product guarantees.
► Business restructurings.
► Environmental damage.

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 Recognition of a Provision

Companies accrue an expense and related liability for a

provision only if the following three conditions are all met:
1. Company has a present obligation (legal or constructive)
as a result of a past event;

2. Probable (the probability of occurrence > 50%) that an

outflow of resources will be required to settle the obligation;
and

3. A reliable estimate can be made.

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 Recognition Examples

Constructive obligation is an obligation that derives from a

company’s actions where:
1. By an established pattern of past practice, published
policies, or a sufficiently specific current statement, the
company has indicated to other parties that it will accept
certain responsibilities; and

2. As a result, the company has created a valid expectation

on the part of those other parties that it will discharge
those responsibilities.

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 Recognition of a Provision

Recognition Examples

It is assumed that a reliable estimate of the amount of the obligation can be determined.

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 Recognition Examples

It is assumed that a reliable estimate of the amount of the obligation can be determined.

What is the difference between

Provision and Allowance
for Doubtful Accounts?
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 Measurement of Provisions

How does a company determine the amount to report

for a provision?

IFRS:
Amount recognized should be the best estimate of the
expenditure required to settle the present obligation.

Best estimate represents the amount that a company would pay

to settle the obligation at the statement of financial position date.

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 Measurement of Provisions

Measurement Examples
Management must use judgment, based on past or similar
transactions, discussions with experts, and any other pertinent
information.

Toyota warranties. Toyota sold 10 million vehicles in 2019. It

determines that 80 percent of its cars will not have any warranty cost,
12 percent will have substantial costs of $20,000/car, and 8 percent will
have a much smaller cost $5,000/car. In this case, by weighting all the
possible outcomes by their associated probabilities, Toyota arrives at
an expected value for its warranty liability.

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 Measurement of Provisions

Measurement Examples
Management must use judgment, based on past or similar
transactions, discussions with experts, and any other pertinent
information.

Carrefour refunds. Carrefour sells many items at

varying selling prices. Refunds to customers for products sold may be
viewed as a continuous range of refunds, with each point in the range
having the same probability of occurrence. In this case, the midpoint
in the range can be used as the basis for measuring the amount of
the refunds.

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 Measurement of Provisions

Measurement Examples

Novartis lawsuit. Large companies like Novartis are

involved in numerous litigation issues related to their products. Where
a single obligation such as a lawsuit is being measured, the most
likely outcome of the lawsuit may be the best estimate of the liability.

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 Measurement of Provisions

What else to consider?

After the oil spill in the Gulf of Mexico in 2010, assume BP
expected that the spill will cost the company about $20
billions in the next 10 years. How should BP measure the
provision to be reported in its 2010 financial statement?

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 Question (Poll #3)
Polska's chemical product division consisting of five plants is
uninsurable because of the special risk of injury to employees and
losses due to fire and explosion. The year 2019 is considered one
of the safest(luckiest) in the division's history because no loss due
to injury or casualty was suffered. Having suffered an average of
three casualties a year during the rest of the past decade (ranging
from €60,000 to €700,000), management is certain that next year
the company will probably not be so fortunate. What should be
reported in Polska’s 2019 financial statements? Explain why.

A. No provision is reported.

B. A provision of 60,000.

C. A provision of 380,000

D. A provision of 700,000.
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 Question (Poll #3)

It is expected future injuries instead of past event; there is no

present obligation.

Therefore, the company should not recognize or disclose any

provisions or expenses, even if the amount is reasonably
estimable.

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 Common Types of Provisions

Common Types:
1. Lawsuits 4. Environmental

2. Warranties 5. Onerous contracts

3. Consideration payable 6. Restructuring

IFRS requires extensive disclosure related to provisions in the notes to

the financial statements. Companies do not record or report in the notes
general risk contingencies inherent in business operations (e.g., the
possibility of war, strike, uninsurable catastrophes, or a business
recession).

