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Reporting Requirements of Contingent Liabilities and GAAP Compliance

The Reporting Requirements of Contingent Liabilities

Contingent liabilities are liabilities that depend on the outcome of an uncertain event. These obligations are likely to become liabilities in the future.

Contingent liabilities must pass two thresholds before they can be reported in financial statements . First, it must be possible to estimate the value of the contingent liability. If the value can be estimated, the liability must have more than a 50% chance of being realized. Qualifying contingent liabilities are recorded as an expense on the income statement and a liability on the balance sheet.

If the contingent loss is remote, meaning it has less than a 50% chance of occurring, the liability should not be reflected on the balance sheet. Any contingent liabilities that are questionable before their value can be determined should be disclosed in the footnotes to the financial statements.

Key Takeaways

• Contingent liabilities are obligations that will become liabilities if certain events occur in the future.
• To be a contingent liability, it must be possible to estimate its value and have more than a 50% chance of being realized. 
• Journal entries are recorded for contingent liabilities, with a credit to the accrued liability account and a debit to the liability-related expense account.
• There are three GAAP-specified categories of contingent liabilities: probable, possible, and remote, each with different compliance guidelines.
• GAAP requires contingent liabilities that are likely to occur and can be reasonably estimated to be recorded in financial statements.

Two classic examples of contingent liabilities include a company warranty and a lawsuit against the company. Both represent possible losses to the company, and both depend on some uncertain future event.

Suppose a lawsuit is filed against a company, and the plaintiff claims damages up to $250,000. It's impossible to know whether the company should report a contingent liability of $250,000 based solely on this information. Here, the company should rely on precedent and legal counsel to ascertain the likelihood of damages.

Contingent assets are assets that are likely to materialize if certain events arise. These assets are only recorded in financial statements' footnotes as their value cannot be reasonably estimated.

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. This is true even if the company has liability insurance .

If the lawsuit is frivolous, there may be no need for disclosure. 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.

A business accounting journal is used to record all business transactions. Each business transaction is recorded using the double-entry accounting method, with a credit entry to one account and a debit entry to another. Contingent liabilities, although not yet realized, are recorded as journal entries.

Contingent liabilities require a credit to the accrued liability account and a debit to an expense account. Once the obligation is realized, the balance sheet's liability account is debited and the cash account is credited. Also, an entry is made in the associated expense of the income statement.

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.

It's important that shareholders and lenders be warned about possible losses—an otherwise sound investment might look foolish after an undisclosed contingent liability is realized.

There are three GAAP-specified categories of contingent liabilities: probable, possible, and remote. Probable contingencies are likely to occur and can be reasonably estimated. Possible contingencies do not have a more-likely-than-not chance of being realized but are not necessarily considered unlikely either. Remote contingencies aren't likely to occur and aren't reasonably possible.

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.

Any probable contingency needs to be reflected in the financial statements—no exceptions. Remote contingencies should never be included. Possible contingencies—those that are neither probable nor remote—should be disclosed in the footnotes of the financial statements.

What Are the GAAP Accounting Rules for Contingent Liabilities?

GAAP accounting rules require probable contingent liabilities—ones that can be estimated and are likely to occur—to be recorded in financial statements. 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.

What Are Contingent Liabilities in Accounting?

Like accrued liabilities and provisions , contingent liabilities are liabilities that may occur if a future event happens.

What Is the Journal Entry for Contingent Liabilities?

For contingent liabilities, a credit is made to the accrued liability account and a debit is made to the debt's expense account.

Where Are Contingent Liabilities Shown on the Financial Statement?

Contingent liabilities are shown as liabilities on the balance sheet and as expenses on the income statement.

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.

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Contingent Liability

Potential future liability dependent on uncertain events or outcomes

Austin has been working with Ernst & Young for over four years, starting as a senior consultant before being promoted to a manager. At EY, he focuses on strategy, process and operations improvement, and business transformation consulting services focused on health provider, payer, and public health organizations. Austin specializes in the health industry but supports clients across multiple industries.

Austin has a Bachelor of Science in Engineering and a Masters of Business Administration in Strategy, Management and Organization, both from the University of Michigan.

Osman started his career as an investment banking analyst at Thomas Weisel Partners where he spent just over two years before moving into a growth equity investing role at  Scale Venture Partners , focused on technology. He's currently a VP at KCK Group, the private equity arm of a middle eastern family office. Osman has a generalist industry focus on lower middle market growth equity and buyout transactions.

Osman holds a Bachelor of Science in Computer Science from the University of Southern California and a Master of Business Administration with concentrations in Finance, Entrepreneurship, and Economics from the University of Chicago Booth School of Business.

What Is a Contingent Liability?

• Why Are Contingent Liabilities Recorded?
• Classifications Of Contingent Liabilities
• Examples Of Contingent Liabilities
• Applicability Of Contingent Liabilities In Investing
• Difference Between Types Of Liabilities

Contingent Liability FAQs

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.

A contingent liability can be very challenging to articulate in monetary terms. As it depends on the probability of the occurrence of that specific circumstance, that probability can vary according to one's judgment. 

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.

• Is the probability of the occurrence of that event over 50% or more?
• Can we express it in monetary figures?

If any potential liability surpasses the above two provided conditions, we can record the event in the books of accounts. Some examples of such liabilities would be product warranties, lawsuits, bank guarantees, and changes in government policies.

When the probability of such an event is extremely low, it is allowed to omit the entry in the books of accounts, and disclosure is also not required. It can be recorded only if estimation is possible; otherwise, disclosure is necessary.

This type of liability is not similar to an actual liability like a debt obligation or accounts payable owed by the business. Instead, such liabilities are typically associated with liabilities that are difficult to predict.

The most common examples of items considered contingent liabilities are:

• Product Warranties
• Shareholder guarantees
• Letter of credit issued
• Guarantees issued by a company
• Natural disasters
• Fines imposed on the pharmaceutical sector
• Investigations on a company
• Change in government policies
• Foreign exchange transactions

One can always depict this type of liability on the company’s financial statements if there are any. It is disclosed in the footnotes of the financial statements as they have an enormous impact on the company’s financial conditions. 

According to the US Generally Accepted Accounting Principles(US GAAP), these liabilities are separated into three sections:

• Probable liability
• Possible liability
• Remote liability

Key Takeaways

• Contingent liability refers to a potential future liability or loss that may or may not occur due to unexpected events or circumstances, and it is recorded if there is a reasonable probability of occurrence.
• Assessing contingent liabilities can be challenging as they depend on uncertain probabilities and may not be easily expressed in monetary terms.
• Two critical questions to ask before accounting for a contingent liability are: Is the probability of occurrence over 50%? Can it be expressed in monetary figures?
• Examples of contingent liabilities include product warranties, lawsuits, guarantees, natural disasters, and changes in government policies.
• Contingent liabilities are classified into three categories based on probability: Probable, Possible, and Remote, each with different accounting treatment and disclosure requirements.

Why are Contingent Liabilities recorded?

First, we need to get hold of three basic accounting principles. Three accounting principles are associated with why contingent liabilities are recorded.

They are as follows:

1. Principle of Prudence

The principle of prudence is a crucial principle that states that a company must not record future anticipated gains into the books of accounts, but any expected losses must be accounted for. 

This ensures that income or assets are not overstated, and expenses or liabilities are not understated.

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.

2. Principle of materiality

The principle of materiality states that all items with some monetary value must be accounted into the books of accounts. Items can be considered to have a monetary value if their inclusion or exclusion has an impact on the business.

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.

Also, materiality would vary from organization to organization as all organizations aren’t of the same size. A $ 10,000 invoice would be material to one organization but immaterial to another.

3. Principle of full disclosure

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 .

Statements that have a material impact on the company’s operations or any decisions must be disclosed

This principle plays an important role in ensuring reduced information asymmetry between the shareholders and the management. This can help investors make informed decisions.

This can help encourage clarity between the company's shareholders and investors and reduce any potential con activities.

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Classifications of Contingent Liabilities

Contingent liabilities are classified into three types by the US GAAP based on the probability of their occurrence.

They are explained in detail below:

1. Probable Contingencies

Any liabilities that have a probability of occurring over 50% are categorized under probable contingencies. These liabilities must be reflected in the company's financial statements .

Here the principle of prudence and materiality is always applied. For example, when a company is fighting a legal battle and the opposite party has a stronger case, and the probability of losing is above 50%, it must be recorded in the books of accounts.

