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Commitments and Contingencies – A commitment is an obligation of a company to external entities that often arises in connection with the legal contracts executed by the company. Contingencies, however, are different from commitments. It is the implied obligation that is expected to take place depending on the outcome of the future event. Hence, one can say that contingencies are those obligations that may or may not become liabilities to the company because of the uncertainty of the future event.
As we see above from the snapshot, Facebook virtual reality division Oculus has been in a lawsuit due to allegations of violating the nondisclosure agreement, copyright infringement and more. Facebook in its SEC filings has included this lawsuit under the contingent liability section.
In this article, we discuss the nuts and bolts of Commitments and Contingencies.
- What are Commitments?
- What do Commitments tell you – AK Steel Example
- What do Commitments tell you – Facebook Example
- What are contingencies?
- Reporting contingencies
- Loss contingencies
- Gain contingencies
- Where is, a contingent liability recorded?
- Why the disclosure of contingent liability remains important?
- Whole Foods Market – Contingencies Example
- Facebook – Contingencies Example
What are Commitments?
A commitment is an obligation of a company to external entities that often arises in connection with the legal contracts executed by the company. In other words, commitments are potential claims against a company with respect to its future performance under a legal contract.
Therefore, one can say that the commitments are those agreements that are expected to take place in the future. However, if the company hasn’t made any payment for such contracts at the balance sheet date, they are not included on the balance sheet despite the fact that they are still considered as liabilities of the companies. Nevertheless, the company has to make disclosure of such commitments along with the nature, amount and any unusual terms and conditions in the 10-K annual reports or SEC filings. These agreements or contracts may include the following items.
- Short-term and long-term contractual obligations with the suppliers for future purchases.
- Capital expenditure commitment contracted but not yet incurred.
- Non-cancelable operating leases.
- Lease of property, land, facilities or equipment.
- Unused letters of credit or obligations to reduce debt.
Let us understand commitment through an example. Suppose a company plans to purchase raw material under a predetermined contract. But, as per the agreement the company will make payments for these raw materials only after these raw materials have been received. Although the company will require cash for these raw materials in the future, the event or transaction hasn’t yet occurred at the time of preparing the balance sheet. Hence, no amount is recorded either in the income statement or balance sheet.
However, the company is expected to make disclosure of such transaction as they are supposed to occur in the future and will impact its cash position. Therefore, the company provides an extensive explanation regarding these commitments in the notes to the financial statement.
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What do Commitments tell you – AK Steel Example
When such commitments are described in the notes to the financial statement, the investors and creditors will get to know that the company has taken a step and this step is likely to lead to a liability. Therefore, the information concerning future commitment remains critical for the analysts, lenders, shareholders, and investors because it provides a complete picture of a company’s current and future liabilities.
Now, let us take a real-life example of a firm and find out what are its current and future commitments and how are they presented in its financial statements. For instance, AK Steel (NYSE: AKS) has entered into various contracts that obligate the company to make legally enforceable payments. These agreements include borrowing money, leasing an equipment and purchasing goods and services. AK Steel has given a detailed information regarding these commitments as shown in the below graph.
Source: AK Steel
As you have seen in the above snapshot, AK Steel has given an extensive explanation regarding its future commitments or obligation in the notes of the financial statement. The most important point to observe here is that despite being the liabilities commitments are not shown on the balance sheet. It is because commitments need special treatment, and therefore, they are disclosed in the footnotes of the financial statements.
Likewise, AK Steel has given a complete information regarding its operating leases. Operating leases are the commitment to pay the future amount. However, it is not recorded as a liability. Instead, the company records it in the financial statement or 10-k annual reports’ footnotes. This disclosure includes items likes of the length of lease and expected yearly payments coupled with minimum lease payments over the entire term of the lease. The graph below illustrates AK Steel’s operating lease payments for the lease period.
Source: AK Steel
Another example of commitment could be a decision of capital investment that a company has contracted with the third party but it hasn’t been yet incurred. For example, AK Steel has a commitment for the future capital investment of $42.5 million that it plans to incur in 2017. Although AK Steel has entered into the agreement, it has not recorded the amount in the balance sheet in 2016, because it hasn’t yet incurred the investment. Still, it has given a note in the financial statement as shown below in the snapshot.
