Contingent Liability Definition, Why to Record

A contingency occurs when a current situation
has an outcome that is unknown or uncertain and will not be
resolved until a future point in time. A contingent liability can
produce a future debt or negative obligation for the company. Some
examples of contingent liabilities include pending litigation
(legal action), warranties, customer insurance claims, and
bankruptcy. GAAP accounting rules require probable contingent liabilities—ones that can be estimated and are likely to occur—to be recorded in financial statements.

To simplify our example, we concentrate strictly on
the journal entries for the warranty expense recognition and the
application of the warranty repair pool. If the company sells 500
goals in 2019 and 5% need to be repaired, then 25 goals will be
repaired at an average cost of $200. The average cost of $200 × 25
goals gives an anticipated future repair cost of $5,000 for 2019. Assume for the sake of our example that in 2020 Sierra Sports made
repairs that cost $2,800.

For a financial figure to be reasonably
estimated, it could be based on past experience or industry
standards (see
Figure 12.9). It does not make any sense to immediately realize a contingent liability – immediate realization signifies the financial obligation has occurred with certainty. A “medium probability” contingency is one that satisfies either, but not both, of the parameters of a high probability contingency. These liabilities must be disclosed in the footnotes of the financial statements if either of the two criteria is true. Even if the outcome is based on the probability of occurrence of the event, it is considered an actual liability. The impact of contingent liability can also hamper a company’s ability to take debt from the market as creditors become more stringent before lending capital due to the uncertainty of the liability.

FASB Statement of Financial Accounting Standards No. 5 requires any obscure, confusing or misleading contingent liabilities to be disclosed until the offending quality is no longer present. Let’s say a mobile phone manufacturer produces many mobiles and sells them with a brand warranty of 1 year. The basic nature of contingent liability is important to know, recognize, and understand. Grant Gullekson is a CPA with over a decade of experience working with small owner/operated corporations, entrepreneurs, and tradespeople. He specializes in transitioning traditional bookkeeping into an efficient online platform that makes preparing financial statements and filing tax returns a breeze. In his freetime, you’ll find Grant hiking and sailing in beautiful British Columbia.

• These liabilities are categorized as being likely to occur and estimable, likely to occur but not estimable, or not likely to occur.
• 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.
• IAS 37 defines and specifies the accounting for and disclosure of provisions, contingent liabilities, and contingent assets.
• On 26 June 2023 the ISSB issued its inaugural standards—IFRS S1 and IFRS S2—ushering in a new era of sustainability-related disclosures in capital markets worldwide.
• If the lawyer and the company decide that the lawsuit is frivolous, there won’t be any need to provide a disclosure to the public.

If the lawyer and the company decide that the lawsuit is frivolous, there won’t be any need to provide a disclosure to the public. As the name suggests, if there are very slight chances of the liability occurring, the US GAAP considers calling it a remote contingency. The full disclosure principle states that all necessary information that poses an impact on the financial strength of the company must be registered in the public filings. A great example of the application of prudence would be recognizing anticipated bad debts. Prudence can be helpful if certain liabilities might occur but aren’t certain; here contingent liabilities. When determining if the contingent liability should be
recognized, there are four potential treatments to consider.

Translations of the updated educational material on applying IFRSs to climate-related matters

A contingent liability threatens to reduce the company’s assets and net profitability and, thus, comes with the potential to negatively impact the financial performance and health of a company. Therefore, such circumstances or situations must be disclosed in a company’s financial statements, per the full disclosure principle. Contingent assets are possible assets whose existence will be confirmed by the occurrence or non-occurrence of uncertain future events that are not wholly within the control of the entity. Contingent assets are not recognised, but they are disclosed when it is more likely than not that an inflow of benefits will occur. However, when the inflow of benefits is virtually certain an asset is recognised in the statement of financial position, because that asset is no longer considered to be contingent. A contingent liability is a potential liability that may occur in the future, such as pending lawsuits or honoring product warranties.

