What Are Commitments and Contingencies in Accounting?

In accounting, commitments and contingencies are future obligations and potential losses that a company faces but that don’t fit neatly onto the balance sheet as ordinary liabilities. A commitment is a binding contract for a future transaction whose existence is certain, such as a signed multi-year purchase agreement. A contingency is a potential loss whose existence depends on something that hasn’t happened yet, such as a pending lawsuit. Under U.S. GAAP, the two travel different paths: commitments are generally disclosed in the footnotes, while contingencies are accrued as liabilities, disclosed, or ignored depending on how likely the loss is and whether the amount can be estimated.

How Commitments Differ From Contingencies

The dividing line is certainty about the obligation itself, not certainty about the amount or the timing.

A commitment is already locked in. The company has signed the agreement and knows what it owes and to whom. A ten-year contract to buy raw materials at a fixed price is a commitment. Cash will flow; the only open question is when.

A contingency is different because whether an obligation exists at all is still unresolved. A pending lawsuit might cost the company nothing or millions, and no one will know until the case ends. The accounting standards define a loss contingency as an existing condition involving uncertainty about a possible loss that will be resolved when one or more future events occur or fail to occur.¹

Two separate standards govern them. ASC Topic 440 addresses commitments and focuses on disclosure of executory contracts. ASC Topic 450 sets the probability-based framework that decides whether a contingent loss appears on the balance sheet, in the footnotes, or nowhere at all.

The Three Probability Levels for Loss Contingencies

ASC 450 sorts every loss contingency into one of three probability buckets, and each one triggers a different accounting response. The classification is the most consequential judgment management makes about a contingency.

Probable. The future event is likely to occur. SFAS 5 defines this as “likely to occur,” which is generally interpreted in practice as roughly a 70 percent or greater likelihood. A probable loss must be accrued on the balance sheet if the amount can be reasonably estimated.¹
Reasonably possible. The chance of loss is more than remote but less than likely. These contingencies are never accrued, but they require footnote disclosure describing the nature of the exposure and an estimate of the potential loss or range of loss.
Remote. The chance of loss is slight. Remote contingencies generally require no disclosure, with limited exceptions for certain guarantees.

The standard sets no numerical thresholds. SFAS 5 left the definitions qualitative on purpose, which means management must exercise judgment on every contingency, often leaning heavily on outside legal counsel for litigation matters.¹

When to Accrue a Loss and How Much

Accrual requires two conditions at once: the loss must be probable, and the amount must be reasonably estimable. If a loss is probable but the company genuinely cannot estimate what it will cost, nothing is accrued. The contingency is disclosed in the footnotes with an explanation that an estimate cannot be determined.²

Estimating a Range

Loss estimates rarely land on a single number. When management identifies a range of outcomes and no amount within the range is a better estimate than any other, the company accrues the minimum of the range. If the probable loss falls between $2 million and $8 million and no single figure is more likely, the recorded liability is $2 million.² The footnotes must then disclose the full range so readers see the exposure above the accrued amount.

If management can point to a best estimate within the range, that specific amount is accrued instead of the minimum. The minimum-of-the-range rule is a fallback, not the default.

Insurance Recoveries

Companies facing a probable loss often expect to recover part of it from an insurance carrier. Netting the expected recovery against the accrued loss is a common mistake. The loss liability is measured on its own, and if recovery is considered probable, the company records a separate receivable rather than reducing the loss accrual. The receivable cannot exceed the total loss recognized, and management must consider whether an allowance for uncollectibility is needed based on the insurer’s ability to pay.

Any expected recovery that exceeds the loss is treated as a gain contingency, which has a higher recognition bar. When the recovery claim itself is in litigation, there is a rebuttable presumption that realization is not probable, so the receivable typically waits until the dispute resolves.

Why Gains Are Treated Differently

Potential gains follow a stricter rule than potential losses. Gain contingencies are not recognized until they are realized or realizable. Even a favorable lawsuit where the company expects to collect damages stays off the income statement until the proceeds arrive or the remaining uncertainties are substantially resolved.¹

The asymmetry is deliberate. Recognizing a gain too early risks misleading readers into thinking revenue has been earned when the outcome is still uncertain. A gain contingency may be disclosed in the footnotes if realization looks likely, but the wording has to avoid suggesting the gain is a done deal.

How Commitments Are Reported

Commitments arise from executory contracts, where neither party has yet fully performed. A company that signs a five-year agreement to buy components at a fixed price has a commitment, but no liability is recorded until the supplier actually delivers goods. No economic resources have been received, and no obligation to pay has been triggered.