However, if there is more than a 50% chance of winning the case, according to the prudence principle, no benefits would be recorded on the books of accounts.

2. Possible Contingencies

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%. This liability is not required to be recorded in the books of accounts, but a disclosure might be preferred.

Possible contingency is not recorded in the books of accounts because it is very difficult to articulate the liability in monetary terms due to its limited occurrence.

Possible contingencies are just disclosed to the investors by the management during the Annual general meetings (AGMs) .

3. Remote Contingencies

As the name suggests, if there are very slight chances of the liability occurring, the US GAAP considers calling it a remote contingency.

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.

The most common example of a remote contingency would be a frivolous lawsuit. 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.

Examples of Contingent liabilities

These obligations result from previous transactions or occurrences, and they are contingent on future events and indeterminate in nature.

We will examine some examples of contingent liabilities that firms could experience and how they might affect financial reporting and decision-making below:

Imagine a business being sued for copyright infringement by a rival business. The business projects a $5 million loss if the firm loses the case, but the legal department of the business believes the rival firm has a strong case.

The company sets an accounting entry to debit (increase) legal expenses for $5 million and credit (raise) accrued expenses for $5 million on the balance sheet because the liability is probable and simple to estimate.

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.

Let's assume that the litigation would likely cost $5 million and would be feasible but not likely.

In this situation, the corporation discloses the contingent liability in the financial statements' footnotes.

The business is exempt from disclosing the possible liability if it considers that the risk of it happening is remote.

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.

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.

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.

Applicability of Contingent liabilities in investing

Contingent liabilities greatly impact one’s decision-making purposes. 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.

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. If the liability arises, it would negatively impact the company’s ability to repay debt.

These liabilities can harm the company's stock price because contingent liabilities can negatively impact the business's future profitability. The magnitude of the impact depends on the time of occurrence and the amount tied to the liability.

The soundness of the company's finances will also have an impact. The liability won't significantly affect the stock price if investors believe the company has strong and stable cash flows and can withstand the damage.

Contingent liabilities are inherently unknown. Determining and quantifying their exact influence on a company's stock price is impossible.

Even if it appears likely that the contingent obligation may become an actual liability, investors may choose to invest in the firm if they believe the company is in such sound financial standing that any losses resulting from the contingent liability would be easily absorbable.

A great example of the incorporation of analysis of contingent liabilities in our investments is given below:

• An investor considers purchasing a stock having huge potential for upside in the stock’s price. The company fundamentals also seem very promising. But the investor has only one concern. 
• The company has a contingent liability recorded in the financial statements, and the liability is of a massive amount and can decrease the price by over 30% of its current value.
• Now, the investor can be in a dilemma whether to invest in the stock, as it has huge upside potentials, but the liability can also push the stock price downwards.

Difference Between Types of Liabilities

Liabilities are related to the financial obligations or debts that a person or a company has to another entity. There are numerous different categories of liabilities, each with special characteristics and implications for the creditor and debtor.

Understanding how different categories of responsibilities differ is necessary for managing financial risks and making well-informed financial decisions. Below is a table that differentiates between the three types of liabilities:

Contingent liabilities are recorded on the P&L statement and the balance sheet if the probability of occurrence is more than 50%.

Contingent liabilities aren’t current liabilities . One major difference between the two is that the latter is an amount you already owe someone, whereas the former is contingent upon the event occurring.

The nature of contingent liability is important for deciding whether it is good or bad. Not all contingencies are necessarily bad for a company.

Even if the outcome is based on the probability of occurrence of the event, it is considered an actual liability. But it will be recorded in the books only if the probability is more than 50%.

Although it is not realized in the books of accounts, a contingent liability is credited to the accrued liabilities account in the journal.

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12.3 Define and Apply Accounting Treatment for Contingent Liabilities

What happens if your business anticipates incurring a loss or debt? Do you need to report this if you are uncertain it will occur? What if you know the loss or debt will occur but it has not happened yet? Do you have to report this event now, or in the future? These are questions businesses must ask themselves when exploring contingencies and their effect on 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. The outcome could be positive or negative. 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.

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.

Pending litigation involves legal claims against the business that may be resolved at a future point in time. The outcome of the lawsuit has yet to be determined but could have negative future impact on the business.

Warranties arise from products or services sold to customers that cover certain defects (see Figure 12.8 ). It is unclear if a customer will need to use a warranty, and when, but this is a possibility for each product or service sold that includes a warranty. The same idea applies to insurance claims (car, life, and fire, for example), and bankruptcy. There is an uncertainty that a claim will transpire, or bankruptcy will occur. If the contingencies do occur, it may still be uncertain when they will come to fruition, or the financial implications.

The answer to whether or not uncertainties must be reported comes from Financial Accounting Standards Board (FASB) pronouncements.

Two Financial Accounting Standards Board (FASB) Requirements for Recognition of a Contingent Liability

There are two requirements for contingent liability recognition:

• There is a likelihood of occurrence.
• Measurement of the occurrence is classified as either estimable or inestimable.

Application of Likelihood of Occurrence Requirement

Let’s explore the likelihood of occurrence requirement in more detail.

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. This financial recognition and disclosure are recognized in the current financial statements. The income statement and balance sheet are typically impacted by contingent liabilities.

For example, Sierra Sports has a one-year warranty on part repairs and replacements for a soccer goal they sell. The warranty is good for one year. Sierra Sports notices that some of its soccer goals have rusted screws that require replacement, but they have already sold goals with this problem to customers. There is a probability that someone who purchased the soccer goal may bring it in to have the screws replaced. Not only does the contingent liability meet the probability requirement, it also meets the measurement requirement.

Application of Measurement Requirement

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. For a financial figure to be reasonably estimated, it could be based on past experience or industry standards (see Figure 12.9 ). It could also be determined by the potential future, known financial outcome.

Let’s continue to use Sierra Sports’ soccer goal warranty as our example. If the warranties are honored, the company should know how much each screw costs, labor cost required, time commitment, and any overhead costs incurred. This amount could be a reasonable estimate for the parts repair cost per soccer goal. Since not all warranties may be honored (warranty expired), the company needs to make a reasonable determination for the amount of honored warranties to get a more accurate figure.

Another way to establish the warranty liability could be an estimation of honored warranties as a percentage of sales. In this instance, Sierra could estimate warranty claims at 10% of its soccer goal sales.

When determining if the contingent liability should be recognized, there are four potential treatments to consider.

Let’s expand our discussion and add a brief example of the calculation and application of warranty expenses. To begin, in many ways a warranty expense works similarly to the bad debt expense concept covered in Accounting for Receivables in that the anticipated expense is determined by examining past period expense experiences and then basing the current expense on current sales data. Also, as with bad debts, the warranty repairs typically are made in an accounting period sometimes months or even years after the initial sale of the product, which means that we need to estimate future costs to comply with the revenue recognition and matching principles of generally accepted accounting principles (GAAP).

Some industries have such a large number of transactions and a vast data bank of past warranty claims that they have an easier time estimating potential warranty claims, while other companies have a harder time estimating future claims. In our case, we make assumptions about Sierra Sports and build our discussion on the estimated experiences.

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. Following are the necessary journal entries to record the expense in 2019 and the repairs in 2020. The resources used in the warranty repair work could have included several options, such as parts and labor, but to keep it simple we allocated all of the expenses to repair parts inventory. Since the company’s inventory of supply parts (an asset) went down by $2,800, the reduction is reflected with a credit entry to repair parts inventory. First, following is the necessary journal entry to record the expense in 2019.

Next, here is the journal entry to record the repairs in 2020.

Before we finish, we need to address one more issue. Our example only covered the warranty expenses anticipated from the 2019 sales. Since the company has a three-year warranty, and it estimated repair costs of $5,000 for the goals sold in 2019, there is still a balance of $2,200 left from the original $5,000. However, its actual experiences could be more, the same, or less than $2,200. If it is determined that too much is being set aside in the allowance, then future annual warranty expenses can be adjusted downward. If it is determined that not enough is being accumulated, then the warranty expense allowance can be increased.

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.

Think It Through

Product recalls: contingent liabilities.

