A loss contingency that is probable and estimable should be recorded as an expense and a liability in the financial statements. Banks factor in expected loan defaults annually and adjust their financial records if actual defaults exceed expected levels, following GAAP.
To account for a loss contingency that is probable and the amount of loss is known or reasonably estimable, a business should record the estimated loss as an expense in its financial statements. This should also include a corresponding liability on the balance sheet. A well-run bank, like the example provided, would estimate and account for the risk of loan defaults annually.
For instance, if a bank anticipates loan defaults due to a recession, it would adjust its expense calculations and balance sheet to reflect the estimated loss. Should the actual defaults exceed estimations, it would further adjust its financial records to accommodate the higher level of loan default losses.
Therefore, recognizing the loss contingency promptly ensures that the financial statements present a fair view of the company's financial position, which is crucial for the users of these statements. Following generally accepted accounting principles (GAAP), if the bank experienced a wave of unexpected defaults which decreased the loan value significantly, reflecting this decrease is mandatory.