Off the balance sheet does not mean unimportant. A company locked into billions of dollars of future purchase obligations has a very different risk profile from one with flexible procurement, and the accounting response is disclosure rather than recognition. Common commitments include non-cancelable purchase obligations for fixed quantities, authorized capital expenditures not yet incurred, take-or-pay contracts with suppliers, and agreements to maintain minimum working capital or restrict dividends.

Lease Commitments and ASC 842

Leases used to be one of the largest categories of off-balance sheet commitments. ASC Topic 842 changed that by requiring both operating and finance leases to be recognized on the balance sheet, unlike the prior standard, which only put capital leases there.³ Companies now record a right-of-use asset and a corresponding lease liability for virtually all leases with terms exceeding twelve months. The footnote schedules of future lease payments remain important because analysts use them to model liquidity and compare leverage across firms with different lease structures.

Guarantees

Guarantees are a distinct category that overlaps with both commitments and contingencies. ASC Topic 460 requires a guarantor to recognize a liability at the inception of a guarantee, measured initially at fair value, even when the likelihood of ever having to perform is remote.

For a guarantee issued in a standalone transaction, the fair value liability typically equals the premium received. When a guarantee is bundled into a larger transaction, the company estimates what premium it would charge to issue the same guarantee on its own.²

Product warranties are the notable exception. Warranties tied to the functional performance of a product the buyer owns fall outside ASC 460’s initial recognition requirements and follow the general loss contingency model under ASC 450. A manufacturer estimates warranty costs at the time of sale using historical claims data, records the full estimated expense against revenue in the same period, and credits a warranty liability. Later claims reduce the liability instead of hitting the income statement again.

What the Footnotes Must Say

The footnotes carry the information the balance sheet cannot show, and the SEC has made clear that vague or boilerplate language does not satisfy the disclosure standards.

Loss Contingencies

Any loss contingency classified as reasonably possible requires footnote disclosure covering the nature of the contingency and an estimate of the potential loss or range of loss. If management cannot make a reasonable estimate, the footnotes must say so explicitly.² Probable losses that have been accrued still require disclosure explaining the nature and circumstances of the accrual.

The SEC staff has pushed back on companies whose litigation disclosures are generic. Comment letters have reminded registrants that when there is at least a reasonable possibility of a loss exceeding amounts already recognized, the company must disclose an estimate of the additional loss or range, or affirmatively state that an estimate cannot be made.⁴ Simply saying “the outcome cannot be predicted” is not enough.

Commitments

Material commitments require footnote disclosure covering the nature, term, and amount of the obligation. For unconditional purchase obligations that meet certain criteria, the disclosure must include the fixed and determinable portion of the obligation for each of the five fiscal years following the balance sheet date, along with the nature of any variable components and the amounts actually purchased under the obligation for each income statement period presented. Analysts use these schedules to calculate the present value of a company’s total commitments, and adding that figure to recorded debt gives a fuller picture of long-term leverage than the balance sheet alone.

GAAP vs. IFRS

Companies that report under IFRS follow IAS 37 instead of ASC 450, and several differences can produce materially different financial statements for identical facts.

Probability threshold. Under IFRS, “probable” means “more likely than not,” which is greater than 50 percent. U.S. GAAP interprets “probable” as “likely to occur,” generally understood as roughly 70 percent or higher. More contingencies qualify for balance sheet recognition under IFRS.⁵¹
Range measurement. When each amount in a range is equally likely, U.S. GAAP records the minimum. IFRS records the midpoint. For a range of $2 million to $10 million, U.S. GAAP accrues $2 million; IFRS accrues $6 million.
Discounting. U.S. GAAP generally does not require loss contingencies to be discounted. IFRS requires provisions to be measured at present value when the time value of money is material, using a pretax discount rate.
Onerous contracts. IFRS requires a provision when a contract becomes onerous, meaning the unavoidable costs of fulfilling it exceed the expected economic benefits. U.S. GAAP has no general onerous contract rule, though narrow guidance exists in specific areas such as leases.

A contingency that sits only in the footnotes under U.S. GAAP may appear as a recognized liability under IFRS, affecting reported equity, leverage ratios, and net income. That gap is worth keeping in mind whenever financial statements from different reporting regimes are being compared side by side.

1
Financial Accounting Standards Board. Statement of Financial Accounting Standards No. 5
2
Financial Accounting Standards Board. Contingencies Topic 450 – Disclosure of Certain Loss Contingencies
3
Financial Accounting Standards Board. Leases
4
U.S. Securities and Exchange Commission. CORRESP – AU Optronics Corp
5
IFRS Foundation. IAS 37 Provisions, Contingent Liabilities and Contingent Assets