Consider the following scenario: A hoverboard is a self-balancing scooter that uses body position and weight transfer to control the device. Hoverboards use a lithium-ion battery pack, which was found to overheat causing an increased risk for the product to catch fire or explode. Several people were badly injured from these fires and explosions. As a result, a recall was issued in mid-2016 on most hoverboard models. Customers were asked to return the product to the original point of sale (the retailer). Retailers were required to accept returns and provide repair when available. In some cases, retailers were held accountable by consumers, and not the manufacturer of the hoverboards. You are the retailer in this situation and must decide if the hoverboard scenario creates any contingent liabilities. If so, what are the contingent liabilities? Do the conditions meet FASB requirements for contingent liability reporting? Which of the four possible treatments are best suited for the potential liabilities identified? Are there any journal entries or note disclosures necessary?

Four Potential Treatments for Contingent Liabilities

If the contingency is probable and estimable , it is likely to occur and can be reasonably estimated. In this case, the liability and associated expense must be journalized and included in the current period’s financial statements (balance sheet and income statement) along with note disclosures explaining the reason for recognition. The note disclosures are a GAAP requirement pertaining to the full disclosure principle, as detailed in Analyzing and Recording Transactions .

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 the contingency is reasonably possible , it could occur but is not probable. The amount may or may not be estimable. 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.

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.

Link to Learning

Google , a subsidiary of Alphabet Inc. , has expanded from a search engine to a global brand with a variety of product and service offerings. Like many other companies, contingent liabilities are carried on Google ’s balance sheet, report expenses related to these contingencies on its income statement, and note disclosures are provided to explain its contingent liability treatments. Check out Google ’s contingent liability considerations in this press release for Alphabet Inc.’s First Quarter 2017 Results to see a financial statement package, including note disclosures.

Let’s review some contingent liability treatment examples as they relate to our fictitious company, Sierra Sports.

Probable and Estimable

If Sierra Sports determines the cost of the soccer goal screws are $30, the labor requirement is one hour at a rate of $40 per hour, and there is no extra overhead applied, then the total estimated warranty repair cost would be $70 per goal: $30 + (1 hour × $40 per hour). Sierra Sports sold ten goals before it discovered the rusty screw issue. The company believes that only six of those goals will have their warranties honored, based on past experience. This means Sierra will incur a warranty liability of $420 ($70 × 6 goals). The $420 is considered probable and estimable and is recorded in Warranty Liability and Warranty Expense accounts during the period of discovery (current period).

An example of determining a warranty liability based on a percentage of sales follows. The sales price per soccer goal is $1,200, and Sierra Sports believes 10% of sales will result in honored warranties. The company would record this warranty liability of $120 ($1,200 × 10%) to Warranty Liability and Warranty Expense accounts.

When the warranty is honored, this would reduce the Warranty Liability account and decrease the asset used for repair (Parts: Screws account) or Cash, if applicable. The recognition would happen as soon as the warranty is honored. This first entry shown is to recognize honored warranties for all six goals.

This second entry recognizes an honored warranty for a soccer goal based on 10% of sales from the period.

As you’ve learned, not only are warranty expense and warranty liability journalized, but they are also recognized on the income statement and balance sheet. 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.

Probable and Not Estimable

Assume that Sierra Sports is sued by one of the customers who purchased the faulty soccer goals. A settlement of responsibility in the case has been reached, but the actual damages have not been determined and cannot be reasonably estimated. This is considered probable but inestimable, because the lawsuit is very likely to occur (given a settlement is agreed upon) but the actual damages are unknown. No journal entry or financial adjustment in the financial statements will occur. Instead, Sierra Sports will include a note describing any details available about the lawsuit. When damages have been determined, or have been reasonably estimated, then journalizing would be appropriate.

Sierra Sports could say the following in its financial statement disclosures: “There is pending litigation against our company with the likelihood of settlement probable. Detailed terms and damages have not yet reached agreement, and a reasonable assessment of financial impact is currently unknown.”

Reasonably Possible

Sierra Sports may have more litigation in the future surrounding the soccer goals. These lawsuits have not yet been filed or are in the very early stages of the litigation process. Since there is a past precedent for lawsuits of this nature but no establishment of guilt or formal arrangement of damages or timeline, the likelihood of occurrence is reasonably possible. The outcome is not probable but is not remote either. Since the outcome is possible, the contingent liability is disclosed in Sierra Sports’ financial statement notes.

Sierra Sports could say the following in their financial statement disclosures: “We anticipate more claimants filing legal action against our company with the likelihood of settlement reasonably possible. Assignment of guilt, detailed terms, and potential damages have not been established. A reasonable assessment of financial impact is currently unknown.”

Sierra Sports worries that as a result of pending litigation and losses associated with the faulty soccer goals, the company might have to file for bankruptcy. After consulting with a financial advisor, the company is pretty certain it can continue operating in the long term without restructuring. The chances are remote that a bankruptcy would occur. Sierra Sports would not recognize this remote occurrence on the financial statements or provide a note disclosure.

IFRS Connection

Current liabilities.

US GAAP and International Financial Reporting Standards (IFRS) define “current liabilities” similarly and use the same reporting criteria for most all types of current liabilities. However, two primary differences exist between US GAAP and IFRS: the reporting of (1) debt due on demand and (2) contingencies.

Liquidity and solvency are measures of a company’s ability to pay debts as they come due. Liquidity measures evaluate a company’s ability to pay current debts as they come due, while solvency measures evaluate the ability to pay debts long term. One common liquidity measure is the current ratio, and a higher ratio is preferred over a lower one. This ratio—current assets divided by current liabilities—is lowered by an increase in current liabilities (the denominator increases while we assume that the numerator remains the same). When lenders arrange loans with their corporate customers, limits are typically set on how low certain liquidity ratios (such as the current ratio) can go before the bank can demand that the loan be repaid immediately.

In theory, debt that has not been paid and that has become “on demand” would be considered a current liability. However, in determining how to report a loan that has become “on-demand,” US GAAP and IFRS differ:

• Under US GAAP, debts on which payment has been demanded because of violations of the contractual agreement between the lender and creditor are only included in current liabilities if, by the financial statement presentation date, there have been no arrangements made to pay off or restructure the debt. This allows companies time between the end of the fiscal year and the actual publication of the financial statements (typically two months) to make arrangements for repayment of the loan. Most often these loans are refinanced.
• Under IFRS, any payment or refinancing arrangements must be made by the fiscal year-end of the debtor. This difference means that companies reporting under IFRS must be proactive in assessing whether their debt agreements will be violated and make appropriate arrangements for refinancing or differing payment options prior to final year-end numbers being reported.

A second set of differences exist regarding reporting contingencies. Where US GAAP uses the term “contingencies,” IFRS uses “provisions.” In both cases, gain contingencies are not recorded until they are essentially realized. Both systems want to avoid prematurely recording or overstating gains based on the principles of conservatism. Loss contingencies are recorded (accrued) if certain conditions are met:

• Under US GAAP, loss contingencies are accrued if they are probable and can be estimated. Probable means “likely” to occur and is often assessed as an 80% likelihood by practitioners.
• Under IFRS, probable is defined as “more likely than not” and is typically assessed at 50% by practitioners.

The determination of whether a contingency is probable is based on the judgment of auditors and management in both situations. This means a contingent situation such as a lawsuit might be accrued under IFRS but not accrued under US GAAP. Finally, how a loss contingency is measured varies between the two options as well. For example, if a company is told it will be probable that it will lose an active lawsuit, and the legal team gives a range of the dollar value of that loss, under IFRS, the discounted midpoint of that range would be accrued, and the range disclosed. Under US GAAP, the low end of the range would be accrued, and the range disclosed.

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Contingent Assets and Contingent Liabilities (IAS 37)

Last updated: 8 March 2024

IAS 37 governs the treatment of contingent assets and contingent liabilities. However, this standard does not cover assets and liabilities that fall under the scope of another standard, as highlighted in IAS 37.2-5. Importantly, all contractual rights or obligations must be accounted for under the relevant standards, often IFRS 15 or IFRS 9. A common misconception is referring to IAS 37 whenever a contractual right or obligation is contested by any party.

Definition of contingent liability

According to IAS 37.10 and IAS 37.27-30, a contingent liability is:

• A possible obligation resulting from past events, the existence of which will be confirmed only by the occurrence or non-occurrence of uncertain future events outside the entity’s control; or
• A present obligation that remains unrecognised because: – It’s not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or – The obligation cannot be measured with sufficient reliability (which is rare).