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 Common Types of Provisions

Litigation Provisions
Companies must consider the following in determining whether
to record a liability with respect to pending or threatened
litigation and actual or possible claims and assessments.
1. The time period in which the underlying cause of action
occurred.

2. The probability of an unfavorable outcome.

3. Ability to make a reasonable estimate of the amount of

loss.

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 Litigation Provisions

With respect to unfiled suits and unasserted claims and

assessments, a company must determine

1. the degree of probability that a suit may be filed or a claim

or assessment may be asserted, and

2. the probability of an unfavorable outcome.

If both are probable, if the loss is reasonably estimable, and if the

cause for action is dated on or before the date of the financial
statements, then the company should accrue the liability.

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 Litigation Provisions

Example: Kingston Inc. is involved in a lawsuit at December 31,

2019. Prepare the December 31 entry for the two situations: (a)
assuming it is probable that Kingston will be liable for $460,000 as
a result of this suit; (b) assuming it is not probable that Kingston
will be liable for any payment as a result of this suit.

(a) Lawsuit Loss 460,000

Lawsuit Liability 460,000

(b) No entry is necessary. The loss is not accrued because it

is not probable that a liability has been incurred at
12/31/19.
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 Question (Poll 4)
During 2019, Maverick Inc. became involved in a tax dispute with the
government. Maverick's attorneys have indicated that they believe it is
probable that Maverick will lose this dispute. They also believe that
Maverick will have to pay the government between €800,000 and
€1,400,000. After the 2019 financial statements were issued, the case
was settled with the government for €1,200,000. What amount, if any,
should be reported as a liability for this tax dispute on Maverick’s
financial statement as of December 31, 2019?
A. 0.
B. 1,100,000.
C. 1,200,000.
D. 100,000.

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 Question (Poll 4)

IFRS requires that

• When some amount within the range appears at the time to be

a better estimate than any other amount within the range, that
amount is accrued.

• When no amount within the range is a better estimate than

any other amount, the expected value (midpoint of the range)
should be used.

In this case, therefore, Maverick Inc. would report a liability of

€1,100,000 at December 31, 2019.

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 Litigation Provisions

Companies can seldom predict the outcome of pending litigation,

however, with any assurance. And, even if evidence available at
the statement of financial position date does not favor the
company, it is hardly reasonable to expect the company to publish
in its financial statements a dollar estimate of the probable
negative outcome. Such specific disclosures might weaken
the company’s position in the dispute and encourage the
plaintiff to intensify its efforts. As a result, many companies
provide a general provision for the costs expected to be incurred
without relating the disclosure to any specific lawsuit or set
of lawsuits.

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 Litigation Provisions

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 Common Types of Provisions

Warranty Provisions
Warranty: Promise made by a seller to a buyer to make good
on a deficiency of quantity, quality, or performance in a
product.

If it is probable that customers will make warranty claims and

a company can reasonably estimate the costs involved, the
company must record an expense and corresponding liability.

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 Warranty Provisions (BMW 2016 Annual Report)

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 Warranty Provisions (BMW 2018 Annual Report)

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 Example (warranty expense)

Warranty expense as a % of revenue

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 Example (warranty expense)

Warranty expense as a % of revenue

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 Example (warranty expense)

How do we recognize warranty provision?

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 Warranty Provisions

Companies often provide one of two types of warranties to

customers:

1. Assurance-Type Warranty
A quality guarantee that the good or service is free from
defects at the point of sale.
 Obligations should be expensed in the period the
goods are provided or services performed (in other
words, at the point of sale).
 Company should record a warranty liability.

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 Assurance-Type Warranty

Example: Denson Machinery Company begins production of a

new machine in July 2019 and sells 100 of these machines for
$5,000 cash by year-end. Each machine is under warranty for one
year. Denson estimates, based on past experience with similar
machines, that the warranty cost will average $200 per unit.
Further, as a result of parts replacements and services performed
in compliance with machinery warranties, it incurs $4,000 in
warranty costs in 2019 and $16,000 in 2020.

