The Notion of Contingent Liability - Essay Example

The Notion of contingent liability Jiahua Chen Florida Atlantic University ACG6135 Advanced Accounting Theory Dr. Terrance R. Skantz 03/10/2010 Table of Contents The Notion of contingent liability 3 Introduction 3 Background information 4 Benefits of Contingency Liability 5 Financial Accounting Standards Board 7 Provisional and Unconditional Liability 10 Conclusion 11 References 13 The Notion of contingent liability Introduction Contingent liabilities refer to future possible liabilities which can only become certain on the occurrence of the future event. Compared to a provision, a contingent liability is less certain. A provision is expected to occur while a contingency liability might occur. An example of a contingent liability is an award from a law suit against a certain company is a contingent liability to the defendant, in this case the company, if there are low chances that the plaintiff will win the case. Another example is where a father acts as a guarantor to a son’s student housing lease, the son is responsible for the rent but if he defaults, the father becomes responsible. In this case the father is faced with a contingent liability. Other contingent liabilities occur in guaranteeing of debts for other people and likelihood of unpleasant judgments in court cases. In cases of borrowing, the lenders sometimes ask to be issued with a list of contingent liabilities for the borrower since it helps them to evaluate the financial strength of the borrower. Contingent liabilities in most cases they never become real liabilities. Sometimes they may be big but they may never be a risk that may have an impact on the business (Saunders 2000). According to FAS (Financial Accounting Standards) proposal, my stand on the issue is that contingent liability should be retained and not replaced with the concept of unconditional and conditional obligations. However, the FAS board seeks to eliminate contingent liabilities from its standards because there is no probable outflow of economic resources to settle the liabilities or because it cannot be measured reliably. Background information The financial accounting board’s plan to eliminate contingent liability from its standards was founded on facts same as those for eliminating contingent asset. A contractual liability usually consists of unconditional obligation which is worth to be termed as a liability and conditional obligation that is an indicator of an associated unconditional obligation but is just a likely future liability which does not qualify to be defined as a liability. An example of unconditional and conditional liability is given in a product warranty. The obligation of a firm or a company to offer a warranty to repair to issue another product in case the one sold defaults is a conditional obligation since it will apply if the product develops faults and the willingness of the customer to ask for replacement or repair. The unconditional obligation in this case is for the firm to issue the warranty, that is, to declare its readiness to repair or replace the product. FAS explains that when the company issues a warranty that declares its readiness to repair or replace, it is offering a service that indicates an outflow of economic resources (Larson & Chiappetta 1999). The declaration of readiness qualifies to be defined as a liability. In this case, the conditional obligation does not dictate whether a liability is present, it only influences the amount of money that will be needed to clear the liability. The board reasons that conditional and unconditional obligations are related in contractual settings, but not in non contractual settings. FAS insist that under its standards, a firm should first determine the availability of a present obligation that qualifies to be defined as a liability. If the obligation exists, the firm should to recognize and measure the obligation. But if it does not exist, there is no issue of recognition and measurement. In case there exist an obligation but it is not recognized, it cannot be described as contingent because it has not been determined to exist. This will be defined as an unrecognized liability. Benefits of Contingency Liability My argument on this issue is that the idea of contingent liability should be retained and not replaced with the concept of conditional and unconditional liability. One of the reasons for this is because in the case of a product warrant, the price for the contingent is included in the general price for the product. The cost of repair or replacement is therefore paid once the product is bought. The firm does not have to incur an extra cost to fulfill the warrant. The issue of the conditional and unconditional obligations should not arise in such a case. For a firm to survive without considering the obligations there should be a biased assessment of the likelihood of the outcome of the bad condition so as to properly account for the contingency. The obligations should be recorded when there is a likelihood of the bad event to occur in the future and the amount to settle the event should be estimated. If there is a high possibility that the event will occur in the future, this only requires a note on the financial statements. The governments in most nations offer contingent support to projects that are determined to be too risky to be handled privately. This is necessary because it will encourage the private sectors to be able to take up risks (Brixi 2002). This is essential because there is no feeling of a loss to the risk taker after a bad event occurs. In a company, the likely hood of happening of the event that will need customer’s compensation will be written in the off-balance sheet. This is because it is like an insurance cover. The company is also covered by the insurance for such losses and therefore it should not be a burden to be placed with the conditional and unconditional liabilities. FAS board explains that contingent liability should be eliminated since there is no defined ways of measuring and assessing it and hence the need for consideration of the conditional and unconditional liabilities. The solution to this should be to create