Do You Know what a Gain Contingency is?

Most people are aware of loss contingencies, where a company writes down a portion of an asset when there is a likelihood that a loss will occur. Some companies have insurance policies to protect from loss, others take the write down. A loss contingency is used is to account for invoices that may not be collectible. You can see this pretty regularly as an Allowance for Bad Debt. The loss hasn’t occurred yet, but history shows that it is likely.

There is a flip side of the coin that is rarely talked about - the gain contingency. This is a situation where a company is likely to gain money in the future. Lawsuits are an example of a gain contingency, where a company can reasonably expect to be awarded a judgement in the future for an action taken today. 

So how does a company account for the possibility that it may benefit if a certain event happens or fails to happen in the future? Accounting standards apply the conservatism principle which states a company should recognize expenses and liabilities as soon as possible when there is uncertainty about the outcome. With revenue and assets, the company should only recognize the event when it is assured of it being received. Thus, when given a choice between several outcomes where the probabilities of occurrence are equally likely, it should recognize that transaction resulting in the lower amount of profit, or at least the deferral of a profit. Similarly, if a choice of outcomes with similar probabilities of occurrence will impact the value of an asset, recognize the transaction resulting in a lower recorded asset valuation.

This means that a company that anticipates a windfall in the future, must wait for the event to actually occur before recording it in its accounting system. In order to err on the side of conservatism or lower profit, the company must have cash in hand. At that point, it is moot talking about the possibility of a gain as a contingency. It is strictly recognized as new revenue. The money received is entered in as Other Revenue on the income statement, with a description of where it was earned.

Unlike a loss contingency where a company would account for a portion of the loss as soon as they expected it; the company can inform lenders and investors about a potential gain by disclosing it in the notes section of the financial statements. Most companies only disclose amounts that are significant and hedge against giving the reader misleading statements about the amount or likelihood of the gain.

 

One of the reasons that a company may disclose gain contingencies is to give investors important information about potential additional revenue. The decision to report a gain contingency is determined by the company only. Most companies make this decision when they are confident the gain contingency will become a reality.