Question: What are the journal entries for the sale and the
related warranty costs for 2019 and 2020?

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 Assurance-Type Warranty

Solution: For the sale of the machines and related warranty costs
in 2019 the entry is as follows.

1. To recognize sales of machines and accrual of warranty

liability:

July–December 2019

Cash 500,000
Sales Revenue 500,000

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 Assurance-Type Warranty

Solution: For the sale of the machines and related warranty costs
in 2019 the entry is as follows.

2. To record payment for warranties incurred:

July–December 2019

Warranty Expense 4,000

Cash, Inventory, Accrued Payroll 4,000

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 Assurance-Type Warranty

Solution: For the sale of the machines and related warranty costs
in 2019 the entry is as follows.

3. Record the adjusting entry to record estimated warranty

expense and warranty liability for expected warranty
claims in 2020:

December 31, 2019

Warranty Expense 16,000

Warranty Liability 16,000

At December 31, 2019, the statement of financial position reports a warranty

liability (current) of $16,000 ($20,000 − $4,000). The income statement for
2019 reports sales revenue of $500,000 and warranty expense of $20,000.
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 Assurance-Type Warranty

Solution: For the sale of the machines and related warranty costs
in 2019 the entry is as follows.

4. To record payment for warranty costs incurred in 2020

related to 2019 machinery sales:

January 1–December 31, 2020

Warranty Liability 16,000

Cash, Inventory, Accrued Payroll 16,000

At the end of 2020, no warranty liability is reported for the machinery

sold in 2019.

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 Warranty Provisions

Companies often provide one of two types of warranties to

customers:

2. Service-Type Warranty
An extended warranty on the product at an additional cost.
 Usually recorded in an Unearned Warranty Revenue
account.
 Recognize revenue on a straight-line basis over the period
the service-type warranty is in effect.

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 Service-Type Warranty

Example: You purchase an automobile from Hamlin Auto for

€30,000 on January 2, 2019. Hamlin estimates the assurance-type
warranty costs on the automobile to be €700 (Hamlin will pay for
repairs for the first 36,000 miles or three years, whichever comes
first). You also purchase for €900 a service-type warranty for an
additional three years or 36,000 miles. Hamlin incurs warranty
costs related to the assurance-type warranty of €500 in 2019 and
€200 in 2020. Hamlin records revenue on the service-type
warranty on a straight-line basis.

Question: What entries should Hamlin make in 2019 and 2022?

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 Service-Type Warranty

Solution:

1. To record the sale of the automobile and related

warranties:

January 2, 2019

Cash (€30,000 + €900) 30,900

Unearned Warranty Revenue 900
Sales Revenue 30,000

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 Service-Type Warranty

Solution:

2. To record warranty costs incurred in 2019:

January 2–December 31, 2019

Warranty Expense 500

Cash, Inventory, Accrued Payroll 500

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 Service-Type Warranty

Solution:

3. The adjusting entry to record estimated warranty expense

and warranty liability for expected assurance warranty
claims in 2020:

January 1–December 31, 2019

Warranty Expense 200

Warranty Liability 200

At December 31, 2019, the statement of financial position reports a warranty

liability of €200 (€700 – €500). The income statement for 2019 reports sales
revenue of €30,000 and warranty expense of €700.
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 Service-Type Warranty

Solution:

4. To record revenue recognized in 2022 on the service-type

warranty:

December 31, 2022

Unearned Warranty Revenue (€900 ÷ 3) 300

Warranty Revenue 300

Warranty costs under the service-type warranty will be expensed as incurred in

2022–2024.

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 Assurance-Type vs. Service-Type
Warranty

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Whether a warranty provides additional service

 Whether the warranty is required by law.

 The length of the coverage period. The longer the coverage period,
the more likely that a warranty provides extra service to the
customer. A vendor should consider the industry norm when making
this assessment.
 The nature of the performance obligations.
 For example, if a software warranty provides more than fixing
bugs or basic trouble shooting, such as training and
customization, then that warranty is likely to provide additional
service.

