Definition of Contingent Liability
A contingent liability is a potential liability that may or may not become an actual liability. Whether the contingent liability becomes an actual liability depends on a future event occurring or not occurring. There is only one scenario where a provision will not be recorded in the books of accounts.
- According to the full disclosure principle, all significant, relevant facts related to the financial performance and fundamentals of a company should be disclosed in the financial statements.
- Banks that issue standby letters of credit or similar obligations carry contingent liabilities.
- The likelihood of loss is described as probable, reasonably possible, or remote.
- As it is not a liable component, it is not included in the accounting system of the company.
In simple words, contingent liabilities are those obligations that will arise in future due to certain events that took place in the past or will be taking place in future. An entity may choose how to classify business interruption insurance recoveries in the statement of operations, as long as that classification is not contrary to existing generally accepted accounting principles (GAAP). 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. For example, Sierra Sports has a one-year warranty on part repairs and replacements for a soccer goal they sell. 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.
What Is Contingent Liability?
Therefore, such circumstances or situations must be disclosed in a company’s financial statements, per the full disclosure principle. Google, a subsidiary of Alphabet Inc., has expanded from a search engine to a global brand with a variety of product and service offerings. 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. 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. Contingent liabilities must pass two thresholds before they can be reported in financial statements.
- The accounting of contingent liabilities is a very subjective topic and requires sound professional judgment.
- Other examples include guarantees on debts, liquidated damages, outstanding lawsuits, and government probes.
- Assume that a company is facing a lawsuit from a rival firm for patent infringement.
- Contingent liabilities, although not yet realized, are recorded as journal entries.
- Contingent liabilities are liabilities that depend on the outcome of an uncertain event.
- A contingent liability is a potential loss that may occur at some point in the future, once various uncertainties have been resolved.
Plus, the impact they could have will also depend on how sound the company is in its financial obligations. The International Financial Reporting Standards (IFRS) and GAAP outline certain requirements for companies to record all of their contingent liabilities. This is because of their connection with three discount accounting principles. Contingent liabilities should be analyzed with a serious and skeptical eye, since, depending on the specific situation, they can sometimes cost a company several millions of dollars. Sometimes contingent liabilities can arise suddenly and be completely unforeseen.
Contingent liabilities are classified into three types by the US GAAP based on the probability of their occurrence. Contingencies may be positive as well as negative, but accounting practices only consider negative outcomes. A liability is something owed by someone—it sets up an obligation or a debt. We undertake various activities to support the consistent application of IFRS Standards, which includes implementation support for recently issued Standards. We do this because the quality of implementation and application of the Standards affects the benefits that investors receive from having a single set of global standards. So if a company has a strong cash flow position and can experience rapid growth earnings, it can probably avoid the impact being too large.
According to the full disclosure principle, all significant, relevant facts related to the financial performance and fundamentals of a company should be disclosed in the financial statements. Examples of contingent liabilities are the outcome of a lawsuit, a government investigation, and the threat of expropriation. 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.
When damages have been determined, or have been reasonably estimated, then journalizing would be appropriate. A contingent liability is a potential loss that may occur at some point in the future, once various uncertainties have been resolved. The exact status of a contingent liability is important when determining which liabilities to present in the balance sheet or in the attached disclosures. It is of interest to a financial analyst, who wants to understand the probability of such an issue becoming a full liability of a business, which could impact its status as a going concern. A contingent liability is recorded in the accounting records if the contingency is probable and the related amount can be estimated with a reasonable level of accuracy. Other examples include guarantees on debts, liquidated damages, outstanding lawsuits, and government probes.
A contingent liability is not recognised in the statement of financial position. However, unless the possibility of an outflow of economic resources is remote, a contingent liability is disclosed in the notes. IAS 37 defines and specifies the accounting for and disclosure of provisions, contingent liabilities, and contingent assets. It does not make any sense to immediately realize a contingent liability – immediate realization signifies the financial obligation has occurred with certainty.
IAS 12 — Accounting for uncertainties in income taxes
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.
Let’s understand why it is important for a business to provide for contingent liabilities with an example. A lawsuit is a legal proceeding taken by the party claiming to have incurred any damage or loss by the other party. The party that made depreciation methods the damages either suffer legal action or have to go through with the compensation demanded by the other party. Supposing the company is coming up with a new product to launch in the market and the product is still in the development stage.
For an item or event to be considered to be material, it means that having knowledge of it occurring could change certain economic decisions for those that use the company’s financial statements. These liabilities become contingent whenever their payment contains a reasonable degree of uncertainty. Only the contingent liabilities that are the most probable can be recognized as a liability on financial statements.
Contingent liability refers to those liabilities that can incur as an entity and depends on the outcomes of the pending lawsuit. Such liabilities are not recorded in the company’s account and are shown in the company’s balance sheet when they are reasonably and probably estimated as a “worst-case” or “contingency” in the outcome. The extent and nature of the contingent liability can be explained by a footnote.
Contingent liabilities adversely impact a company’s assets and net profitability. Contingent liabilities are defined as those potential liabilities that may occur in a future date as a result of an uncertain event that is beyond the control of the business. A contingent liability will only be recorded in the balance sheet when the probability of its occurrence is certain, and the extent of such liability can be determined. Let’s expand our discussion and add a brief example of the calculation and application of warranty expenses.
What is a Contingent Liability?
If the firm determines that the likelihood of the liability occurring is remote, the company does not need to disclose the potential liability. The likelihood of occurrence and the measurement requirement are the FASB required conditions. 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.