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Impact of Contingent Liabilities on Financial Reporting and Decision-Making Professor: March 24, 2024

Enterprises function within an ever-evolving landscape where unforeseen circumstances can affect financial information. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) require companies to disclose contingent liabilities and potential future obligations that can significantly affect their financial position to represent their financial standing accurately (Palmer,2024). As per FASB codification 450-20-05- 2 alongside Subtopics 450-10- and 450-30, general guidance is offered regarding gain and loss contingencies. Stakeholders, including investors and creditors, must be informed about these potential liabilities, as they can influence the Company's risk exposure, cash flow, and overall financial resilience. The current study delves into contingent liabilities, explores the accounting principles, discusses the classification, and examines their impact on decision-making processes. What is a Contingent Liability? Contingent liabilities refer to prospective financial obligations or losses that rely on the result of an unpredictable event. US GAAP from FASB (2023) codification outlined in ASC 450- 20-20 that contingency is a current condition, situation, or scenario with uncertainty about an entity's potential gain (gain contingency) or loss (loss contingency). The resolution of these uncertainties depends on the occurrence or non-occurrence of one or more future events. Moreover, according to FASB Statement No. 5, a contingency is "a current condition, circumstance, or series of events characterized by uncertainty regarding potential profit or loss for a company, which will be resolved upon the happening or non-happening of one or more future events." Instances comprise obligations stemming from legal action, notes receivable with discounted values, disagreements over income tax, potential penalties resulting from prior activities, warranty and debts guaranteed by the Company. In contingent liability scenarios, the Company typically lacks certainty regarding the existence and extent of the liability. For more examples of contingent liability, please see the images below. (Srivastav, 2024)

Principles of Contingent Liability Anderson Austin (2024) stated in a review published in the Wall Street Journal that, according to Generally Accepted Accounting Principles (GAAP), contingent liabilities are recorded based on three accounting principles: full disclosure, prudence, and materiality.  Principle of prudence: It mandates that a company refrain from recording anticipated gains but must account for expected losses. This safeguards against overstating income/assets and understating expenses/liabilities.  Principle material states that any items with financial value must be recorded in the accounting books. Items have financial value if their presence or absence impacts the business.  Principle Disclosure: It aims to provide users of financial statements with a comprehensive understanding of the Company's financial position and operating results, enabling them to make informed decisions. Classification of Contingent liability GAAP and IFS recognize three categories of contingent liabilities: probable, possible, and remote. However, evaluating a contingent liability in monetary terms can prove difficult, as it is a liability that could arise contingent upon the outcome of a future event, a probability subject to individual judgment. Given the inherent ambiguity and uncertainty surrounding the amount to allocate for such expenses. It is important to ask two (4) four essential questions before accounting for any potential unforeseen obligation:  If the contingent loss is probable and can be estimated, legal counsel determines the probable standard, which should be greater than 50% (IFRS) or 80% (GAAP). If the contingency meets the 80% occurrence, GAAP requires that the contingency be recorded in the income and balance statements. The journal entries will be debit liability-related expenses and accrue credit liability (Ross,2023).  The entity must disclose this note on the financial statements if the contingent loss is probable or possible and cannot be estimated. The disclosure lets the reader know that there are potential liabilities, but the estimated value is unknown.  If the contingent loss is remote, it is unlikely to occur in Occur. It should not be disclosed.

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Wiley CPAexcel Moreover, the FASB's Accounting for Contingencies (Issued 3/75) sets standards for addressing loss contingencies in financial reporting. It requires recording and disclosing anticipated losses from such events if two conditions are met: indication of asset impairment or liability occurrence based on available information and a reasonably determinable loss estimate. General reserves for unspecified risks are prohibited, while gain contingencies follow recognition upon realization, as outlined in Accounting Research Bulletin No. 50, with no alterations. Balance Sheet Contingent liabilities can significantly impact a company's financial stability and transparency. Their uncertain nature introduces unpredictability into financial planning and reporting, potentially affecting the balance sheet and income statement. While contingent liabilities are often not initially reflected on the balance sheet, they are acknowledged when they become probable, and their estimated cost can be reasonably determined. This process involves establishing an expense account, decreasing the Company's net income, and retaining earnings within the shareholders' equity section. Consequently, it also raises the Company's current liabilities, reducing working capital and the current ratio and potentially impacting its liquidity position. (Kieso et al. ,2022). Income Statement The income statement, which offers insights into a company's revenue, costs, net earnings, and earnings per share, is also susceptible to the impact of contingent liabilities. When a contingent liability becomes probable and its magnitude can be established, the Company must reflect an expense in the income statement. The extra expenditure reduces the Company's pre-tax income, net earnings, and earnings per share, assuming the contingent event occurs. If the liability materializes into an actual obligation, the resulting expenses could significantly reduce the Company's profits. Disclosure While the estimated probable or possible contingent liability may not be included in the balance sheet due to uncertainty, it should be disclosed in accompanying notes. The disclosure