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 CPA Question (Poll #5) important

During 2018, Eaton Co. introduced a new product carrying a two-year

warranty against defects. The estimated warranty costs related to dollar sales
are 2% within 12 months following sale and 4% in the second 12 months
following sale. Sales and actual warranty expenditures for the years ended
December 31, 2018 and 2019 are as follows:

Actual Warranty
Sales Expenditures
2018 € 800,000 €12,000
2019 1,000,000 30,000
€1,800,000 €42,000

At December 31, 2019, Eaton should report an estimated warranty liability of

a. €0.
b. €10,000. 1,800,000*(2%+4%) – 42,000
c. €30,000.
d. €66,000.

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 Common Types of Provisions

Consideration Payable
Companies often make payments (provide
consideration) to their customers as part of a
revenue arrangement.

Companies offer premiums, coupon offers,

and rebates to stimulate sales.
 Companies should charge the costs of
premiums and coupons to expense in
the period of the sale that benefits from
the plan.

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 Consideration Payable

Example: Fluffy Cake Mix Ltd. sells boxes of cake mix for £3 per
box. In addition, Fluffy Cake Mix offers its customers a mixing bowl
in exchange for £1 and 10 box tops. The mixing bowl costs Fluffy
Cake Mix £2, and the company estimates that customers will
redeem 60 percent of the box tops. The premium offer began in
June 2019. During 2019, Fluffy Cake Mix purchased 20,000 mixing
bowls at £2, sold 300,000 boxes of cake mix for £3 per box, and
redeemed 60,000 box tops.

Question: What entries should Fluffy Cake Mix record in 2019?

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 Consideration Payable

Solution:

1. To record purchase of 20,000 mixing bowls at £2 per

bowl:

Premium Inventory (20,000 bowls x £2) 40,000

Cash 40,000

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 Consideration Payable

Solution:

2. The entry to record the sale of the cake mix boxes in 2019
is as follows.

Cash (300,000 boxes x £3) 900,000

Sales Revenue 900,000

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 Consideration Payable

Solution:

3. To record the actual redemption of 60,000 box tops, the

receipt of £1 per 10 box tops, and the delivery of the
mixing bowls:

Cash [(60,000 ÷ 10) x £1] 6,000

Premium Expense 6,000
Inventory of Premiums [(60,000 ÷ 10) x £2] 12,000

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 Consideration Payable

Solution:

The computation of the Premium Liability at 12/31/19 is as

follows.

Purchase costs What customers

need to pay

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 Consideration Payable

Solution:

4. The adjusting entry to record additional premium

expense and the estimated premium liability at December
31, 2019, is as follows:
Premium Expense 12,000
Premium Liability 12,000

The December 31, 2019, statement of financial position reports Premium

inventory of £28,000 (£40,000 − £12,000) as a current asset and Premium
Liability of £12,000 (£18,000 − £6,000) as a current liability. The 2019 income
statement reports £18,000 (£6,000 + £12,000) premium expense as a selling
expense.

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 7,500,000 + 2,500,000*80%– 3,400,000

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 Common Types of Provisions

Environmental Provisions
A company must recognize an environmental liability when it
has an existing legal obligation associated with the retirement of a
long-lived asset and when it can reasonably estimate the amount
of the liability.

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 Environmental Provisions

Obligating Events. Examples of existing legal obligations,

which require recognition of a liability include, but are not
limited to:
► Decommissioning nuclear facilities.
► Dismantling, restoring, and reclamation of oil and gas
properties.
► Certain closure, reclamation, and removal costs of mining
facilities.
► Closure and post-closure costs of landfills.

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 Environmental Provisions

BP 2016 Annual Report

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 Environmental Provisions

Measurement. A company initially measures an

environmental liability at the best estimate of its future costs.

