It’s critical for business owners and managers to understand how to present contingent liabilities accurately in the financial statements. Under U.S. Generally Accepted Accounting Principles (GAAP), some contingent losses may be reported on the balance sheet and income statement, while others are only disclosed in the footnotes. Here’s an overview of the rules for properly identifying, measuring, and reporting contingencies to provide a fair and complete picture of your company’s financial position.

Likelihood vs. measurability

Under GAAP, contingent liabilities are governed by Accounting Standards Codification (ASC) Topic 450, Contingencies. It requires companies to recognize liabilities for contingencies when two conditions are met:

1. The contingent event is probable, and
2. The amount can be reasonably estimated.

If these criteria aren’t met but the event is reasonably possible, companies must disclose the nature of the contingency and the potential amount (or range of amounts). If the likelihood is remote, no disclosure is generally required unless required under another ASC topic. However, if a remote contingency is significant enough to potentially mislead financial statement users, the company may voluntarily disclose it.

Common examples

For instance, a company must estimate a contingent liability for pending litigation if the outcome is probable and the loss can be reasonably estimated. In such cases, the company must recognize a liability on the balance sheet and record an expense in the income statement. If the loss is reasonably possible but not probable, the company must disclose the nature of the litigation and the potential loss range. However, when disclosing contingencies related to pending litigation, it’s important to avoid revealing the company’s legal strategies. If the outcome is remote, no accrual or disclosure is required.

Other common types of contingent liabilities include:

Product warranties. If the company can reasonably estimate the cost of warranty claims based on historical data, it should record a warranty liability. Otherwise, it should disclose potential warranty obligations.

Environmental claims. Some businesses may face environmental obligations, particularly in the manufacturing, energy, and mining sectors. If cleanup is probable and measurable, a liability should be recorded. If the obligation is uncertain, the business should disclose it, describing the nature and extent of the potential liability.

 

Tax disputes. If a company is involved in a dispute with the IRS or state tax agency, it should assess whether it is likely to result in a payment and whether the amount can be estimated.

Under GAAP, companies are generally prohibited from recognizing gain contingencies in financial statements until they’re realized. These may involve potential benefits, such as the favorable outcome of a lawsuit or a tax rebate.

Transparency is essential in financial reporting. However, some companies may be reluctant to recognize contingent liabilities because they lower earnings and increase liabilities, potentially raising a red flag for stakeholders.

Best practices

To help ensure transparency when reporting contingencies, companies must maintain thorough records of all contingencies. Proper documentation may include contracts, legal filings, and communications with attorneys and regulatory bodies. Legal and financial advisors can provide insights into the likelihood of contingencies and help estimate potential losses.

As new information becomes available, management may need to reassess contingencies. For instance, if new evidence in a lawsuit makes a favorable outcome more likely, the financial statements may need to be updated in future accounting periods.

We can help

In today’s uncertain marketplace, accurate, timely reporting of contingencies helps business owners and other stakeholders manage potential risks and make informed financial decisions. Contact us for help categorizing contingencies based on likelihood and measurability and disclosing relevant information in a clear, concise manner.

 

Running a closely held business is challenging. Owners usually prioritize core business operations — such as managing employees, serving customers and bringing in new sales — over tedious bookkeeping tasks. Plus, the accounting rules can be overwhelming.

However, access to timely, accurate financial data is critical to your business’s success. Could applying outsourced bookkeeping tasks to a third-party provider be a smart business decision? Here are five reasons why the answer might be a resounding “Yes!”

1. Lower costs and scalability

Your company could hire a full-time bookkeeper, but the expenses of hiring an employee go beyond just his or her salary. You also need to factor in benefits, payroll taxes, office space, and equipment. It’s one more employee for you to manage — and accounting talent may be hard to find these days, especially for smaller companies. Plus, your access to financial data may be interrupted if your in-house bookkeeper takes sick or vacation time — or leaves your company.

With outsourced bookkeeping, you pay for only the services you need. Outsourcing firms offer scalable packages for these services that you can dial up (or down) based on the complexity of your business at any given time. Outsourcing also involves a team of bookkeeping professionals, so you have continuous access to bookkeeping services without worrying about staff absences or departures.

2. Enhanced accuracy

Do-it-yourself bookkeeping can be perilous. Mistakes in recording transactions can have serious consequences, including tax assessments, cash flow problems, and loan defaults.

Professional bookkeepers are trained to pay close attention to detail and follow best practices, minimizing the risk of errors. Outsourcing firms work with many companies and are aware of common pitfalls — and how to steer clear of them. They’re also familiar with the latest fraud schemes and can help your business detect anomalies and implement accounting procedures to minimize fraud risks.

3. Expanded access to expertise

The accounting rules and tax regulations continually change. It may be difficult for you or an in-house bookkeeper to stay updated.

With outsourcing, you have experienced professionals at your disposal who specialize in bookkeeping, accounting, and tax. This helps ensure you comply with the latest rules, accurately report financial results, and minimize taxes. In addition, as you encounter special circumstances, such as a sales tax audit or a merger, you can quickly call on other professionals at the same firm who can help manage the situation. If your provider lacks the necessary in-house expertise, the firm can refer you to another reputable professional to meet your special needs.

4. Improved timeliness

Timely financial data helps you identify problems before they spiral out of control — and opportunities you need to jump on before your competitors do. Outsourcing professionals typically use cloud-based platforms and set up automated processes for routine tasks, like invoicing and expense management. This improves efficiency and gives you access to real-time financial data to make better-informed decisions.