should detail the nature of the liability, potential loss estimates, and factors influencing the outcome. It enhances transparency, aiding shareholders, and investors in making informed decisions. For instance, during the initial three months, a U.S. District Court in Miami, Florida, granted the Company a $5.1 million ruling against Barth Industries (Barth) of Cleveland, Ohio, and its parent company, Nesco Holdings, Inc. (Nesco). The ruling concerns a contract wherein Barth and Nesco were tasked with facilitating the automation of a plastic lens production facility in Fort Lauderdale, Florida. The Company has refrained from recognizing any income tied to this ruling due to Barth and Nesco lodging an appeal. Incorrectly identifying or failing to disclose contingent liabilities can have serious consequences: OpenStax. (n.d.).  It may mislead investors, leading to poor decisions.  Inaccurate recognition can strengthen future profitability, leaving the Company unprepared for future financial responsibilities.  It could result in legal penalties and damage to reputation, especially if seen as deceptive. Case studies of Contingent liability The most common contingent liabilities are lawsuits, warranties, rebates and premiums, coupon liability, and guarantees of indebtedness. Let’s examine a couple of examples of warranty and legal matters. For instance, consider Company X Ltd., which sells cars with a three-year warranty on the engine valued at approximately $1,000. If they sell 5000 units, they must predict how many cars might require engine replacements during the warranty period. Consequently, the Company must disclose contingent liabilities in its financial statements. If the Company anticipates 25%- or 1250-units needing engine replacements, they must recognize (1250 * $1,000) as their contingent liability. Consider this scenario from DART. Com. (n.d): Hoverboards and self-balancing scooters powered by lithium-ion batteries are prone to overheating, posing fire hazards. Following numerous injuries, a mid-2016 recall was issued for most models. Retailers were required to accept returns and facilitate repairs. Retailers sometimes bore consumer liability rather than manufacturers. Determine if this scenario entails contingent liabilities, assess FASB compliance, choose the appropriate treatment, and consider necessary disclosures. The Company is involved in various legal proceedings, and reserves are set up for specific matters when it is likely that an unfavorable outcome will occur. The potential loss can be reasonably estimated. Moreover, management has identified other legal issues where an adverse outcome is possible, and in some cases, the potential losses cannot be estimated. Management's view is that the overall liabilities arising from ongoing legal proceedings will not significantly impact the Company. Contingent liability Management Frank Beddor declared that if circumstances demanded, he would even prepare a backup plan for the backup plan's backup plan. A proactive and strategic approach is essential for handling potential financial risks associated with contingent liabilities. Initially, companies should conduct thorough financial planning and forecasting to predict liabilities in the financial

projections. The Company would be ready if the event causing the liability appears probable. A contingency reserve is recommended to tackle unexpected liabilities, providing financial protection for unforeseen obligations. Given the legal consequences of contingent liabilities, having legal expertise is crucial. Legal advisors can aid in negotiating contracts to reduce the Company's liability exposure and recognize and address potential legal risks. In summary, contingent liability represents a potential future obligation arising from uncertain events. Heinz Pagels declares that the world changed from having the determinism of a clock to having the contingency of a pinball machine. Effectively handling contingent liabilities requires a proactive organizational approach. Recognizing contingency is essential for experiencing freedom (Rorty 1998, p326). Businesses can mitigate risks by promptly identifying, evaluating, and disclosing these liabilities following FASB IFS standards, fostering stakeholder confidence, and making well-informed decisions. Furthermore, implementing sound risk management practices and internal controls can help organizations prepare for potential liabilities and reduce their impact on financial statements. However, misidentifying or omitting contingent liabilities can mislead investors, impacting decisions. Consequently, inaccurate recognition may inflate profits, leaving the Company ill- equipped for financial obligations, potentially leading to legal penalties and reputation damage.

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Reference Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2022). Intermediate Accounting (18th ed.). John Wiley & Sons, Inc. https://read.wiley.com/books/9781119778899/page/25/section/head4 Ross, S. (2023, August 29). Investopedia. Reporting Requirements of Contingent Liabilities and GAAP Compliance. https://www.investopedia.com/ask/answers/042415/how-are-contingent-liabilities-reflected- balance-sheet.asp Anderson, A. (2024, January 24). Wallstreetoasis. Contingent Liability https://www.wallstreetoasis.com/resources/skills/accounting/what-is-contingent-liability OpenStax. (n.d.). 12.3 Define and Apply Accounting Treatment for Contingent Liabilities - Principles of Accounting, Volume 1: Financial Accounting | Openstax.org. https://openstax.org/books/principles-financial-accounting/pages/12-3-define-and- apply-accounting-treatment-for-contingent-liabilities |DART. Com. (n.d). Deloitte Accounting Research Tool. FAS 5 Accounting for Contingencies https://dart.deloitte.com/USDART/pdf/a9947e95-3f30-11e6-95db-ef2573d6199a FASB. (n, d). Summary of Statement No. 5. Accounting for Contingencies (Issued 3/75) https://fasb.org/page/PageContent?pageId=/reference-library/superseded-standards/summary-of- statement-no-5.html&bcpath=tff Srivastav. (2024, January 3). Wall Street mojo Team. Contingent Liabilities Example https://www.wallstreetmojo.com/contingent-liabilities-example/ FASB. (2023). FASB Accounting Standards Codification®. Asc.fasb.org. https://asc.fasb.org/home