Recognition and Allocation. To record an environmental

liability a company includes
► the cost associated with the environmental liability in the
carrying amount of the related long-lived asset, and
► records a liability for the same amount.

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 Environmental Provisions

Illustration: On January 1, 2019, Wildcat Oil Company erected an

oil platform in the Gulf of Mexico. Wildcat is legally required to
dismantle and remove the platform at the end of its useful life,
estimated to be five years. Wildcat estimates that dismantling and
removal will cost $1,000,000. Based on a 10 percent discount rate,
the fair value of the environmental liability is estimated to be
$620,920 ($1,000,000 x .62092). Wildcat records this liability on Jan.
1, 2019 as follows.

Drilling Platform 620,920

Environmental Liability 620,920
Why do we
debit asset here?
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 Environmental Provisions

Illustration: During the life of the asset, Wildcat allocates the asset
retirement cost to expense. Using the straight-line method, Wildcat
makes the following entries to record this expense.

December 31, 2019, 2020, 2021, 2022, 2023

Depreciation Expense ($620,920 ÷ 5) 124,184

Accumulated Depreciation—Plant Assets 124,184

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 Environmental Provisions

Illustration: In addition, Wildcat must accrue interest expense each

period. Wildcat records interest expense and the related increase in
the environmental liability on December 31, 2019, as follows.

December 31, 2019

Interest Expense ($620,920 x 10%) 62,092

Environmental Liability 62,092

How about year 2020?

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 Environmental Provisions

Illustration: On January 10, 2024, Wildcat contracts with Rig

Reclaimers, Inc. to dismantle the platform at a contract price of
$995,000. Wildcat makes the following journal entry to record
settlement of the liability.
January 10, 2024

Environmental Liability 1,000,000

Gain on Settlement of Environmental Liability 5,000
Cash 995,000

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 Question (Poll #6)
Bruegger Transportation purchased a ship on January 1, 2019, for
£20,000,000. The useful life of the ship is 40 years, but is subject to
a government-mandated major overhaul every 4 years with a total
projected cost of £4,000,000. The present value related to these
payments is £3,200,000. Buregger uses the straight-line method of
depreciation and assumes no residual value for the ship. What will
be reported as depreciation expense related to this transaction in
2019 financial statement?

A. 500,000.
B. 580,000.
C. 100,000.
D. 80,000.
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 Answer

The present value of the major overhaul payments (£3,200,000)

should be included as part of the cost of the ship. The ship should be
recorded at £23,200,000.

Ship 23,200,000
Cash 20,000,000
Environmental Liability 3,200,000

Depreciation Expense 580,000

Accumulated Depreciation 580,000

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 Common Types of Provisions

Onerous Contract Provisions

An onerous contract arises if the unavoidable costs of
meeting the obligations exceed the economic benefits
expected to be received.

The expected costs should reflect the least net cost of

exiting from the contract, which is the lower of

1. the cost of fulfilling the contract, or

2. the compensation or penalties arising from failure to fulfill

the contract.

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 Onerous Contract Provisions

Examples of Onerous Contract

 An onerous contract may occur if the market price of the
commodity being held falls below the cost that is needed in
order to obtain, uncover or produce the commodity.
 Leases are another instance where an onerous contract
may arise. For example, consider a lessee with an
obligation to continue making payments on an asset, per the
terms of his lease, but who is actually no longer making use
of the asset. The remaining balance of the lease payments
might be recognized as a loss.

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 Onerous Contract Provisions
Thomas Cook Group 2016 Annual Report

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 Onerous Contract Provisions

Illustration: Sumart Sports operates in a factory that it has

leased and on which it pays monthly rentals. Sumart decides to
relocate its operations to another facility. However, the lease on
the old facility continues for the next three years. Unfortunately,
Sumart cannot cancel the lease nor will it be able to sublet the
factory to another party. The expected costs to satisfy this
onerous contract are €200,000. In this case, Sumart makes the
following entry.