Disclosure of contingent liabilities

Contingent liabilities aren’t recognised in the primary financial statements but should be disclosed in the notes. However, if the risk of a resource outflow is remote, then such liabilities shouldn’t be disclosed. Generally, a ‘remote’ likelihood ranges between 5% and 10%, though IAS 37 doesn’t explicitly specify this. IAS 37.86 details the disclosure requirements, emphasising that any contingent liability with an outflow possibility exceeding ‘remote’ should be disclosed. However, individually immaterial items can be grouped into classes.

The ‘ not-to-prejudice ‘ exemption in IAS 37.92 is also applicable to contingent liabilities.

Are you tired of the constant stream of IFRS updates? I know it's tough! That's why I created Reporting Period – a once-a-month summary for professional accountants. It consolidates all essential IFRS developments and Big 4 insights into one readable email. I personally curate every issue to ensure it's packed with the most relevant information, delivered straight to your inbox. It's free, with no spam, and you can unsubscribe with just one click. Ready to give it a try?

Definition of contingent asset

A contingent asset is a potential asset resulting from past events, and its existence will be confirmed only by uncertain future events not entirely under the entity’s control (IAS 37.10; IAS 37.31-35).

Recognition and disclosure of contingent assets

If the likelihood of resource inflow exceeds 50%, contingent assets are disclosed in the notes to financial statements (as per IAS 37.89) but aren’t recognised in the primary financial statements. If it becomes ‘virtually certain’ (roughly 90-95%, not explicitly defined in IAS 37) that resources will flow in, then the asset is recognised in the statement of financial position and profit or loss. For likelihoods under 50%, no disclosure is made.

The ‘ not-to-prejudice ‘ exemption in IAS 37.92 also extends to contingent assets. Additionally, see the forum’s discussion regarding a scenario where a once-recognised contingent asset’s likelihood of resource inflow is no longer virtually certain.

Continuous reassessment

Contingent liabilities are subject to continuous reassessment due to the possibility of their development differing from initial expectations. This ongoing evaluation is crucial to ascertain whether a probable outflow of resources has become probable. When an outflow of future economic benefits for an item, previously classified as a contingent liability, becomes probable, it necessitates the recognition of a provision in the period during which this change in probability is identified (IAS 37.30).

Similarly, the evaluation of contingent assets is a continuous process, ensuring that any developments are accurately represented in the financial statements. If it becomes virtually certain that there will be an inflow of economic benefits, the corresponding asset and related income are to be recognised in the period in which this certainty arises. Moreover, if the likelihood of an economic benefit inflow increases to the level of probability, the entity is required to disclose the contingent asset (IAS 37.35).

Deposits paid in ongoing proceedings

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. In such instances, the ‘virtually certain’ threshold is applicable before a disputed asset can be recognised.

© 2018-2024 Marek Muc

The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Excerpts from IFRS Standards come from the Official Journal of the European Union (© European Union, https://eur-lex.europa.eu). You can access full versions of IFRS Standards at shop.ifrs.org. IFRScommunity.com is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org.

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LO 11.3 Define and Apply Accounting Treatment for Contingent Liabilities

Mitchell Franklin

What happens if your business anticipates incurring a loss or debt? Do you need to report this if you are uncertain it will occur? What if you know the loss or debt will occur but it has not happened yet? Do you have to report this event now, or in the future? These are questions businesses must ask themselves when exploring contingencies and their effect on 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. The outcome could be positive or negative. 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.

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.

Pending litigation involves legal claims against the business that may be resolved at a future point in time. The outcome of the lawsuit has yet to be determined but could have negative future impact on the business.

Warranties arise from products or services sold to customers that cover certain defects (see (Figure) ). It is unclear if a customer will need to use a warranty, and when, but this is a possibility for each product or service sold that includes a warranty. The same idea applies to insurance claims (car, life, and fire, for example), and bankruptcy. There is an uncertainty that a claim will transpire, or bankruptcy will occur. If the contingencies do occur, it may still be uncertain when they will come to fruition, or the financial implications.

The answer to whether or not uncertainties must be reported comes from Financial Accounting Standards Board (FASB) pronouncements.

Two Financial Accounting Standards Board (FASB) Requirements for Recognition of a Contingent Liability

There are two requirements for contingent liability recognition:

• There is a likelihood of occurrence.
• Measurement of the occurrence is classified as either estimable or inestimable.

Application of Likelihood of Occurrence Requirement

Let’s explore the likelihood of occurrence requirement in more detail.

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. This financial recognition and disclosure are recognized in the current financial statements. The income statement and balance sheet are typically impacted by contingent liabilities.

For example, Sierra Sports has a one-year warranty on part repairs and replacements for a soccer goal they sell. The warranty is good for one year. Sierra Sports notices that some of its soccer goals have rusted screws that require replacement, but they have already sold goals with this problem to customers. There is a probability that someone who purchased the soccer goal may bring it in to have the screws replaced. Not only does the contingent liability meet the probability requirement, it also meets the measurement requirement.

Application of Measurement Requirement

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. For a financial figure to be reasonably estimated, it could be based on past experience or industry standards (see (Figure) ). It could also be determined by the potential future, known financial outcome.

Let’s continue to use Sierra Sports’ soccer goal warranty as our example. If the warranties are honored, the company should know how much each screw costs, labor cost required, time commitment, and any overhead costs incurred. This amount could be a reasonable estimate for the parts repair cost per soccer goal. Since not all warranties may be honored (warranty expired), the company needs to make a reasonable determination for the amount of honored warranties to get a more accurate figure.

Another way to establish the warranty liability could be an estimation of honored warranties as a percentage of sales. In this instance, Sierra could estimate warranty claims at 10% of its soccer goal sales.

When determining if the contingent liability should be recognized, there are four potential treatments to consider.

Let’s expand our discussion and add a brief example of the calculation and application of warranty expenses. To begin, in many ways a warranty expense works similarly to the bad debt expense concept covered in Accounting for Receivables in that the anticipated expense is determined by examining past period expense experiences and then basing the current expense on current sales data. Also, as with bad debts, the warranty repairs typically are made in an accounting period sometimes months or even years after the initial sale of the product, which means that we need to estimate future costs to comply with the revenue recognition and matching principles of generally accepted accounting principles (GAAP).

Some industries have such a large number of transactions and a vast data bank of past warranty claims that they have an easier time estimating potential warranty claims, while other companies have a harder time estimating future claims. In our case, we make assumptions about Sierra Sports and build our discussion on the estimated experiences.

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. Following are the necessary journal entries to record the expense in 2019 and the repairs in 2020. The resources used in the warranty repair work could have included several options, such as parts and labor, but to keep it simple we allocated all of the expenses to repair parts inventory. Since the company’s inventory of supply parts (an asset) went down by $2,800, the reduction is reflected with a credit entry to repair parts inventory. First, following is the necessary journal entry to record the expense in 2019.

Next, here is the journal entry to record the repairs in 2020.

Before we finish, we need to address one more issue. Our example only covered the warranty expenses anticipated from the 2019 sales. Since the company has a three-year warranty, and it estimated repair costs of $5,000 for the goals sold in 2019, there is still a balance of $2,200 left from the original $5,000. However, its actual experiences could be more, the same, or less than $2,200. If it is determined that too much is being set aside in the allowance, then future annual warranty expenses can be adjusted downward. If it is determined that not enough is being accumulated, then the warranty expense allowance can be increased.

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.

Consider the following scenario: A hoverboard is a self-balancing scooter that uses body position and weight transfer to control the device. Hoverboards use a lithium-ion battery pack, which was found to overheat causing an increased risk for the product to catch fire or explode. Several people were badly injured from these fires and explosions. As a result, a recall was issued in mid-2016 on most hoverboard models. Customers were asked to return the product to the original point of sale (the retailer). Retailers were required to accept returns and provide repair when available. In some cases, retailers were held accountable by consumers, and not the manufacturer of the hoverboards. You are the retailer in this situation and must decide if the hoverboard scenario creates any contingent liabilities. If so, what are the contingent liabilities? Do the conditions meet FASB requirements for contingent liability reporting? Which of the four possible treatments are best suited for the potential liabilities identified? Are there any journal entries or note disclosures necessary?

Four Potential Treatments for Contingent Liabilities

If the contingency is probable and estimable , it is likely to occur and can be reasonably estimated. In this case, the liability and associated expense must be journalized and included in the current period’s financial statements (balance sheet and income statement) along with note disclosures explaining the reason for recognition. The note disclosures are a GAAP requirement pertaining to the full disclosure principle, as detailed in Analyzing and Recording Transactions .

