Financial statements consist of accounting information required to forecast the outcome of past and present financial events. As a result, investors rely on the statements to assess the amounts, timing and uncertainty of a company's cash flow. In fact, some accounting data appears in the statements before it is documented in the company's accounting system because of its predictive value in regard to the company's cash flow. Such information pertains to a condition referred to as either a loss contingency or a gain contingency. Loss contingencies in particular can arise in a number of circumstances, including a company's use of a sales promotion that offers a premium to a customer with the purchase of a complementary product.
Generally Accepted Accounting Procedures, or GAAP, in accordance with Financial Accounting Standards Board, define a contingency as "an existing condition, situation or set of circumstances involving uncertainty as to a possible gain or loss that will be resolved when a future event occurs or fails to occur." In the event the contingency involves a gain, the amount is referred to as a gain contingency; and where the contingency pertains to a loss, it is described as a loss contingency. For a contingency to be recorded in a financial statement, an event must have already occurred, or a condition must exist, on or before the balance sheet date. In addition, the outcome of the event or the condition must be dependent on a separate event that has not yet occurred.
A company may attempt to promote the sale of one product by making another product, referred to as a premium, available to any customer who responds appropriately to a company's instructions. For example, a company may price and sell two complementary products as one unit at a price less than the total of the original prices of the two products. The customer benefits from the premium by doing as the company instructs, which is to purchase the two products simultaneously. Such a premium offer leads to the creation of a loss contingency.
According to GAAP, the likelihood that a future event will confirm a loss may be probable, reasonably possible or remote. This likelihood of the event's occurrence determines the accounting and disclosure requirements for the loss contingency. The estimated loss is accrued and reported as an expense in the income statement and a liability in the balance sheet if it is probable that the liability has been incurred and the amount of the loss can be estimated as of the date of the financial statements. In the event the exact amount of the loss can't be estimated, a range of values can serve as the basis of the required accounting entries. For example, assume a company estimates that customers will take advantage of a premium offer and receive free products that have a dollar value of between $1 million and $3 million, depending on the premiums redeemed. In this instance, the company is required to accrue the loss for the minimum amount of $1 million. As a result, $1 million is debited to a premium expense account and credited to a liability, asset or contra account. In addition, the maximum value of $3 million must be disclosed in the notes to the financial statements.
A company uses a sales promotion that offers a customer the option to purchase a printer cartridge at a 50 percent discount if the cartridge and a laser printer are purchased simultaneously. The premium obligates the store to sell the cartridge at a discount, which creates a loss contingency that is recorded at the end of the accounting period. The resulting debit entry to the premium expense account and the credit entry to the premium liability account are equal to the estimated number of the coupons that will be redeemed multiplied by the cost of the cartridge. For example, if the company estimates that 1,000 coupons will be redeemed for the purchase of cartridges that cost the company $20 per cartridge, both the debit to the premium expense account and the credit to the premium liability account will be $20,000.
- FASB: Accounting Standards: Disclosure of Certain Loss Contingencies
- 2009 U.S. Master GAAP Guide; Bill D. Jarnagin
- Intermediate Accounting: Financial Reporting and Analysis; Curtis Norton et al.
- Intermediate Accounting; Loren Nikolai et al.
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