acceptable means for measuring and assessing the contingent issues. Assessment and evaluation of contingency liabilities involves quantification which is aimed at avoiding financial crisis. Frameworks to monitor the liabilities should be put in place by the organizations. Maintaining contingent liability will also encourage economic growth and development in a country. The conditional and unconditional obligations are a discouragement to most entities since they will fear to take up risky ventures due to lack of guarantors. Some of the risky ventures are however very important in economic development and failure to take them will be pushing back the economic developments. Contingency liability can sometimes turn to be a gain contingency. This is for example in product warranty where the cots for replacing or repair are already embedded in the buying price of the item. In most cases the products do not fault and the customer has already unknowingly paid for the cost. In such a case, the contingency is a gain to the entity. In loss contingency, the likelihood of the event to occur in the future ranges from probable to remote. Probable means that the event is likely to occur while remote means that the chances of the event to occur are very slim (International Accounting Standards Committee 1997). When the conditional and the unconditional obligations are therefore placed in this situation, the entity assumes that the chances of the event to occur are high. The conditional and unconditional obligations should only come in where there is a probable future outflow of resources and when the outflow is measurable. In the occurrence of most events, the cost incurred is very small and the entity does not feel the cost. In most cases, contingent liabilities do not ever become tangible liabilities. In case they are large, they may not be enough of a risk to possess a significant impact upon valuation. The settlement of the contingency when an event occurs is sometimes a gain to the entity since it is a reduction of the liabilities. The liability already exists from the time a warrant is declared. The conditional and unconditional obligations do not make it to cease from becoming a liability. Settlement will therefore be a positive move for the entity because it is a reduction in the liabilities. Contingent liability is also a gain to the entity when it occurs and is resolved since it changes from becoming a liability to an asset. Financial Accounting Standards Board I differ with the Financial Accounting Standards Board definition of contingent liability where they state that it is a present obligation in an entity whose reality can be confirmed by occurrence, or failure to occur of an uncertain event fir which is under the control of the entity. The other definition they give to contingent liability is that it is a present obligation that is not given attention because there is no probable outflow of resources that are required to settle it or its quantity cannot be reliably measured (Jarnagin 1995). In this definition, contingency liability is not recognized. The definition only recognizes the conditional and unconditional obligation hence their proposal to eliminate it and replace with the obligations. This definition also uses the term probable which means that the chances of the event to occur are more than fifty percent. This offers a role to probability and uncertainty in the measurement of the liability. My opinion on this is that criteria for measuring the certainties of the event should be provided instead of rating it as a conditional or unconditional obligation. If a firm is a defendant on a court, the liability in this case is the possibility of it to be required to pay for the penalties that may be imposed by the court. This should be defined as a contingent liability by the entity since it will be written on the off side of the balance sheet. If one follows the issues of unconditional and conditional obligations as stated by the Financial Accounting Standards board, it will be a burden to the entity to settle the event since it was not in their accounts budgets (Welsch 2003). There is no need of an entity to assess the probability of the outflow of resources for it to accept the occurrence of the event because there is no certainty that the settlement of the event will require more of economic resources. Where the conditional obligation is associated with the unconditional obligation, this should be defined as a liability. A contingency is not taken in regard to the existence of an asset or a liability but in regard to future event that affects the liabilities and the assets of an entity (Solomons 1997). A contingency liability should not only be recorded when it is probable and estimable. They should not be recorded under any conditions. If they are recognized under fair face value, they should meet the definition of liability and not placed under the conditions of unconditional and conditional obligations. The measure of contingency liability should however be based on thing the valuation of the extent of the event. This should be as the case with the insurance companies where after an event has taken place, the valuers are involved in measuring the extent of the loss. Unconditional obligation does not however exist unless it is created by law. If it is an obligation, this means that it will be recognized after the extent of the event is assessed and measured. But if the entity takes it as a contingent liability, there will be no issues of recognition after measurement. With such a notion, this should not be a big issue to the entity and the issue of conditional and unconditional obligations should not apply. Accounting for contingencies however requires consistency in order for the company to have the estimated values in its accounts budget. There should be nearly correct estimates that will be incorporate in the company’s budget as values for contingency liability. When things are in that manner, the company, form the word go, will be able to allocate funds for contingency management in the budget. If this is not observed, the customers of the products will be forwarding compensation requests which are