Commitments are the obligation to the external parties of the company which arises with respect to any legal contract made by the company with those external parties whereas the contingencies are the obligations of the company whose occurrence is dependent on the outcome of a specific future events.
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 filingsSEC FilingsSEC filings are formal documents submitted to the Securities and Exchange Commission in the United States that contain financial information about the company as well as any other relevant information about recent or upcoming activities., has included this lawsuit under the contingent liability section.
In this article, we discuss the nuts and bolts of Commitments and Contingencies.
- What are the Commitments?
- AK Steel Example – What do Commitments tell you?
- Facebook Example – What do Commitments tell you?
- 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 the 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 although they are still considered as liabilities of the companies. Nevertheless, the company has to disclose such commitments along with the nature, amount, and any unusual terms and conditions in the 10-K annual reportsAnnual ReportsAn annual report is a document that a corporation publishes for its internal and external stakeholders to describe the company's performance, financial information, and disclosures related to its operations. Over time, these reports have become legal and regulatory requirements. 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 expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year. commitment contracted but not yet incurred.
- Non-cancelable operating leases.
- Lease of property, land, facilities, or equipment.
- Unused letters of creditLetters Of CreditA letter of credit is a payment mechanism in which the issuer's bank gives an economic guarantee to the exporter for the agreed payment amount if the buyer defaults. In international trade, buyers employ LC to reduce credit risk. or obligation 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 disclose such transactions 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.
AK Steel Example – What do Commitments tell you?
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 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 they are presented in its financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.. 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 equipmentLeasing EquipmentEquipment Lease is where the equipment owner allows another party to use it in exchange of periodic rentals with no transfer of ownership and has the right to cancel the lease right away in case of breach of the lease agreement., and purchasing goods and services. AK Steel has given a piece of 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 complete information regarding its operating leases. Operating leasesOperating LeasesAn operating lease is a type of lease that allows one party (the lessee), to use an asset held by another party (the lessor) in exchange for rental payments that are less than the asset's economic rights for a particular period and without transferring any ownership rights at the end of the lease term. are the commitment to pay the future amount. However, it is not recorded as a liability. Instead, the company records it in the annual financial statement or 10-k reports’ footnotes. This disclosure includes items like 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 paymentsLease PaymentsLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration. for the lease period.
Source: AK Steel
Another example of commitment could be a decision of capital investmentCapital InvestmentCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc. that a company has contracted with the third party, but it hasn’t yet been incurred. For example, AK Steel commits the future capital investment of $42.5 million that it planned to incur in 2017. Although AK Steel has agreed, 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
Facebook Example – What do Commitments tell you?
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.
The 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 a 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. Let’s assume that a former employee sues a company 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, it will have to incur a liability of $100,000 in the future because the employee has won the lawsuits.
FASB has recognized several 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 three critical treatments that have to be taken care of 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 statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements. 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 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. At the time of preparing the balance sheet for 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 the company identifies a loss of $300,000 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 the 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 take place. The following example better illustrates the gain contingencies.
Company A files a lawsuit against company B, and company A thinks that it has a reasonable chance of winning the claims. Now, the 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 company A wins the claims and collects $270,000.
In this case, the gain contingencies are $270,000, which company A reports in its income statement at the end of year three. Here, I have taken $270,000 as again 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 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 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 expenseWarranty ExpenseWarranty expenses refers to those repair or replacement expense which are either expected to or already incurred by the company on the goods which have been sold by the company in the past and are still under the warranty period as provided by the company to its customers. 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 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 $500 for the dealers that undertake the repair work. Now, the manufacturer will have left the warranty liability of $1,500 for the new repair under the warranty period.
Why the disclosure of contingent liability remains important for companies?
We know that contingent liabilities are the future expensesContingent Liabilities Are The Future ExpensesContingent Liabilities are the potential liabilities of the company that may arise at some future date as a result of a contingent event that is beyond the company's control. that might incur. Hence, the risk associated with the contingent liabilities is high due to an increased frequency with which it occurs in 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. Besides, contingent liabilities might pose a different risk. For instance, a company may overstate its contingent liabilities, and by doing so, it might scare off investors, pay high interest on its credit, or remains hesitant to expand sufficiently due to fear of loss. Owing to these risks, the auditorsAuditorsAn auditor is a professional appointed by an enterprise for an independent analysis of their accounting records and financial statements. An auditor issues a report about the accuracy and reliability of financial statements based on the country's local operating laws. keep an eye on the undisclosed contingent liabilities and help the investors and creditors with 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 bonuses earned by employees across the company.
As per Foxnews.com, these plaintiffs are now seeking nearly $200 million in 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 fiscal 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 liabilityCurrent LiabilityCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc. 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 day-to-day life enter into contracts to run their business in the best possible manner. Thus, these contracts are considered as future obligations that do not necessarily qualify as liabilities. But, the organizations have to describe these contracts in the notes of the financial statements for accounting purposes. Whereas, contingencies are considered as potential liabilities that might occur due to past events. However, the likelihood of loss or the actual loss both remains uncertain.