Contingent Liability Definition, Why to Record

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. 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. This ensures that income or assets are not overstated, and expenses or liabilities are not understated. Review each of the transactions and prepare any necessary journal entries for each situation.

Here, the company should rely on precedent and legal counsel to ascertain the likelihood of damages. 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. Another fantastic example of contingent liability would be product warranties. Let’s say a mobile phone manufacturer produces many mobiles and sells them with a brand warranty of 1 year.

Similarly, the guidance in ASC 460 on accounting for guarantee liabilities, which has existed for two decades, is often difficult to apply because the determination of whether an arrangement constitutes a guarantee is complex. The accrual account permits the firm to immediately post an expense without the need for an immediate cash payment. If the lawsuit results in a loss, a debit is applied to the accrued account (deduction) and cash is credited (reduced) by $2 million. If a court is likely to rule in favor of the plaintiff, whether because there is strong evidence of wrongdoing or some other factor, the company should report a contingent liability equal to probable damages. Contingent liabilities are liabilities that depend on the outcome of an uncertain event.

Contingent liabilities are possible obligations whose existence will be confirmed by uncertain future events that are not wholly within the control of the entity. An example is litigation against the entity when it is uncertain whether the entity has committed an act of wrongdoing and when it is not probable that settlement will be needed. If the contingency is reasonably possible, it could occur but is not probable. Since this condition does not meet the requirement of likelihood, it should not be journalized or financially represented within the financial statements. Rather, it is disclosed in the notes only with any available details, financial or otherwise.

3 Define and Apply Accounting Treatment for Contingent Liabilities

Pending lawsuits and product warranties are common contingent liability examples because their outcomes are uncertain. The accounting rules for reporting a contingent liability differ depending on the estimated dollar amount of the liability and the likelihood of the event occurring. The accounting rules ensure that financial statement readers receive sufficient information.

  • The accounting rules ensure that financial statement readers receive sufficient information.
  • Warranties arise from products or services sold to customers that cover certain defects (see Figure 12.8).
  • Liabilities are related to the financial obligations or debts that a person or a company has to another entity.
  • A contingent liability that is expected to be settled in the near future is more likely to impact a company’s share price than one that is not expected to be settled for several years.
  • The determination of whether a contingency is probable is based on the judgment of auditors and management in both situations.

Sometimes contingent liabilities can arise suddenly and be completely unforeseen. The $4.3 billion liability for Volkswagen related to its 2015 emissions scandal is one such contingent liability example. A contingent liability that is expected to be settled in the near future is more likely to impact a company’s share price than one that is not expected to be settled for several years. Often, the longer the span of time it takes for a contingent liability to be settled, the less likely that it will become an actual liability. Any case with an ambiguous chance of success should be noted in the financial statements but do not need to be listed on the balance sheet as a liability. Even if the outcome is based on the probability of occurrence of the event, it is considered an actual 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. Although contingent liabilities are necessarily estimates, they only exist where it is probable that some amount predetermined overhead rate of payment will be made. This is why they need to be reported via accounting procedures, and why they are regarded as “real” liabilities. An estimated liability is certain to occur—so, an amount is always entered into the accounts even if the precise amount is not known at the time of data entry.

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Contingent liabilities are recorded if the contingency is likely and the amount of the liability can be reasonably estimated. The liability may be disclosed in a footnote on the financial statements unless both conditions are not met. The key principle established by the Standard is that a provision should be recognised only when there is a liability i.e. a present obligation resulting from past events. 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.

What Is Important to Know About Contingent Liability?

Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Let’s say that the manufacturer has estimated that out of all the mobile phones produced, about 2,000 mobiles would be called back due to fault reasons. Possible contingencies are just disclosed to the investors by the management during the Annual general meetings (AGMs). This can help encourage clarity between the company’s shareholders and investors and reduce any potential con activities. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.

Is it good or bad to have a contingency on books of accounts?

Modeling contingent liabilities can be a tricky concept due to the level of subjectivity involved. The opinions of analysts are divided in relation to modeling contingent liabilities. The business is exempt from disclosing the possible liability if it considers that the risk of it happening is remote. An example of this principle is when a $ 100 invoice to a company with net assets of $ 5 billion would be immaterial, but a $ 50 million invoice to the same company would be materialistic.

Plus, the impact they could have will also depend on how sound the company is in its financial obligations. Examples of contingent liabilities are the outcome of a lawsuit, a government investigation, and the threat of expropriation. An entity recognises a provision if it is probable that an outflow of cash or other economic resources will be required to settle the provision. IAS 37 defines and specifies the accounting for and disclosure of provisions, contingent liabilities, and contingent assets. It does not make any sense to immediately realize a contingent liability – immediate realization signifies the financial obligation has occurred with certainty. The accounting of contingent liabilities is a very subjective topic and requires sound professional judgment.

Integrated Reporting

(Figure)Emperor Pool Services provides pool cleaning and maintenance services to residential clients. Review each of the transactions, and prepare any necessary journal entries for each situation. 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. The IFRS Foundation is a not-for-profit, public interest organisation established to develop high-quality, understandable, enforceable and globally accepted accounting and sustainability disclosure standards. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

This type of liability only gets recorded if the contingency is a possibility, and also if the total amount of the potential liability is reasonably and accurately estimated. 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.

You should also describe the liability in the footnotes that accompany the financial statements. (Figure)Roundhouse Tools has several potential warranty claims as a result of damaged tool kits. While a contingency may be positive or negative, we only focus on outcomes that may produce a liability for the company (negative outcome), since these might lead to adjustments in the financial statements in certain cases. Positive contingencies do not require or allow the same types of adjustments to the company’s financial statements as do negative contingencies, since accounting standards do not permit positive contingencies to be recorded. Now assume that a lawsuit liability is possible but not probable and the dollar amount is estimated to be $2 million.

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