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 the contingency is reasonably possible , it could occur but is not probable. The amount may or may not be estimable. 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.

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.

Google , a subsidiary of Alphabet Inc. , has expanded from a search engine to a global brand with a variety of product and service offerings. Like many other companies, contingent liabilities are carried on Google ’s balance sheet, report expenses related to these contingencies on its income statement, and note disclosures are provided to explain its contingent liability treatments. Check out Google ’s contingent liability considerations in this press release for Alphabet Inc.’s First Quarter 2017 Results to see a financial statement package, including note disclosures.

Let’s review some contingent liability treatment examples as they relate to our fictitious company, Sierra Sports.

Probable and Estimable

If Sierra Sports determines the cost of the soccer goal screws are $30, the labor requirement is one hour at a rate of $40 per hour, and there is no extra overhead applied, then the total estimated warranty repair cost would be $70 per goal: $30 + (1 hour × $40 per hour). Sierra Sports sold ten goals before it discovered the rusty screw issue. The company believes that only six of those goals will have their warranties honored, based on past experience. This means Sierra will incur a warranty liability of $420 ($70 × 6 goals). The $420 is considered probable and estimable and is recorded in Warranty Liability and Warranty Expense accounts during the period of discovery (current period).

An example of determining a warranty liability based on a percentage of sales follows. The sales price per soccer goal is $1,200, and Sierra Sports believes 10% of sales will result in honored warranties. The company would record this warranty liability of $120 ($1,200 × 10%) to Warranty Liability and Warranty Expense accounts.

When the warranty is honored, this would reduce the Warranty Liability account and decrease the asset used for repair (Parts: Screws account) or Cash, if applicable. The recognition would happen as soon as the warranty is honored. This first entry shown is to recognize honored warranties for all six goals.

This second entry recognizes an honored warranty for a soccer goal based on 10% of sales from the period.

As you’ve learned, not only are warranty expense and warranty liability journalized, but they are also recognized on the income statement and balance sheet. The following examples show recognition of Warranty Expense on the income statement (Figure) and Warranty Liability on the balance sheet (Figure) for Sierra Sports.

Probable and Not Estimable

Assume that Sierra Sports is sued by one of the customers who purchased the faulty soccer goals. A settlement of responsibility in the case has been reached, but the actual damages have not been determined and cannot be reasonably estimated. This is considered probable but inestimable, because the lawsuit is very likely to occur (given a settlement is agreed upon) but the actual damages are unknown. No journal entry or financial adjustment in the financial statements will occur. Instead, Sierra Sports will include a note describing any details available about the lawsuit. When damages have been determined, or have been reasonably estimated, then journalizing would be appropriate.

Sierra Sports could say the following in its financial statement disclosures: “There is pending litigation against our company with the likelihood of settlement probable. Detailed terms and damages have not yet reached agreement, and a reasonable assessment of financial impact is currently unknown.”

Reasonably Possible

Sierra Sports may have more litigation in the future surrounding the soccer goals. These lawsuits have not yet been filed or are in the very early stages of the litigation process. Since there is a past precedent for lawsuits of this nature but no establishment of guilt or formal arrangement of damages or timeline, the likelihood of occurrence is reasonably possible. The outcome is not probable but is not remote either. Since the outcome is possible, the contingent liability is disclosed in Sierra Sports’ financial statement notes.

Sierra Sports could say the following in their financial statement disclosures: “We anticipate more claimants filing legal action against our company with the likelihood of settlement reasonably possible. Assignment of guilt, detailed terms, and potential damages have not been established. A reasonable assessment of financial impact is currently unknown.”

Sierra Sports worries that as a result of pending litigation and losses associated with the faulty soccer goals, the company might have to file for bankruptcy. After consulting with a financial advisor, the company is pretty certain it can continue operating in the long term without restructuring. The chances are remote that a bankruptcy would occur. Sierra Sports would not recognize this remote occurrence on the financial statements or provide a note disclosure.

US GAAP and International Financial Reporting Standards (IFRS) define “current liabilities” similarly and use the same reporting criteria for most all types of current liabilities. However, two primary differences exist between US GAAP and IFRS: the reporting of (1) debt due on demand and (2) contingencies.

Liquidity and solvency are measures of a company’s ability to pay debts as they come due. Liquidity measures evaluate a company’s ability to pay current debts as they come due, while solvency measures evaluate the ability to pay debts long term. One common liquidity measure is the current ratio, and a higher ratio is preferred over a lower one. This ratio—current assets divided by current liabilities—is lowered by an increase in current liabilities (the denominator increases while we assume that the numerator remains the same). When lenders arrange loans with their corporate customers, limits are typically set on how low certain liquidity ratios (such as the current ratio) can go before the bank can demand that the loan be repaid immediately.

In theory, debt that has not been paid and that has become “on demand” would be considered a current liability. However, in determining how to report a loan that has become “on-demand,” US GAAP and IFRS differ:

• Under US GAAP, debts on which payment has been demanded because of violations of the contractual agreement between the lender and creditor are only included in current liabilities if, by the financial statement presentation date, there have been no arrangements made to pay off or restructure the debt. This allows companies time between the end of the fiscal year and the actual publication of the financial statements (typically two months) to make arrangements for repayment of the loan. Most often these loans are refinanced.
• Under IFRS, any payment or refinancing arrangements must be made by the fiscal year-end of the debtor. This difference means that companies reporting under IFRS must be proactive in assessing whether their debt agreements will be violated and make appropriate arrangements for refinancing or differing payment options prior to final year-end numbers being reported.

A second set of differences exist regarding reporting contingencies. Where US GAAP uses the term “contingencies,” IFRS uses “provisions.” In both cases, gain contingencies are not recorded until they are essentially realized. Both systems want to avoid prematurely recording or overstating gains based on the principles of conservatism. Loss contingencies are recorded (accrued) if certain conditions are met:

• Under US GAAP, loss contingencies are accrued if they are probable and can be estimated. Probable means “likely” to occur and is often assessed as an 80% likelihood by practitioners.
• Under IFRS, probable is defined as “more likely than not” and is typically assessed at 50% by practitioners.

The determination of whether a contingency is probable is based on the judgment of auditors and management in both situations. This means a contingent situation such as a lawsuit might be accrued under IFRS but not accrued under US GAAP. Finally, how a loss contingency is measured varies between the two options as well. For example, if a company is told it will be probable that it will lose an active lawsuit, and the legal team gives a range of the dollar value of that loss, under IFRS, the discounted midpoint of that range would be accrued, and the range disclosed. Under US GAAP, the low end of the range would be accrued, and the range disclosed.

Key Concepts and Summary

• Contingent liabilities arise from a current situation with an uncertain outcome that may occur in the future. Contingent liabilities may include litigation, warranties, insurance claims, and bankruptcy.
• Two FASB recognition requirements must be met before declaring a contingent liability. There must be a probable likelihood of occurrence, and the loss amount is reasonably estimated.
• The four contingent liability treatments are probable and estimable, probable and inestimable, reasonably possible, and remote.
• Recognition in financial statements, as well as a note disclosure, occurs when the outcome is probable and estimable. Probable and not estimable and reasonably possible outcomes require note disclosures only. There is not recognition or note disclosure for a remote outcome.

Multiple Choice

(Figure) Which of the following best describes a contingent liability that is likely to occur but cannot be reasonably estimated?

• reasonably possible
• probable and estimable
• probable and inestimable

(Figure) Blake Department Store sells television sets with one-year warranties that cover repair and replacement of television parts. In the month of June, Blake sells forty television sets with a per unit cost of $500. If Blake estimates warranty fulfillment at 10% of sales, what would be the warranty liability reported in June?

(Figure) What accounts are used to record a contingent warranty liability that is probable and estimable but has yet to be fulfilled?

• warranty liability and cash
• warranty expense and cash
• warranty liability and warranty expense, cash
• warranty expense and warranty liability

(Figure) Which of the following best describes a contingent liability that is unlikely to occur?

(Figure) What is a contingent liability?

(Figure) What are the two FASB required conditions for a contingent liability to be recognized?

The likelihood of occurrence and the measurement requirement are the FASB required conditions. A contingent liability must be recognized and disclosed if there is a probable liability determination before the preparation of financial statements has occurred, and the company can reasonably estimate the amount of loss.