above the usual value since then entity has no limit for specific entities. The proposal to eliminate the term contingent liability and leave the probability recognition criterion for the non financial liability should also not be applied. The use of probability and uncertainty are the best terms in definition of a contingent since this is a happening that lacks guarantee of occurrence. Whether the obligation is there or not there, the issue is based on uncertainties and probability. It should be a liability in the entity that should be based on uncertainty and should therefore be on the off balance sheet. The issue of warrant and guarantees is not non financial since in the case of an occurrence whether under contingent or under obligations, there will be usage of funds to settle the event. The best way to measure the liability in case an event occurs should be the estimated cash outflow required in the settlement of the event. If there exists nonfinancial liabilities in any business entity, they would rather be looked for another measurement criterion instead of eliminating the contingent liabilities to incorporate the non financial definition of the liabilities (Stickney 2009). The proposed measurement requirement for non-financial liability does not consider the level of confidence that is required to be found in a financial statement for use by the investors. The concept of probability in the recognitio0n of obligations and the measurement on the liabilities is not appropriate. Their stated probability measurement criterion is applicable for intangible assets thus when applied for liabilities it creates inconsistencies (Dillavou 1998). Provisional and Unconditional Liability On the other side, contingency liability can be replaced with the terms conditional and unconditional liability. This is because a contractual liability is comprised of the conditional obligation and unconditional obligation. The unconditional obligation meets the definition of a liability while the conditional obligation that may indicate the presence of a unconditional obligation which is related to it but is just future possibility of a happening that has not taken place. This therefore does not meet the definitional of a liability. The conditional obligation does not determine whether the event takes place. Ti only affects the funds that will be used to settle the liability if the event happens. The use the terms based on obligation will however be contradicting in many cases. This is because in the case of a law suit where the entity is the defendant, if it will be forced to pay some amount to the plaintiff, this is a non contractual setting where the issue of obligation does not apply. This is different from the issue of warrant. For an entity to issue warrant to a customer, it is a commitment that the entity itself has made and not under any condition. This can however be defined as an obligation because it is self commitment not by law or by impending situations Based on my argument, I would only agree with the proposal to eliminate contingency liability only on cases of guarantee or warrant. But in the cases of law suits, this is a real contingent liability because it is an event that no one is certain that it will happen. But in issuance of a warranty, the entity already knows that it committed itself on the product, either to repair or to replace it. In its balance sheet, it should therefore include the funds for fulfillment of the warrant. This can therefore be termed as an obligation since the entity is aware of it and should even be prepared to meet it if it happens without considering the outflow of resources (Britton & Bauer 2002). Conclusion On the above issue, to avoid the inconsistencies and contradictions that entities would face if the proposal by the Financial Accounting Standards Board is adopted, the recommendations should first be put into practice by the business entities to confirm on its applicability. When this is done, they will be able to distinguish in which situations should the term contingency liability applies and in which ones should unconditional and conditional obligations feature. If the case of conditional and unconditional obligation applies, the Financial Accounting Standards Board should look at the issue once again and try another means of definition. It would be good if the whole issue of liabilities be divided into different issues so that in one group, contingent liability features and in others, conditional and unconditional obligations features. Cases of warrant and guarantees should carry the conditional and unconditional liability while issues related to the law suit should maintain the definition of contingent liability. It is however important that the board, together with the concerned entities discuss and agree on the issue while considering the applicability of the two definitions in real sense. If the terms conditional and unconditional obligations must apply, the issues relating to guarantee and warrant should be referred to have unconditional obligation but not conditional obligation. References Britton, W., & Bauer, R., (2002). Cases on business law. Boston: Publisher West publishing co. Brixi, H., (2002), Government at risk: contingent liabilities and fiscal risk, Mexico, World Bank Publications. Dillavou, E., (1998). Principles of business law. London: Prentice-Hall. International Accounting Standards Committee. (1997). Provisions, contingent liabilities and contingent assets, London, International Accounting Standards Committee. Jarnagin, B. (1995). Financial accounting standards: explanation and analysis, Commerce Clearing House. Larson, K., & Chiappetta, B., (1999), Fundamental accounting principles, Volume 1, New York, McGraw-Hill. Solomons, D. (1997). Financial accounting standards: regulation or self regulation? New York, Stanford University press. Stickney, C., et al. (2009). Financial Accounting: An Introduction to Concepts, Methods and Uses. New York, Cengage Learning. Saunders, A., (2000). Contingent liability in banking: useful policy for developing countries, Mexico, World Bank Publications. Welsch, G., (2003) Intermediate Accounting, New York, R.D. Irwin Read More