EBITDA and Other Scary Words: Scary Words No.10 - Commitments and Contingencies
In our last installment, we learned all about Accrued Expenses: that accrued expenses are necessary when your business incurs costs, but your vendor has not yet sent an invoice.
Today, we explore a lesser-known topic: Commitments and Contingencies
What Is that Strange Line on the Balance Sheet?
Many balance sheets have a line called “Commitments and Contingencies” between the liability and equity sections. The strange part is there are no dollar amounts listed.
So, what the heck are commitments and contingencies?
Let’s start with the first one – commitments. We all have commitments. Some of them are easy—like promising to call your grandmother on her birthday or committing to a diet.
What type of commitment do you list on a financial statement? A car lease or an office lease are examples of commitments. Another example is a contract to purchase equipment or inventory in the future.
Commitments get special treatment. Even though there will be a future payment (like when you record a liability), commitments do not show up on the balance sheet as a liability.
Instead, commitments get disclosed in the footnotes.
Example: Our bar, which provides us many fun nights, also gives us an endless supply of accounting references. For this article, we’ll dig into some of the more common commitments and contingencies.
The most significant commitment is a lease for the building. It is a five-year lease at $1,000 per month, plus we have to pay the real estate taxes, utilities and maintenance.
This is known as an “NNN” or “triple net lease,” since we must pay the real estate taxes (net 1), utilities (net 2) and maintenance (net 3).
The lease is a commitment to pay future amounts. Yet, as mentioned above, it is not recorded as a liability. Instead, we disclose it in the financial statement footnotes. This disclosure includes significant items, such as the length of the lease and required monthly payments—along with minimum lease payments over the entire term of the lease.
All of this information is important to the reader of a financial statement because it gives a complete picture of the company’s current and future commitments.
Contingencies can be included on the balance sheet as a liability if certain requirements are met. First, the likelihood of a loss or claim has to be greater than 50%. Second, the amount of loss must be reasonably determinable.
Example: A few weeks ago, a customer allegedly slipped in the parking lot and sued the bar for $50,000 to cover medical expenses and pain and suffering.
So far, we only have a letter and single phone call from the customer’s attorney, which we forwarded to our attorney and our insurance company. The likelihood of a loss (and the amount of potential loss) on this matter is impossible to determine at this point in time. The pending claim should be disclosed but an accrual for the liability is not needed yet since an amount cannot be determined.
Consider this second incident: A customer cut their hand on a broken beer bottle last year. After a full year of legal fighting, we finally decided to settle for $10,000. The likelihood of the loss was greater than 50% (we have an accepted settlement offer) and the amount of the loss can be reasonable estimated (the settlement is for $10,000).
In this case, an accrual for the $10,000 settlement should be recorded on the balance sheet. A footnote disclosure will briefly describe the settlement.
That Time We Put a Craft Brewery in Our Basement
The bar has been shifting away from the macro brewers, such as Budweiser and Coors, and expanding into craft beers.
To take advantage of this, we placed a small brewery in the basement. We began producing our own line of craft beers called EBITDA Brewing and our flagship beer is Busy Season IPA. We mainly sell the beer at our bar, but we do distribute some in our region.
We’re proud of our beer, and we include a guarantee or warranty on every bottle that the beer will taste fresh for at least six months—or the customer can get their money back.
Our product warranty is a contingency.
Just like our loss contingency above, if the possibility of loss is greater than 50% and the amount of loss can be estimated, we would record a liability. In our case, there have been no warranty claims over the past few years. We do not anticipate any future losses, so we only provide a footnote explaining that the warranty exists.
Commitments and contingencies may only be a few words on the balance sheet, but they are still an important component of the financial statements. They give a reader a more complete view of the company’s financial strength and are important when considering the future performance of a company.
"This article originally appeared on Financial Poise and is reprinted here with permission."
- EBITDA and Other Scary Words: What Did They Just Say?
- Scary Word No. 1 – GAAP
- Scary Word No. 2 – Financial Statements
- Scary Word No. 3 – Cash
- Scary Word No. 4 – Accounts Receivable
- Scary Word No. 5 – Inventory
- Scary Word No. 6 – PP&E
- Scary Word No. 7 - 'Intangible' Assets
- Scary Word No. 8 - Accounts Payable
- Scary Word No. 9 - Accrued Expenses
- Scary Word No. 10 - Commitments and Contingencies
- Scary Word No. 11 - Debt, Collateral, Covenants, Guarantees and More
- Scary Word No. 12 - "The Deferreds"
- Scary Word No. 13 - "Equity"