(Figure) If a bankruptcy is deemed likely to occur and is reasonably estimated, what would be the recognition and disclosure requirements for the company?

(Figure) Name the four contingent liability treatments.

They are probable and estimable, probable and inestimable, reasonably possible, and remote.

(Figure) A company’s sales for January are $250,000. If the company projects warranty obligations to be 5% of sales, what is the warranty liability amount for January?

Exercise Set A

(Figure) Following is the unadjusted trial balance for Sun Energy Co. on December 31, 2017.

You are also given the following supplemental information: A pending lawsuit, claiming $2,700 in damages, is considered likely to favor the plaintiff and can be reasonably estimated. Sun Energy Co. believes a customer may win a lawsuit for $3,500 in damages, but the outcome is only reasonably possible to occur. Sun Energy calculated warranty expense estimates of $210.

• Using the unadjusted trial balance and supplemental information for Sun Energy Co., construct an income statement for the year ended December 31, 2017. Pay particular attention to expenses resulting from contingencies.
• Construct a balance sheet, for December 31, 2017, from the given unadjusted trial balance, supplemental information, and income statement for Sun Energy Co., paying particular attention to contingent liabilities.
• Prepare any necessary contingent liability note disclosures for Sun Energy Co. Only give one to three sentences for each contingency note disclosure.

Exercise Set B

(Figure) Following is the unadjusted trial balance for Pens Unlimited on December 31, 2017.

You are also given the following supplemental information: A pending lawsuit, claiming $4,200 in damages, is considered likely to favor the plaintiff and can be reasonably estimated. Pens Unlimited believes a customer may win a lawsuit for $5,000 in damages, but the outcome is only reasonably possible to occur. Pens Unlimited records warranty estimates on the basis of 2% of annual sales revenue.

• Using the unadjusted trial balance and supplemental information for Pens Unlimited, construct an income statement for the year ended December 31, 2017. Pay particular attention to expenses resulting from contingencies.
• Construct a balance sheet, for December 31, 2017, from the given unadjusted trial balance, supplemental information, and income statement for Pens Unlimited. Pay particular attention to contingent liabilities.
• Prepare any necessary contingent liability note disclosures for Pens Unlimited. Only give one to three sentences for each contingency note disclosure.

Problem Set A

(Figure) Machine Corp. has several pending lawsuits against its company. Review each situation and (1) determine the treatment for each situation as probable and estimable, probable and inestimable, reasonably possible, or remote; (2) determine what, if any, recognition or note disclosure is required; and (3) prepare any journal entries required to recognize a contingent liability.

• A pending lawsuit, claiming $100,000 in damages, is considered likely to favor the plaintiff and can be reasonably estimated.
• Machine Corp. believes there might be other potential lawsuits about this faulty machinery, but this is unlikely to occur.
• A claimant sues Machine Corp. for damages, from a dishonored service contract agreement; the plaintiff will likely win the case but damages cannot be reasonably estimated.
• Machine Corp. believes a customer will win a lawsuit it filed, but the outcome is not likely and is not remote. It is possible the customer will win.

(Figure) Emperor Pool Services provides pool cleaning and maintenance services to residential clients. It offers a one-year warranty on all services. Review each of the transactions, and prepare any necessary journal entries for each situation.

• March 31: Emperor provides cleaning services for fifteen pools during the month of March at a sales price per pool of $550 cash. Emperor records warranty estimates when sales are recognized and bases warranty estimates on 2% of sales.
• April 5: A customer files a warranty claim that Emperor honors in the amount of $100 cash.
• April 13: Another customer, J. Jones, files a warranty claim that Emperor does not honor due to customer negligence.
• June 8: J. Jones files a lawsuit requesting damages related to the dishonored warranty in the amount of $1,500. Emperor determines that the lawsuit is likely to end in the plaintiff’s favor and the $1,500 is a reasonable estimate for damages.

Problem Set B

(Figure) Roundhouse Tools has several potential warranty claims as a result of damaged tool kits. Review each situation and (1) determine the treatment for each situation as probable and estimable, probable and inestimable, reasonably possible, or remote; (2) determine what, if any, recognition or note disclosure is required; and (3) prepare any journal entries required to recognize a contingent liability.

• Roundhouse Tools has several claims for replacement of another tool kit not listed as one of their damaged tool kits. The honored warranty for these tool kits is not likely but is not remote. It is possible.
• A pending warranty claim has been received with the projected cost to be $450. Roundhouse Tools believes honoring that warranty claim is likely to occur and that figure is reasonably estimated.
• Roundhouse Tools believes other potential warranties may have to be honored outside of the warranty period, but this is unlikely to occur.
• Warranty replacements will cost the company a percentage of sales for the period. This amount allotted for warranty replacements cannot be reasonably estimated but is likely to occur.

(Figure) Shoe Hut sells custom, handmade shoes. It offers a one-year warranty on all shoes for repair or replacement. Review each of the transactions and prepare any necessary journal entries for each situation.

• May 31: Shoe Hut sells 100 pairs of shoes during the month of May at a sales price per pair of shoes of $240 cash. Shoe Hut records warranty estimates when sales are recognized and bases warranty estimates on 4% of sales.
• June 2: A customer files a warranty claim that Shoe Hut honors in the amount of $30 for repair to laces. Laces Inventory corresponds to shoelace inventory used for repairs.
• June 4: Another customer files a warranty claim that Shoe Hut honors. Shoe Hut replaces the damaged shoes at a cost of $200, affecting their Shoe Replacement Inventory account.
• August 10: Shoe Hut explores the possibility of bankruptcy, given the current economic conditions (recession). It determines the bankruptcy is unlikely to occur (remote).

Thought Provokers

(Figure) Toyota is a car manufacturer that has issued several recalls over the years. One major recall centered on faulty air bags from Takata . A prior recall focused on unintentional pedal acceleration. Research information about the car manufacturer, and one of the two recall situations described. Answer the following questions:

• What are some of the main points discussed in the supplements you researched?
• What negative impact did this recall have on Toyota?
• As a result of the recall, what contingent liabilities were (or could be) created?
• How did Toyota handle the reporting of these contingent liabilities?
• How did Toyota determine the estimated liability amounts?
• Do you agree with Toyota’s treatment assignment for reported liabilities (probable and estimable, probable and inestimable, for example)?
• What note disclosures accompanied the recognized contingent liabilities?
• What long-term effect, if any, did the recall have on Toyota’s financials and reputation?

LO 11.3 Define and Apply Accounting Treatment for Contingent Liabilities Copyright © 2020 by Mitchell Franklin is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License , except where otherwise noted.

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12.3: Define and Apply Accounting Treatment for Contingent Liabilities

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What happens if your business anticipates incurring a loss or debt? Do you need to report this if you are uncertain it will occur? What if you know the loss or debt will occur but it has not happened yet? Do you have to report this event now, or in the future? These are questions businesses must ask themselves when exploring contingencies and their effect on 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. The outcome could be positive or negative. 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.

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.

Pending litigation involves legal claims against the business that may be resolved at a future point in time. The outcome of the lawsuit has yet to be determined but could have negative future impact on the business.

Warranties arise from products or services sold to customers that cover certain defects (see Figure 12.8 ). It is unclear if a customer will need to use a warranty, and when, but this is a possibility for each product or service sold that includes a warranty. The same idea applies to insurance claims (car, life, and fire, for example), and bankruptcy. There is an uncertainty that a claim will transpire, or bankruptcy will occur. If the contingencies do occur, it may still be uncertain when they will come to fruition, or the financial implications.

The answer to whether or not uncertainties must be reported comes from Financial Accounting Standards Board (FASB) pronouncements.

Two Financial Accounting Standards Board (FASB) Requirements for Recognition of a Contingent Liability

There are two requirements for contingent liability recognition:

• There is a likelihood of occurrence.
• Measurement of the occurrence is classified as either estimable or inestimable.

Application of Likelihood of Occurrence Requirement

Let’s explore the likelihood of occurrence requirement in more detail.

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. This financial recognition and disclosure are recognized in the current financial statements. The income statement and balance sheet are typically impacted by contingent liabilities.

For example, Sierra Sports has a one-year warranty on part repairs and replacements for a soccer goal they sell. The warranty is good for one year. Sierra Sports notices that some of its soccer goals have rusted screws that require replacement, but they have already sold goals with this problem to customers. There is a probability that someone who purchased the soccer goal may bring it in to have the screws replaced. Not only does the contingent liability meet the probability requirement, it also meets the measurement requirement.