Source: AK Steel
What do Commitments tell you – Facebook Example
Facebook has primarily two types of Commitments.
#1 – Leases
Facebook has entered into various non-cancelable operating lease agreements for offices, data centers, facilities etc.
Operating lease expense commitment for 2017 is $277 million.
source: Facebook SEC Filings
#2 – Other contractual Commitments
Facebook has also entered into non-cancelable contractual payment commitments of $1.24 billion, related to network infrastructure and data center operations. These commitments are due within five years.
source: Facebook SEC Filings
As an analyst, it is important to make note of these commitments as they affect the cash position of the company.
What are contingencies?
Contingencies are different from commitments. It is the implied obligation that is expected to take place depending on the outcome of the future event. Hence, one can say that contingencies are those obligations that may or may not become liabilities to the company because of the uncertainty of the future event.
Let us understand contingencies by the following example. Assuming that a company is sued by a former employee for $100,000 because the employee feels that he has been terminated wrongly. So, does it mean that the company has liabilities of $100,000? Well, it depends on the outcome of this event. If the company justifies the termination of the employee it may not be a liability to the company. However, if the company fails to justify the termination of the employee it will have to incur a liability of $100,000 in the future because the employee has won the lawsuits.
FASB has recognized a number of examples of loss contingencies that are evaluated and reported in the same manner. These loss contingencies are as follows.
- The risk of loss or damage to property by fire, explosion, or other hazards.
- The threat of expropriation of assets.
- Actual or possible claims and assessments.
- Pending or threatened litigation.
- Obligation related to product warranties and product defects.
There are basic three critical treatments that have to be taken care while reporting contingencies. They are as follows.
- A loss contingency is not recorded in the balance sheet if it is not realized due to improbability. It means if the likely losses are not more than 50% or the amount is not a reliable measured, they are not recorded on the balance sheet. Meanwhile, the gain contingencies are usually reported in the income statement upon realization.
- A probable contingency can be defined as more than 50% due to a prior obligation.
- If a probable loss can be determined based on the historical information, then, it is considered a reliable measure.
Let us understand loss contingencies through an example. Assuming a company incurs a contingency at the end of year one. At that time the company believes that a loss of $300,000 is probable but a loss of $390,000 is reasonably possible. However, nothing has been settled at the end of year two. On the time of preparing the balance sheet for the year two, the company believes that a loss of $340,000 is probable but a loss of $430,000 is reasonably possible. Finally, at the end of the third year, the company pays $270,000 to the third party to settle the problem. Therefore, the company recognizes a gain of $70,000.
Now let us find out how this gain has been calculated. We know that a loss of $300,000 is identified by the company at the end of year one. I have taken $300,000 because it is a probable amount (more than 50%). However, the company expects to recognize an additional probable loss of $40,000 at the end of year two. Therefore, its total possible loss reported at the end of year two is now $340,000. But, at the end of third year, the company pays only $270,000 to the third party to settle the problem. Thus, it recognizes a gain of $70,000 ($340,000-$270,000).
There are times when companies can have gain contingencies. Yet, the reporting of gain contingencies is different from that of loss contingencies. In loss contingencies, losses are reported when they become probable whereas in gain contingencies the gain is delayed until they actually take place. The following example better illustrates the gain contingencies.
Company A files a lawsuit against the company B and company A thinks that it has a reasonable chance of winning the claims. Now, company’s An accountant believes that a gain of $300,000 is probable but a gain of $390,000 is reasonably possible. However, nothing is settled at the end of year two. Thus, its accountants again believe that an increase of $340,000 is probable but a gain of $430,000 is reasonably possible. Now, the contingencies get settled at the end of year three and the company A wins the claims and collects $270,000.
In this case the gain contingencies are $270,000, which the company A reports in its income statement at the end of year three. Here, I have taken $270,000 as a gain contingencies because it is the final amount at the end of the completion of the lawsuit. In gain contingencies, we do not include any amount in the income statement until a substantial completion is reached.