5. Reliable security protocols

Cyberattacks are a serious threat to any business. Stolen data can lead to monetary losses, operational downtime, and reputational damage.

Many business owners are understandably cautious about sharing financial data with third parties. Reputable outsourced bookkeeping providers use advanced security measures, encryption, and secure software to protect your financial data and client records from hackers. However, not all providers have the same level of security. So, it’s essential to carefully vet outsourcing firms to ensure that your company’s data is adequately protected.

Work smarter, not harder

At any given moment, business owners are being pulled in multiple directions by customers, employees, lenders, investors, and other stakeholders. Outsourcing your bookkeeping helps alleviate some of that stress by ensuring your financial records are up-to-date, accurate, and secure. Contact us for more information.

When reviewing their income statements, business owners tend to focus on profits (or losses). However, focusing solely on the bottom line can lead to mismanagement and missed opportunities. Instead, you should analyze this financial report from top to bottom for deeper insights.

Think like an auditor

Review your company’s income statement with an auditor’s mindset. External auditors are trained to have professional skepticism, ask questions continually and evaluate evidence without bias. They pay close attention to details and rely on data to identify risks and formulate evidence-based conclusions.
This approach can improve your knowledge of your company’s financial health and help you make more strategic decisions based on the key drivers of profitability — revenue and expenses. It can also help expose fraud and waste before they spiral out of control.

Start with revenue

Revenue (or sales) is the money generated from selling goods or services before any expenses are deducted. It’s the top line of your income statement.

Compare revenue for the current accounting period to the previous period and your budget. Has revenue grown, declined, or held steady? Did your company meet the sales goals you set at the beginning of the year? If not, investigate what happened. Perhaps management’s goals were unrealistic. Alternatively, the cause might relate to internal issues (such as the loss of a key salesperson or production delays) or external issues (such as the emergence of a new competitor or weak customer demand). Pinpointing the reasons behind lackluster sales is critical. View internal mistakes as opportunities to learn and improve performance in the future.

Evaluating revenue can be particularly challenging for cyclical or seasonal businesses. These businesses should compare results for one time period to those from the same period the previous year. Or they may need to look back more than just one year to evaluate revenue trends over an entire business cycle.

It also may be helpful to look at industry trends to gauge your business’s performance. If your industry is growing but your company is faltering, the cause is likely internal.

If your business offers more than one type of product or service, break down the composition of revenue to see what’s selling — and what’s not. Variances in sales composition over time may reveal changes in customer demand. This analysis can lead to modifications in marketing, sales, production and purchasing strategies.

Move on to cost of sales

The next line item on your company’s income statement is the cost of sales (or cost of goods sold). It includes direct labor, direct materials, and overhead. These are costs incurred to make products and provide services. The difference between revenue and cost of sales is your gross profit.

Look at how the components of cost of sales have changed as a percentage of revenue over time. The relationship between revenue and direct costs generally should be stable. Changes may relate to the cost of inputs or your company’s operations. For example, hourly wages might have increased over time due to inflation or regulatory changes. You might decide to counter increasing labor costs by purchasing automation equipment that makes your company less reliant on human capital or adding a shift to reduce overtime wages.

Changes in your revenue base can also affect cost of sales. For instance, if your company is doing more custom work than before, the components of direct costs as a percentage of revenue will likely differ from past results. Evaluating gross profit on a product or job basis can help you understand what’s most profitable so you can pivot to sell more high-margin items.

It’s also helpful to compare the components of your company’s cost of sales against industry benchmarks. This can help evaluate whether you’re operating as efficiently as possible. For instance, compute your company’s direct materials as a percentage of total revenue. If your ratio is significantly higher than the industry average, you might need to negotiate lower prices with suppliers or take steps to minimize waste and rework.

Monitor operating expenses

Operating expenses are ongoing costs related to running your business’s day-to-day operations. They’re necessary for a company to generate revenue but aren’t directly tied to producing goods or services. Examples of operating expenses include:

• Compensation for managers, salespeople, and administrative staff,
• Rent,
• Insurance,
• Office supplies,
• Facilities maintenance and utilities,
• Advertising and marketing,
• Professional fees,
• Travel and entertainment, and
• Depreciation and amortization.

Many operating expenses are fixed over the short run. That is, they aren’t affected by changes in revenue. For instance, rent and the marketing director’s salary usually don’t vary based on revenue. Compare the total amount spent on fixed costs in the current accounting period to the amount spent in the previous period. Auditors review individual operating expenses line by line and inquire about any change that’s, say, greater than $10,000 or 10% of the cost from the prior period. This approach can help you ask targeted questions to find the root causes of significant cost increases and make improvements.

To illustrate, let’s say your company’s maintenance costs increased by 20% this year. After further investigation, you might discover that you incurred significant, nonrecurring charges to clean up and repair damages from a major storm — or maybe you discover that your payables clerk is colluding with a friend who works at the landscaping company to bilk your company for excessive fees. You won’t know the reason for a cost increase without digging into the details like an auditor would.

Use the income statement as a management tool

Your company’s income statement contains valuable information if you take the time to review it thoroughly. Adopting an auditor’s mindset can help business owners identify trends quickly, detect problems and anomalies early, and make better-informed decisions. Contact us for help interpreting your company’s historical results and using them to improve its future performance.