Application of Measurement Requirement

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. For a financial figure to be reasonably estimated, it could be based on past experience or industry standards (see Figure 12.9 ). It could also be determined by the potential future, known financial outcome.

Let’s continue to use Sierra Sports’ soccer goal warranty as our example. If the warranties are honored, the company should know how much each screw costs, labor cost required, time commitment, and any overhead costs incurred. This amount could be a reasonable estimate for the parts repair cost per soccer goal. Since not all warranties may be honored (warranty expired), the company needs to make a reasonable determination for the amount of honored warranties to get a more accurate figure.

Another way to establish the warranty liability could be an estimation of honored warranties as a percentage of sales. In this instance, Sierra could estimate warranty claims at 10% of its soccer goal sales.

When determining if the contingent liability should be recognized, there are four potential treatments to consider.

Let’s expand our discussion and add a brief example of the calculation and application of warranty expenses. To begin, in many ways a warranty expense works similarly to the bad debt expense concept covered in Accounting for Receivables in that the anticipated expense is determined by examining past period expense experiences and then basing the current expense on current sales data. Also, as with bad debts, the warranty repairs typically are made in an accounting period sometimes months or even years after the initial sale of the product, which means that we need to estimate future costs to comply with the revenue recognition and matching principles of generally accepted accounting principles (GAAP).

Some industries have such a large number of transactions and a vast data bank of past warranty claims that they have an easier time estimating potential warranty claims, while other companies have a harder time estimating future claims. In our case, we make assumptions about Sierra Sports and build our discussion on the estimated experiences.

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. Following are the necessary journal entries to record the expense in 2019 and the repairs in 2020. The resources used in the warranty repair work could have included several options, such as parts and labor, but to keep it simple we allocated all of the expenses to repair parts inventory. Since the company’s inventory of supply parts (an asset) went down by $2,800, the reduction is reflected with a credit entry to repair parts inventory. First, following is the necessary journal entry to record the expense in 2019.

Next, here is the journal entry to record the repairs in 2020.

Before we finish, we need to address one more issue. Our example only covered the warranty expenses anticipated from the 2019 sales. Since the company has a three-year warranty, and it estimated repair costs of $5,000 for the goals sold in 2019, there is still a balance of $2,200 left from the original $5,000. However, its actual experiences could be more, the same, or less than $2,200. If it is determined that too much is being set aside in the allowance, then future annual warranty expenses can be adjusted downward. If it is determined that not enough is being accumulated, then the warranty expense allowance can be increased.

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.

THINK IT THROUGH

Product recalls: contingent liabilities.

Consider the following scenario: A hoverboard is a self-balancing scooter that uses body position and weight transfer to control the device. Hoverboards use a lithium-ion battery pack, which was found to overheat causing an increased risk for the product to catch fire or explode. Several people were badly injured from these fires and explosions. As a result, a recall was issued in mid-2016 on most hoverboard models. Customers were asked to return the product to the original point of sale (the retailer). Retailers were required to accept returns and provide repair when available. In some cases, retailers were held accountable by consumers, and not the manufacturer of the hoverboards. You are the retailer in this situation and must decide if the hoverboard scenario creates any contingent liabilities. If so, what are the contingent liabilities? Do the conditions meet FASB requirements for contingent liability reporting? Which of the four possible treatments are best suited for the potential liabilities identified? Are there any journal entries or note disclosures necessary?

Four Potential Treatments for Contingent Liabilities

If the contingency is probable and estimable , it is likely to occur and can be reasonably estimated. In this case, the liability and associated expense must be journalized and included in the current period’s financial statements (balance sheet and income statement) along with note disclosures explaining the reason for recognition. The note disclosures are a GAAP requirement pertaining to the full disclosure principle, as detailed in Analyzing and Recording Transactions .

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 the contingency is reasonably possible , it could occur but is not probable. The amount may or may not be estimable. 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.

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.

Financial Statement Treatments

Table 12.2 Four Treatments of Contingent Liabilities. Proper recognition of the four contingent liability treatments.

LINK TO LEARNING

Google , a subsidiary of Alphabet Inc. , has expanded from a search engine to a global brand with a variety of product and service offerings. Like many other companies, contingent liabilities are carried on Google ’s balance sheet, report expenses related to these contingencies on its income statement, and note disclosures are provided to explain its contingent liability treatments. Check out Google ’s contingent liability considerations in this press release for Alphabet Inc.’s First Quarter 2017 Results to see a financial statement package, including note disclosures.

Let’s review some contingent liability treatment examples as they relate to our fictitious company, Sierra Sports.

Probable and Estimable

If Sierra Sports determines the cost of the soccer goal screws are $30, the labor requirement is one hour at a rate of $40 per hour, and there is no extra overhead applied, then the total estimated warranty repair cost would be $70 per goal: $30 + (1 hour × $40 per hour). Sierra Sports sold ten goals before it discovered the rusty screw issue. The company believes that only six of those goals will have their warranties honored, based on past experience. This means Sierra will incur a warranty liability of $420 ($70 × 6 goals). The $420 is considered probable and estimable and is recorded in Warranty Liability and Warranty Expense accounts during the period of discovery (current period).

An example of determining a warranty liability based on a percentage of sales follows. The sales price per soccer goal is $1,200, and Sierra Sports believes 10% of sales will result in honored warranties. The company would record this warranty liability of $120 ($1,200 × 10%) to Warranty Liability and Warranty Expense accounts.

When the warranty is honored, this would reduce the Warranty Liability account and decrease the asset used for repair (Parts: Screws account) or Cash, if applicable. The recognition would happen as soon as the warranty is honored. This first entry shown is to recognize honored warranties for all six goals.

This second entry recognizes an honored warranty for a soccer goal based on 10% of sales from the period.

As you’ve learned, not only are warranty expense and warranty liability journalized, but they are also recognized on the income statement and balance sheet. 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.

Probable and Not Estimable

Assume that Sierra Sports is sued by one of the customers who purchased the faulty soccer goals. A settlement of responsibility in the case has been reached, but the actual damages have not been determined and cannot be reasonably estimated. This is considered probable but inestimable, because the lawsuit is very likely to occur (given a settlement is agreed upon) but the actual damages are unknown. No journal entry or financial adjustment in the financial statements will occur. Instead, Sierra Sports will include a note describing any details available about the lawsuit. When damages have been determined, or have been reasonably estimated, then journalizing would be appropriate.

Sierra Sports could say the following in its financial statement disclosures: “There is pending litigation against our company with the likelihood of settlement probable. Detailed terms and damages have not yet reached agreement, and a reasonable assessment of financial impact is currently unknown.”

Reasonably Possible

Sierra Sports may have more litigation in the future surrounding the soccer goals. These lawsuits have not yet been filed or are in the very early stages of the litigation process. Since there is a past precedent for lawsuits of this nature but no establishment of guilt or formal arrangement of damages or timeline, the likelihood of occurrence is reasonably possible. The outcome is not probable but is not remote either. Since the outcome is possible, the contingent liability is disclosed in Sierra Sports’ financial statement notes.

Sierra Sports could say the following in their financial statement disclosures: “We anticipate more claimants filing legal action against our company with the likelihood of settlement reasonably possible. Assignment of guilt, detailed terms, and potential damages have not been established. A reasonable assessment of financial impact is currently unknown.”

Sierra Sports worries that as a result of pending litigation and losses associated with the faulty soccer goals, the company might have to file for bankruptcy. After consulting with a financial advisor, the company is pretty certain it can continue operating in the long term without restructuring. The chances are remote that a bankruptcy would occur. Sierra Sports would not recognize this remote occurrence on the financial statements or provide a note disclosure.

IFRS CONNECTION

Current liabilities.

US GAAP and International Financial Reporting Standards (IFRS) define “current liabilities” similarly and use the same reporting criteria for most all types of current liabilities. However, two primary differences exist between US GAAP and IFRS: the reporting of (1) debt due on demand and (2) contingencies.

Liquidity and solvency are measures of a company’s ability to pay debts as they come due. Liquidity measures evaluate a company’s ability to pay current debts as they come due, while solvency measures evaluate the ability to pay debts long term. One common liquidity measure is the current ratio, and a higher ratio is preferred over a lower one. This ratio—current assets divided by current liabilities—is lowered by an increase in current liabilities (the denominator increases while we assume that the numerator remains the same). When lenders arrange loans with their corporate customers, limits are typically set on how low certain liquidity ratios (such as the current ratio) can go before the bank can demand that the loan be repaid immediately.

