For an item or event to be considered to be material, it means that having knowledge of it occurring could change certain economic decisions for those that use the company’s financial statements. A loss contingency that is remote will not be recorded and it will not have to be disclosed in the notes to the financial statements. An example is a nuisance lawsuit where there is no similar case that was ever successful. The reason is that the event (“the injury itself”) giving rise to the loss arose in Year 1.
On the other hand, if it is only reasonably possible that the contingent liability will become a real liability, then a note to the financial statements is required. Likewise, a note is required when it is probable a loss has occurred but the amount simply cannot be estimated. Normally, accounting tends to be very conservative (when in doubt, book the liability), but this is not the case for contingent liabilities.
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. Let’s expand our discussion and add a brief example of the calculation and application of warranty expenses.
- 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.
- At the end of the year, the accounts are adjusted for the actual warranty expense incurred.
- 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.
- 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%.
For our purposes, assume that Sierra Sports has a line of soccer goals that sell for $800, and the company anticipates selling 500 goals this year (2019). Past experience for the goals that the company has sold is that 5% of them will need to be repaired under their three-year warranty program, and the cost of the average repair is $200. 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.
Two Financial Accounting Standards Board (FASB) Requirements for Recognition of a Contingent Liability
The income statement and balance sheet are typically impacted by contingent liabilities. 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.
Conversely, if the injury occurred in Year 2, Year 1’s financial statements would not be adjusted no matter how bad the financial effect. However, a note to the financial statements may be needed to explain that a material adverse event arising subsequent to year end has occurred. What about business decision risks, like deciding to reduce insurance coverage because of the high cost of the insurance premiums?
- Google, a subsidiary of Alphabet Inc., has expanded from a search engine to a global brand with a variety of product and service offerings.
- 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.
- According to the FASB, if there is a probable liability determination before the preparation of financial statements has occurred, there is a likelihood of occurrence, and the liability must be disclosed and recognized.
Do not confuse these “firm specific” contingent liabilities with general business risks. General business risks include the risk of war, storms, and the like that are presumed to be an unfortunate part of life for which no specific accounting can be made in advance. These are questions businesses must ask themselves when exploring contingencies and their effect on liabilities. Possible contingent liabilities include loss from damage to property or employees; most companies carry many types of insurance, so these liabilities are normally expressed in terms of insurance costs. 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.
Check for Disclosures in the Footnotes
The following examples show recognition of Warranty Expense on the income statement (Figure) and Warranty Liability on the balance sheet (Figure) for Sierra Sports. The following examples show recognition of Warranty Expense on the income statement Figure 12.10 and Warranty Liability on the balance sheet Figure 12.11 for Sierra Sports. Contingent liabilities adversely impact a company’s assets and net profitability. Companies operating in the United States rely on the guidelines established in the generally accepted accounting principles (GAAP). Under GAAP, a contingent liability is defined as any potential future loss that depends on a “triggering event” to turn into an actual expense.
Amendments under consideration by the IASB
Therefore, one should carefully read the notes to the financial statements before investing or loaning money to a company. If the contingent liability is considered remote, it is unlikely to occur and may or may not be estimable. This does not meet the likelihood requirement, and the possibility of actualization is minimal. In this situation, no journal entry or note disclosure in financial statements is necessary. 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.
For a contingent liability to become relevant, it depends on its timing, its value can be estimated or is known, and whether or not it will become an actual liability. An example might be a hazardous waste spill that will require a large outlay to clean up. It is probable that funds will be spent and the amount can likely be estimated. If the estimated loss can only be defined as a range of outcomes, the U.S. approach generally results in recording the low end of the range. International accounting standards focus on recording a liability at the midpoint of the estimated unfavorable outcomes. A contingent liability is not recognised in the statement of financial position.
IAS 37 — Provisions, Contingent Liabilities and Contingent Assets
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. Contingent assets are assets that are likely to materialize if certain events arise.
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. A contingent liability is a specific type of liability that could happen based on the outcome of an uncertain future event.
When damages have been determined, or have been reasonably estimated, then journalizing would be appropriate. According to the FASB, if there is a probable liability determination before the preparation of financial what are the three main valuation methodologies statements has occurred, there is a likelihood of occurrence, and the liability must be disclosed and recognized. This financial recognition and disclosure are recognized in the current financial statements.
While this is true for all facets of your business, it’s crucial when starting a new contract. In order to safeguard your company’s finances and reputation, you must take both existing and potential obligations into consideration when you engage into a contract. When determining if the contingent liability should be recognized, there are four potential treatments to consider. Banks that issue standby letters of credit or similar obligations carry contingent liabilities. All creditors, not just banks, carry contingent liabilities equal to the amount of receivables on their books.