Contingent Liability: What Is It, and What Are Some Examples?

This liability is not required to be recorded in the books of accounts, but a disclosure might be preferred. Contingent Liabilities must be recorded if the contingency is deemed probable and the expected loss can be reasonably estimated. Therefore, contingent liabilities—as implied by the name—are conditional on the occurrence of a specified outcome.

Any contingent liabilities that are questionable before their value can be determined should be disclosed in the footnotes to the financial statements. For example, a customer files a lawsuit against a business, claiming that its product broke, causing $500,000 of damage. The organization’s attorney believes that the customer will win in court, and believes that the firm will have to pay the full $500,000.

IAS 12 — Accounting for uncertainties in income taxes

If the firm manufactures 1,000 bicycle seats in a year and offers a warranty per seat, the firm needs to estimate the number of seats that may be returned under warranty each year. Any probable contingency needs to be reflected in the financial statements—no exceptions. Possible contingencies—those that are neither probable nor remote—should be disclosed in the footnotes of the financial statements. A possible contingency is when the event might or might not happen, but the chances are less than that of a probable contingency, i.e., less than 50%.

Estimation of contingent liabilities is another vague application of accounting standards. Under GAAP, the listed amount must be «fair and reasonable» to avoid misleading investors, lenders, or regulators. Estimating the costs of litigation or any liabilities resulting from legal action should be carefully noted. Future costs are expensed first, and then a liability account is credited based on the nature of the liability. In the event the liability is realized, the actual expense is credited from cash and the original liability account is similarly debited. Even if the outcome is based on the probability of occurrence of the event, it is considered an actual liability.

What Are Contingent Liabilities in Accounting?

If the lawsuit results in a loss, a debit is applied to the accrued account (deduction) and cash is credited (reduced) by $2 million. Let’s say a mobile phone manufacturer produces many mobiles and sells them with a brand warranty https://www.bookkeeping-reviews.com/how-to-calculate-taxable-income/ of 1 year. The accrual account enables the company to record expenses without requiring an immediate cash payment. If the case is unsuccessful, $5 million in cash is credited (reduced), and the accruing account is debited.

These liabilities are not recorded in a company’s accounts and shown in the balance sheet when both probable and reasonably estimable as ‘contingency’ or ‘worst case’ financial outcome. A footnote to the balance sheet may describe the nature and extent of the contingent liabilities. The ability to estimate a loss is described as known, reasonably estimable, or not reasonably estimable. Contingent liabilities are those that are likely to be realized if specific events occur. These liabilities are categorized as being likely to occur and estimable, likely to occur but not estimable, or not likely to occur.

These assets are only recorded in financial statements’ footnotes as their value cannot be reasonably estimated. Any liabilities that have a probability of occurring over 50% are categorized under probable contingencies. A Contingent Liability is a possible liability or a potential loss that may or may not occur based on the result of an unexpected future event or circumstance. These liabilities will get recorded if the liability has a reasonable probability of occurrence.

Contingent liabilities are classified into three types by the US GAAP based on the probability of their occurrence. Historical data often serves as the precedent by which the percentage assumption is set, i.e. to estimate the future liability incurred for purposes of internal planning. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. The business is exempt from disclosing the possible liability if it considers that the risk of it happening is remote.

There are strict and sometimes vague disclosure requirements for companies claiming contingent liabilities. Such contingency is neither recorded on the financial statements nor disclosed to the investors by the management. This shows us that the probability of occurrence of such an event is less than that of a possible contingency. Disclose the existence of a contingent liability in the notes accompanying the financial statements if the liability is reasonably possible but not probable, or if the liability is probable, but you cannot estimate the amount.

1. These assets are only recorded in financial statements’ footnotes as their value cannot be reasonably estimated.
2. Disclose the existence of a contingent liability in the notes accompanying the financial statements if the liability is reasonably possible but not probable, or if the liability is probable, but you cannot estimate the amount.
3. So the mobile manufacturer will record a contingent liability in the P&L statement and the balance sheet, an amount at which the 2,000 mobile phones were made.
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If only one of the conditions is met, the liability must be disclosed in the footnotes section of the financial statements to abide by the full disclosure principle of accrual accounting. The journal entry for a contingent liability—as illustrated below—is a credit entry to the contingent warranty liability account and a debit entry to the warranty expense account. If the contingency is deemed probable with a reasonably estimated amount, it is recorded in a financial statement. However, suppose neither of those conditions can be met—then, the contingent liability could be inserted in the footnote of a financial statement (or leftover if immaterial). A warranty is another common contingent liability because the number of products returned under a warranty is unknown. Assume, for example, that a bike manufacturer offers a three-year warranty on bicycle seats, which cost $50 each.

Reporting Requirements of Contingent Liabilities and GAAP Compliance

Since it has the potential to affect the company’s Cash flow and net income negatively, one has to take important steps to decide the impact of these contingencies. As this concept hovers around ambiguity and uncertainty about the amount of money one should set aside for the expense, here are two questions one must ask before accounting for any potential unforeseen obligation. As it depends on the probability of the occurrence of that specific circumstance, that probability can vary according to one’s judgment. Hence, contingent liabilities carry much uncertainty and risk to each side of the parties involved until resolved on a future date.

Under these circumstances, the company discloses the contingent liability in the footnotes of the financial statements. If the firm determines that the likelihood of the liability occurring is remote, the company does not need to disclose the potential liability. Assume that a company is facing a lawsuit from a rival firm for patent infringement. The company’s how to calculate the ending inventory legal department thinks that the rival firm has a strong case, and the business estimates a $2 million loss if the firm loses the case. Because the liability is both probable and easy to estimate, the firm posts an accounting entry on the balance sheet to debit (increase) legal expenses for $2 million and to credit (increase) accrued expense for $2 million.

Contingent liabilities are shown as liabilities on the balance sheet and as expenses on the income statement. Working through the vagaries of contingent accounting is sometimes challenging and inexact. Company management should consult experts or research prior accounting cases before making determinations. In the event of an audit, the company must be able to explain and defend its contingent accounting decisions.

Contingent liabilities that are likely to occur but cannot be estimated should be included in a financial statement’s footnotes. Remote (not likely) contingent liabilities are not to be included in any financial statement. Record a contingent liability when it is probable that a loss will occur, and you can reasonably estimate the amount of the loss. If you can only estimate a range of possible amounts, then record that amount in the range that appears to be a better estimate than any other amount; if no amount is better, then record the lowest amount in the range. You should also describe the liability in the footnotes that accompany the financial statements.

The accounting of contingent liabilities is a very subjective topic and requires sound professional judgment. Contingent liabilities can be a tricky concept for a company’s management, as well as for investors. Judicious use of a wide variety of techniques for the valuation of liabilities and risk weighting may be required in large companies with multiple lines of business. As a general guideline, the impact of contingent liabilities on cash flow should be incorporated in a financial model if the probability of the contingent liability turning into an actual liability is greater than 50%. In some cases, an analyst might show two scenarios in a financial model, one which incorporates the cash flow impact of contingent liabilities and another which does not. Like accrued liabilities and provisions, contingent liabilities are liabilities that may occur if a future event happens.