In theory, debt that has not been paid and that has become “on demand” would be considered a current liability. However, in determining how to report a loan that has become “on-demand,” US GAAP and IFRS differ:

• Under US GAAP, debts on which payment has been demanded because of violations of the contractual agreement between the lender and creditor are only included in current liabilities if, by the financial statement presentation date, there have been no arrangements made to pay off or restructure the debt. This allows companies time between the end of the fiscal year and the actual publication of the financial statements (typically two months) to make arrangements for repayment of the loan. Most often these loans are refinanced.
• Under IFRS, any payment or refinancing arrangements must be made by the fiscal year-end of the debtor. This difference means that companies reporting under IFRS must be proactive in assessing whether their debt agreements will be violated and make appropriate arrangements for refinancing or differing payment options prior to final year-end numbers being reported.

A second set of differences exist regarding reporting contingencies. Where US GAAP uses the term “contingencies,” IFRS uses “provisions.” In both cases, gain contingencies are not recorded until they are essentially realized. Both systems want to avoid prematurely recording or overstating gains based on the principles of conservatism. Loss contingencies are recorded (accrued) if certain conditions are met:

• Under US GAAP, loss contingencies are accrued if they are probable and can be estimated. Probable means “likely” to occur and is often assessed as an 80% likelihood by practitioners.
• Under IFRS, probable is defined as “more likely than not” and is typically assessed at 50% by practitioners.

The determination of whether a contingency is probable is based on the judgment of auditors and management in both situations. This means a contingent situation such as a lawsuit might be accrued under IFRS but not accrued under US GAAP. Finally, how a loss contingency is measured varies between the two options as well. For example, if a company is told it will be probable that it will lose an active lawsuit, and the legal team gives a range of the dollar value of that loss, under IFRS, the discounted midpoint of that range would be accrued, and the range disclosed. Under US GAAP, the low end of the range would be accrued, and the range disclosed.

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Home > Graduate Research & Artistry > Theses & Dissertations > 1950

Graduate Research Theses & Dissertations

Contingent liabilities and their presentation on the balance sheet.

Dennis N. Bunjes

Publication Date

Document type.

Dissertation/Thesis

First Advisor

Avery, Clarence G.||Thistlethwaite, Robert L.

Degree Name

M.S. (Master of Science)

Legacy Department

Department of Accountancy

Financial statements

In the preparation of financial statements it is necessary to give consideration to items of a contingent nature. Contingent liabilities affect the usefulness of statements in interpreting the future potentialities of a business. The financial condition of a company may be just as seriously affected by contingencies as by items of a real and present nature. Contingent liabilities and their presentation on the balance sheet were selected for study because this area of the disclosure problem has not fulfilled the general and particular needs of the various interested parties concerned with financial reports such as stockholders, creditors, the general public, auditors, and the Security and Exchange Commission. The purpose of this study was to develop a method for the presentation of contingent liabilities on the balance sheet. In order to accomplish this objective, the following questions were resolved: 1. What is the history of the presentation of contingent liabilities on the balance sheet from 1917-1966? 2. What is the problem of reporting for contingent liabilities? 3. Is it possible to determine generally accepted methods of contingent liability presentation from the standpoint of stockholders, creditors, the general public, auditors, and the Security and Exchange Commission? Data for this study was derived mainly from library research. This included principally the professional journals of accountancy and other literature of the accounting profession. The problem of reporting contingent liabilities is the determination of the existence of possible contingent liabilities at the balance sheet date. The auditing procedure for contingent liabilities is directed toward the detection of the items, and their possible future effect on operations and financial position. A major conclusion of this study is that generally accepted methods of disclosure of contingent liabilities are by means of parenthetical remarks, accompanying notes, or descriptions under a special contingent liabilities heading. A related conclusion is that the accounting profession can add to the accounting concepts it has developed, which have provided an adequate framework for the presentation of contingent liabilities on the balance sheet, by determining and stating the limits and nature of the meaning of judgment in the light of the circumstances surrounding the contingent item. Confronted with wide variations in the extent of disclosure of contingent liabilities, the accounting profession should adopt measures to develop a framework within which the accountant may exercise judgment in adequate disclosure in financial statements. A detailed study should be made to determine the criteria the accountant uses in determining judgment in the light of the circumstances surrounding the contingent item.

Includes bibliographical references.

Recommended Citation

Bunjes, Dennis N., "Contingent liabilities and their presentation on the balance sheet" (1971). Graduate Research Theses & Dissertations . 1950. https://huskiecommons.lib.niu.edu/allgraduate-thesesdissertations/1950

vii, 89 pages

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Quickonomics

Contingent Liability

Definition of contingent liability.

A contingent liability is a potential financial obligation that may arise in the future, depending on the outcome of a specific event. The recognition of contingent liabilities in financial accounting is prescribed by accounting standards, which generally require that such liabilities be disclosed in a company’s financial statements if the liability is probable and the amount can be reasonably estimated. Contingent liabilities may stem from lawsuits, loan guarantees, environmental concerns, or other conditions that are unresolved or pending.

Consider a company, XYZ Corp, that is currently involved in a lawsuit. The lawsuit claims damages due to an alleged defect in one of XYZ Corp’s products. If the court rules against XYZ Corp, it may be required to pay a substantial amount in damages. This potential financial obligation represents a contingent liability for the company. Until the lawsuit is resolved, the company faces uncertainty regarding the financial impact.

To account for this, XYZ Corp must evaluate the likelihood of the lawsuit’s outcome. If it is probable that XYZ Corp will lose the lawsuit and the amount of the potential damages can be reasonably estimated, the company is required to disclose this contingent liability in its financial statements. This disclosure informs investors, creditors, and other stakeholders of the possible financial implications, even though the outcome may still be uncertain.

Why Contingent Liabilities Matter

Contingent liabilities are significant because they represent potential future obligations that could have a material impact on a company’s financial health and stability. Investors and creditors need to be aware of these possible liabilities when assessing a company’s risk level and making informed decisions. For the company itself, understanding and managing contingent liabilities is crucial for financial planning and risk management. By identifying and estimating potential liabilities, a company can take proactive steps to mitigate negative financial impacts, such as setting aside reserves or obtaining insurance coverage.

Even though contingent liabilities are not immediately recognized as debts on the balance sheet, they can affect a company’s borrowing capacity and investment attractiveness. A large or numerous contingent liabilities may signal to the market that a company is facing significant risks, potentially impacting its stock price and the cost of raising capital.

Frequently Asked Questions (FAQ)

How do companies evaluate the likelihood of a contingent liability becoming an actual liability.

Companies evaluate the likelihood of a contingent liability becoming an actual liability by assessing the probability of the triggering event occurring. This evaluation often involves legal and financial experts who analyze the specifics of each case, including legal precedents, the strength of evidence, and the financial implications of various outcomes. Generally, accounting standards require that for a contingent liability to be recorded on financial statements, the event causing the liability must be probable (typically interpreted as more than a 50% chance) and the amount must be reasonably estimable.

What is the difference between a contingent liability and a provision?

The difference between a contingent liability and a provision primarily lies in the level of certainty. A provision is recorded in the financial statements as a liability when the obligation is more likely than not to occur and the amount can be reliably estimated. Contrarily, a contingent liability represents a potential obligation that may or may not arise, based on future events. Thus, provisions are recognized as liabilities and affect the financial statements by reducing net income and equity, whereas contingent liabilities are disclosed in the notes to the financial statements unless their occurrence is remote.

Can contingent liabilities ever become assets?

Contingent liabilities typically represent potential outflows of economic benefits, and thus, they do not become assets. However, the resolution of a contingent liability in a company’s favor (for example, winning a lawsuit where damages were claimed) can prevent an outflow of resources and might have a positive impact on the company’s financial position. In certain scenarios, a contingent situation could give rise to a contingent asset, where an inflow of economic benefits is possible depending on future events. Contingent assets are not recognized in financial statements until it becomes virtually certain that the inflow of benefits will occur.

Understanding and managing contingent liabilities is essential for accurate financial reporting and effective risk management. By adequately disclosing these potential obligations, companies provide a clearer picture of their financial health and future prospects, aiding stakeholders in making informed decisions.

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