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12 - Contingent Liabilities - YouTube
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I'm Larry Walter this is principles of
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accounting dot-com chapter 12 and in
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this module we
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for contingent liabilities contingent
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liabilities are those obligations that
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are uncertain or potential they may give
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rise to actual liabilities they may not
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and the timing and amounts are uncertain
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example include legal disputes
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environmental contamination problem
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product warranty other firm specific
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risk perhaps they're different from
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general business risks such as the risk
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of war storms where no specific
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accounting is made in advance we have
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some criteria driven outcomes here first
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of all if the liability the contingency
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becoming an actual liability is probable
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and sudden reasonable estimation then we
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record the liability in the financial
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statement however if it's only
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reasonably possible that we'll have an
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unfavorable outcome we generally only
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footnote the existence of the
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contingency and for contingencies where
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an unfavorable outcome is viewed as
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being remote no disclosure is required
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so continuing we record a contingent
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liability in the accounts if it is
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probable that the future event will
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occur and the amount can be reasonably
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estimated in that case a loss is
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recorded or debit to a loss and a
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liabilities established our credit a
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liability if the estimated loss can only
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be defined as a range of outcomes we
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can't identify a specific point estimate
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then under us a gap we generally record
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only the low end of the estimated
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liability the midpoint is used for
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International Accounting Standards
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there's an interesting history and logic
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behind these particular ideas about what
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amounts should be recorded but it's
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certainly not the most conservative
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approach to record the lower end of the
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range it's simply the approach that's
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stipulated under GAAP so one needs to be
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very careful when they look at
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contingent liabilities in their
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calculation and presentation in the
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financial statements because the firm
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risk can actually run much higher than
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that if it's only reasonably possible
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that the contingent liability will
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become a real liability a note to the
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financial statements is appropriate a
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similar treatment is for t1 as probable
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losses occurred and the loss can not
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even be estimated normally accounting
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tends to be conservative but that's
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certainly not the case with contingent
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liabilities promote risks do not need to
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be disclosed they're viewed as needless
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clutter distractions for example a
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frivolous lawsuit where there's almost
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notes
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of an unfavorable outcome disclosures
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the business decision risks are not
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required but neither are they
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discouraged for example a company may
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decide to reduce their insurance
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coverage to save money to avoid a high
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premium well that exposes the company to
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certain risks but it was a business
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decision that was made and as I say
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that's not required to be disclosed but
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neither is a discouraged contingent
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assets or contingent gains are almost
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never recognized in the financial
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statements at least never until the
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payment of the benefit of that is
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actually received for example a
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company's claim against another company
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for a patent infringement while it could
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be significant and material we
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ordinarily would not report that as a
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benefit or an asset the timing of the
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events also needs to be considered for
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example if a customer was injured by a
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defective product in the year 1 but we
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did not even learn about the injury
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until year - the question is should we
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go back assuming year 1 financial
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statements have not been issued and
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adjust them for the event that we did
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not even know about in year 1 the answer
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in that case is yes because the event
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giving rise to the loss occurred in year
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1 we should adjust year 1 financial
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statements for that amount if we flip
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this around the injury occurred in year
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2 even though it might be very material
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and adverse year ones financial
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statements are not affected because the
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event giving rise to the loss did not
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occur in year until year 2 we might have
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a note to the financial statement say
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saying hey subsequent to year-end this
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issue arose and will have this potential
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future cost associated with it but we
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would not adjust the financial
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statements let's think about a specific
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case such as a warranty liability which
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you might view as an estimated liability
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or a contingent liability when goods are
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sold an estimate of the amount of the
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warranty costs to be incurred on the
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goods should be recorded as an expense
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with an offsetting credit to a warranty
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liability account as the warranty work
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is performed we're going to be crediting
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cash and debiting the warranty liability
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account this follows the matching
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principle such that we're recording
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expenses in the period of sale the
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actual work might be done in a
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subsequent year here's an example Zef
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company had a beginning of the year
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warranty liability account balance of
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25,000 during the years eff sold three
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million five hundred thousand dollars of
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goods and estimated that we would incur
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warranty cost equal to two percent of
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sales it's just an estimate
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actually that 80,000 warranty work
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during the year let's look at a
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t-account to analyze the effect of
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what's occurred for Zef first of all
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there's the $25,000 beginning balance in
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the warranty liability account we did
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sales of three million five and we
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provided two percent of sales or seventy
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thousand dollars as an additional
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accrual so we have ninety five thousand
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credits as we did the work credit cash
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to pay vendors and so forth for parts or
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whatever for the warranty work we're
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gonna offset that by debiting the
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warranty liability eighty thousand
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dollars and that will give rise to a
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fifteen thousand dollar ending balance
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for the estimated remaining liability at
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the end of the period here's the journal
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entries there's the sales debit cash
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credit sales three million five
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simultaneous with recording the sales
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will debit warranty expense and credit
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warranty liability that's two percent of
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sales and as the work is done throughout
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the period will credit cash and debit
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the warranty liability amount there are
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other costs that are similar to
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warranties these would include coupons
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prizes rebates airlines with their
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advantaged miles programs and so forth
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free hotel stays free rentals other
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items associated with sales activities
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all of these represent items that are
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deemed to be probable and subject to
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reasonable estimations they're estimated
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liabilities that broadly fall under the
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umbrella of contingent liabilities
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susceptible to accrual
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