Updated July 20, 2023
Definition of Commitments and Contingencies
Commitment is the promise made by the company to the outside parties due to contract or legal obligations whereas contingencies are the obligations of the company the occurrence of which depends upon the happening or non-happening of uncertain future events hence contingency may or may not result in an outflow of funds.
A business organization has to fulfill certain contracts and obligations to survive in the industry and to run the business smoothly. The contracts or obligations are said to be commitments for business organization and which are certain in nature i.e., they result in an inflow of outflow of fund irrespective of other events. There are also some uncertain events the occurrence of which may result in an outflow of funds and that events are termed as contingencies. Contingencies are uncertain in nature and depend upon the happening or non-happening of uncertain events that are future-based. Commitments are the future obligations which has to fulfill and they are independent from any other business event. Contingencies may or may not result in the liabilities as they are future based.
Example of Commitment and Contingency
ABC Ltd. Entered into a transaction with XYZ Ltd. for purchase of goods and payment will be made after 3 months and for this ABC Ltd. Signed the contract of the above transactions with XYZ Ltd. The transaction between ABC Ltd and XYZ Ltd is said to be commitment.
Another Example of commitment: ABC Ltd. took loan from XYZ Ltd. at the interest rate of 4% p.a. for 5 years and agreed to pay the monthly instalment consisting of principle and interest. Hence ABC Ltd. has to pay to XYZ Ltd without considering the fact whether ABC Ltd is actually earning from applying those funds taken on loan. The payment is independent and does not change or canceled due to any other transactions. Hence the above agreement is termed as commitment.
Whereas contingency means payment which is not certain and depends upon the future event. The example of contingency is XYZ Ltd filed a suit against ABC Ltd for damaging the goodwill by selling at the price lower than the market price and to attract the customers and demanded the compensation for the same. The outflow of compensation depends on whether ABC Ltd. Will win the suit or loss the suit. Hence the above arrangement is termed as a contingency as it is not certain whether ABC Ltd. Will win or loss.
Commitment and Contingencies (GAAP)
As per Generally accepted accounting principles commitments are to be recorded as and when occurs whereas the contingencies are recorded in notes to balance sheet if the contingency is related to outflow of the funds. The commitments which does not belongs to the reporting period are to be shown as foot notes in the balance sheet. All commitments and contingencies are to be disclosed in footnotes so as to make the clear picture and to comply with the accounting principles and disclosure requirements.
Company is supposed to enter into lease is the example of commitments which the company is required to disclosed in the footnotes as the transactions does not occur and if there is chances of cancellation of lease agreement and for this company is required to pay penalty as per penalty clause of agreement is the type of contingency and if the amount is ascertainable then the amount of contingency is to be disclosed.
Commitment and Contingencies (IFRS)
IFRS 37 related to commitments and contingencies the main objective is to set the principal globally. According to IFRS commitments are to be recorded as liability if it occurs in the reporting period as well as in notes so as to inform that organization is efficiently completing the commitments. The details like nature, timing and extent of commitment and the causes if commitment is not fulfilled is to be disclosed in the notes.
IFRS excludes commitment related to financial instruments, insurance contracts or construction contracts. According to IFRS the contingencies whether it results in inflow or outflow of funds are to be disclosed in the notes to the accounts. If the amount of contingency is measurable then the amount is also to be disclosed.
Commitment and Contingencies Notes to Financial Statements
Commitments if not relate to the reporting period are to be disclosed by way of notes to Financial Statements. The following are the things that are required to disclosed in notes to accounts.
- Short and long term contractual commitments for future purchases.
- Capital or Revenue expenses commitments.
- Lease commitments.
- Guarantees given as guarantors.
- Other contractual obligations.
- Amount involved in all of the above.
Following are the things required to disclosed in the notes related to contingencies:
- Nature of Contingency.
- Chances of Occurrence.
- Amount involved if it is measurable.
- Case pending with the court.
Advantages of Commitment and Contingencies
Following are the advantages :
- Gives more transparent disclosures.
- Results in gaining the faith of stakeholders.
- Attracts the investors as the investors may access from the future transactions about the profitability of the company.
- Disclosure requirements leads to comply with the legal norms.
Conclusion
Commitments and Contingencies are the terms used in the presentation of financial statements. Commitment refers to the contractual obligations which are certain and independent in nature. If the commitments relates to the reporting period they needs to disclosed in the balance sheet as liabilities and if commitments does not belong to the reporting period they needs to disclosed in notes to accounts. There are accounting standards and disclosure requirements as per generally accepted accounting principles which needs to be complied.
Contingencies are the events the occurrence of which depends upon the happening or non-happening of uncertain future events. They are dependent in nature. Contingencies are to be disclosed in the disclosures after the balance sheet. The amount of contingencies if measurable also to be disclosed. The major difference between commitments and contingencies is commitment is the certain obligation non fulfillment of which results into a penalty. And contingency is the uncertain event which may or may not become the obligation for the organization.
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