Where is, a contingent liability recorded?
A contingent liability, which is probable and the amount is easily estimated can be registered in both the income statement and balance sheet. In the income statement, it is recorded as an expense or loss and on the balance sheet, it is recorded in the current liability section. Due to this reason, a contingent liability is also known as a loss contingency. The typical examples of a contingent liabilities include warranties on the company’s product and services, unsettled taxes, and lawsuits.
In the case of product warranty liability, it is recorded at the time the product is sold. The customers can make claims under the warranty and the probable amount can be estimated. You can read the discussion of product warranties in the FASB’s financial accounting standards at FASB.
However, let us understand this through an example. An automobile manufacturer debits $2,000 for a car as a warranty expense once it is ready and credits warranty liabilities of $2,000 in the books of account when the car is sold. However, if a car needs a repair of $500 under the warranty, the manufacturer will now reduce the warranty liability by debiting the account for $500. In contrast, another account such as cash will be credited for the $500 for the dealers that undertake the repair work. Now, the manufacturer will have left the warranty liability of $1,500 for the new repairing under the warranty period.
Why the disclosure of contingent liability remains important for companies?
We know that contingent liabilities are the future expenses that might incur. Hence, the risk associated with the contingent liabilities is high due to an increased frequency with which it occurs in the day-to-day life. Therefore, the disclosure of contingent liability remains critical for credit rating agencies, investors, shareholders, and creditors because it exposes the hidden risks of the businesses. In addition, contingent liabilities might pose the different risk. For instance, a company may overstate its contingent liabilities and by doing so it might scare off investors, pay a high interest on its credit or remains hesitant to expand sufficiently due to fear of loss. Owing to these risks, the auditors keep an eye on the undisclosed contingent liabilities and help the investors and creditors with a transparent financial information.
Whole Foods Market – Contingencies Example
Now, let us take a real-life example of contingencies and their reporting in the balance sheet. Whole Foods Market (NASDAQ: WFM) for instance has recently been involved in the class-action lawsuits for its grocery chains. According to Chicago Tribune, Nine managers were fired by Whole Foods Market due to allegedly manipulating a bonus program. However, these managers filed a class-action lawsuit against Whole Foods Market for not paying bonus earned by employees across the company.
As per Foxnews.com, these plaintiffs are now seeking for nearly $200 million in the punitive damages, among other relief. However, WFM is investigating the issues raised by the accusers. Nevertheless, the company has established a loss provision for matters such as these. Although WFM has not shown the amount separately, it has included the loss liability in the other current liabilities in the balance sheet ending December 2016. A snapshot of the financial note for commitments and contingencies of Whole Foods Market is given below that discloses the detailed information regarding the probable liabilities.
Note – the issue pertaining to the termination of employees hasn’t yet resolved. Therefore, the company hasn’t included the probable loss liability in its balance sheet. In other words, the concerning issue for WFM might be a possible obligation, which is yet to confirm if the current liability could lead to an outflow of resources or presenting economic benefits such as gaining employee’s confidence, market presence etc.
Facebook – Contingencies Example
Among other contingencies listed in Facebook SEC Filing, the most important is related to Oculus VR inc. ZeniMax Media Inc sued Facebook for trade secret misappropriation, copyright infringement, break of contract, tortious interference with Contracts. ZeniMax was seeking actual damages of up to $2.0 billion, punitive damages of up to $4.0 billion. On Feb 1, 2017, when the verdict was announced, Facebook was asked to pay $500 million in aggregate.
source: Facebook SEC Filings
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Conclusion – Commitments and Contingencies
Organizations in the day-to-day life enter into contracts in order to run their business in the best possible manner. Thus, these contracts are considered as future obligations which do not necessarily qualify as liabilities. But, the organizations have to describe these contracts in the notes of the financial statements for the accounting purposes. Whereas, contingencies are considered as potential liabilities that might occur due to the past events. However, the likelihood of loss or the actual loss both remains uncertain.