Loss on Lease Contract 200,000

Lease Contract Liability 200,000

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 Onerous Contract Provisions

Assume the same facts as above for the Sumart example and
the expected costs to fulfill the contract are €200,000. However,
Sumart can cancel the lease by paying a penalty of €175,000. In
this case, Sumart should record the liability as follows.

Loss on Lease Contract 175,000

Lease Contract Liability 175,000

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 Question (Poll #7)
Marquardt Company signs a 5-year lease related to office space
at an annual rental of £30,000. At the end of the second year, the
company decides to close its operation in this part of country. Its
lease is non-cancelable, and the penalty for non-payment is
£62,000. The present value of future payments on the lease is
estimated to be £81,000. The company does not believe that it
can sublet these facilities. This transaction leads to

A. Provision from lease contract liability of 62,000.

B. Provision from lease contract liability of 81,000.

C. Provision from lease contract liability of 30,000.

D. No provision liability.
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 Common Types of Provisions

Restructuring Provisions
Restructurings are defined as a “program that is planned and
controlled by management and materially changes either
1. the scope of a business undertaken by the company; or

2. the manner in which that business is conducted.”

Companies are required to have a detailed formal plan for the restructuring
and to have raised a valid expectation to those affected by implementation
or announcement of the plan.

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 Restructuring Provisions

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 Restructuring Provisions

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 Restructuring Provisions
Nestle 2016 Annual Report

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 Restructuring Provisions

What to Include?

A restructuring provision shall include only the direct

expenditures arising from the restructuring, which are
those that are both:

(a) necessarily entailed by the restructuring; and

(b) not associated with the ongoing activities of the

entity.

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 Restructuring Provisions

IFRS provides specific guidance related to certain costs and

losses that should be excluded from the restructuring
provision.

In general, the costs to be exclude relate to the future

operations of the business and are not liabilities
associated with the restructuring as of the end of the
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reporting period. LO 2
 Restructuring Provisions

What to Include?

Gains or losses from the expected disposal of assets shall not

be taken into account in measuring a provision.

 Gains or losses on the expected disposal of assets are not

taken into account in measuring a provision, even if the
expected disposal is closely linked to the event giving rise to
the provision. Instead, an entity recognises gains or losses
on expected disposals of assets at the time dealing with the
assets concerned.

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 Restructuring Provisions

ILLUSTRATION 13.14
Accounting for Restructuring

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 Include the costs?
EADS Company is involved in a restructuring related to its energy division. The
CFO are considering the following costs to accrue as part of the restructuring.

1. The company has a long-term lease on one of the facilities related to the
division. It is estimated that it will have to pay a penalty cost of 400,000 to
break the lease. The company estimates that the present value related to
payment on the lease contract are 650,000.
2. Due to the restructuring, some employees will be shifted to some of the
other divisions. The cost of retraining these individuals is estimated to be
2,000,000.
3. The company has hired an outplacement firm to help them in dealing with
the number of terminations related to the restructuring. It is estimated the
cost for this company will be 600,000.
4. It is estimated that employee termination costs will be 3,000,000.
5. The company believes that it will cost 320,000 to move useable assets from
the energy division to other divisions in the company.

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 Question (Poll #8)
K Ltd. manufactures plastic products and has various plants across the
country. K Ltd. decides to shut down a plant as a results of poor
performance, and has communicated the plan to the employees. Related
costs include the following (in millions):
• K Ltd. decided to reallocate staff to the nearest plant ($60), but some
staff will be retrenched ($40).
• Manufacturing assets will be moved to other plants ($150).
• Other assets will be sold (loss on sale = $80)
• The lease for the premises will be terminated upon payment of penalty
($125).
• K Ltd. will incur consulting costs for the restructuring ($25).

What amount would K Ltd recognize as a restructuring provision?

A. 165.
B. 190. 40+125+25
C. 250.
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 LEARNING OBJECTIVE 3
Contingencies Explain the accounting for loss
and gain contingencies.