• Both represent possible losses to the company, and both depend on some uncertain future event.
• Contingent liabilities are liabilities that may occur if a future event happens.
• International accounting standards focus on recording a liability at the midpoint of the estimated unfavorable outcomes.
• Only the contingent liabilities that are the most probable can be recognized as a liability on financial statements.
• Within the generally accepted accounting principles (GAAP) there are three main categories of contingent liabilities.

This means that a loss would be recorded (debit) and a liability established (credit) in advance of the settlement. If the contingent liability is probable and
inestimable, it is likely to occur but cannot be
reasonably estimated. In this case, a note disclosure is required
in financial statements, but a journal entry and financial
recognition should not occur until a reasonable estimate is
possible. If a contingent liability is deemed probable, it must be directly reported in the financial statements. Nevertheless, generally accepted accounting principles, or GAAP, only require contingencies to be recorded as unspecified expenses. Now assume that a lawsuit liability is possible but not probable and the dollar amount is estimated to be $2 million.

The Materiality Principle

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. Generally accepted accounting principles (GAAP) require contingent liabilities that can be estimated and are more likely to occur to be recorded in a company’s financial statements. A contingent liability is a potential obligation that may arise from an event that has not yet occurred. Instead, only disclose the existence of the contingent liability, unless the possibility of payment is remote.

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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 likelihood of loss is described as probable, reasonably possible, or remote.

A contingent liability is a liability that may occur depending on the outcome of an uncertain future event. A contingent liability has to be recorded if the contingency is likely and the amount of the liability can be reasonably estimated. Both generally accepted accounting principles (GAAP) and what is the cost of sales International Financial Reporting Standards (IFRS) require companies to record contingent liabilities. In accounting, contingent liabilities are liabilities that may be incurred by an entity depending on the outcome of an uncertain future event[1] such as the outcome of a pending lawsuit.

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Since this warranty expense allocation will probably be carried
on for many years, adjustments in the estimated warranty expenses
can be made to reflect actual experiences. Also, sales for 2020,
2021, 2022, and all subsequent years will need to reflect the same
types of journal entries for their sales. In essence, as long as
Sierra Sports sells the goals or other equipment and provides a
warranty, it will need to account for the warranty expenses in a
manner similar to the one we demonstrated.

Educational material on applying IFRSs to climate-related matters updated

A noteworthy agenda decision revolves around the accounting treatment of a deposit made to tax authorities. In the scenario discussed by the IFRS Interpretations Committee, an entity, confident about winning a dispute with tax authorities, pays the disputed amount as a deposit to avert penalties if it loses. Upon resolution, the deposit will either be refunded to the entity (if it wins) or offset against the obligation (if it loses). The Committee concluded that this deposit constitutes an asset, and the entity isn’t required to be virtually certain of a favourable outcome to recognise it (as opposed to expensing this amount). The deposit ensures future economic benefits, either through a cash refund or settling the liability. Nonetheless, this agenda decision shouldn’t be generalised to regular legal proceedings where, facing an adverse verdict, an entity doesn’t retain any assets.

If the liability is likely to occur and the amount can be reasonably estimated, the liability should be recorded in the accounting records of a firm. Contingent liabilities must pass two thresholds before they can be reported in financial statements. If the value can be estimated, the liability must have more than a 50% chance of being realized.

A contingent liability is an existing condition or set of circumstances involving uncertainty regarding possible business loss, according to guidelines from the Financial Accounting Standards Board (FASB). In the Statement of Financial Accounting Standards No. 5, it says that a firm must distinguish between losses that are probable, reasonably probable or remote. There are strict and sometimes vague disclosure requirements for companies claiming contingent liabilities.

There are sometimes significant risks that are simply not in the liability section of the balance sheet. Most recognized contingencies are those meeting the rather strict criteria of “probable” and “reasonably estimable.” One exception occurs for contingencies assumed in a business acquisition. The measurement requirement refers to the
company’s ability to reasonably estimate the amount of loss. Even
though a reasonable estimate is the company’s best guess, it should
not be a frivolous number.