Contingent Liabilities
Contingent liabilities are not recognized in the financial
statements because they are
1. A possible obligation (not yet confirmed),

2. A present obligation for which it is not probable that

payment will be made, or

3. A present obligation for which a reliable estimate of the

obligation cannot be made.

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 Contingent Liabilities

ILLUSTRATION 13-16 presents the general guidelines for the

accounting and reporting of contingent liabilities.

ILLUSTRATION 13.16
Contingent Liability Guidelines

In a general sense, all provisions are contingent because they are

uncertain in timing or amount. However, IFRS uses the term “contingent”
for liabilities and assets that are not recognized in the financial statements.
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 Provisions vs. Contingent Liabilities
Provisions Contingent Liability

Obligation A present obligation A possible obligation

Probable (the probability Not probable (the

Outflow of resources of occurrence>50%) probability of
occurrence<=50%)

Reliable estimate can’t

Amount of obligation Reliable estimate
be made

Disclose in notes,
Accounting Treatment Report as liability providing a brief
description of the nature

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 Contingent Liabilities: Disclosure

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 Contingencies

Contingent Assets
A contingent asset is a possible asset that arises from past
events and whose existence will be confirmed by the
occurrence or non-occurrence of uncertain future events not
wholly within the control of the company. Typical contingent
assets are:
1. Possible receipts of monies from gifts, donations, bonuses.

2. Possible refunds from the government in tax disputes.

3. Pending court cases with a probable favorable outcome.

Contingent assets are not recognized on the statement of financial position.

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 Contingent Assets

The general rules related to contingent assets are presented

in ILLUSTRATION 13-18.

ILLUSTRATION 13.18
Contingent Asset Guidelines

Contingent assets are disclosed when an inflow of economic benefits

is considered more likely than not to occur (greater than 50 percent).

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 Contingent Assets

Example: Litigation is being pursued for the recovery of

€1,300,000 consulting fees on a failed project of Polska
Corporation. The attorney believes it is possible that their claim
will be successful.

Question: How should Polska Corporation report this

information in its financial statements?

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 Contingent Assets

Solution:

Possible favorable outcomes from pending court cases are

considered contingent assets. Contingent assets are not
recognized unless the outcome is virtually certain.

The outcome in Polska’s situation is not virtually certain. The

evidence provided does not even support that the outcome is
probable.

Without evidence that the outcome is probable, the litigation

should not be disclosed.

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 Netting Contingent Liability and Asset?

In some circumstances, both contingent liability and contingent

asset will exist in the same case.

For example, a company is at the risk of losing a lawsuit.

However, if the company loses, it can possibly claim insurance
compensation.

Do NOT net the amounts automatically. The contingent liability

and contingent asset must be analyzed SEPARATELY.

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 Question (Poll #9)
On October 1, 2019, Holmgren Chemical was identified as
potentially responsible party by its Environmental Regulatory
Agency. Holmgren's management along with its legal counsel have
concluded that it is probable that Holmgren will be responsible for
damages, and a reasonable estimate of these damages is
€6,000,000. Homgren's insurance policy of €9,000,000 has a
deductible clause of €500,000. Holmgren’s financial statements at
December 31, 2019 will include:

A. Net contingent liability of 5,500,000.

B. Provision of 6,000,000 and contingent asset of 500,000.

C. Provision and corresponding loss of 6,000,000.

D. This transaction will not be recorded.

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 Question (Poll #10)

Litigation is being pursued for the recovery of €1,300,000

consulting fees on a failed project. The directors believe it is
more likely than not that their claim will be successful.

How should the company report this information in its annual

report?

A. Report contingent asset of 1,300,000.

B. Disclose contingent liability of 1,300,000.

C. Disclose contingent asset of 1,300,000.

D. No disclosure is required.
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13-90
 Suggested End-of-Chapter Exercises

• P13-6
• P13-13
• P13-14
• Accounting, Analysis, and Principles (No. 1&3)

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