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. If a contingent liability is deemed probable, it must be directly reported in the financial statements. Nevertheless, generally accepted accounting principles, or GAAP, only require contingencies to be recorded as unspecified expenses. Record a contingent liability when it is probable that the loss will occur, and you can reasonably estimate the amount of the loss. A contingent liability is a potential liability that may occur in the future, such as pending lawsuits or honoring product warranties.
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. 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. 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.
- 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.
- A contingent liability is a liability that may occur depending on the outcome of an uncertain future event.
- This liability is not required to be recorded in the books of accounts, but a disclosure might be preferred.
- All creditors, not just banks, carry contingent liabilities equal to the amount of receivables on their books.
A contingent liability is a liability that may occur depending on the outcome of an uncertain future event. A contingent liability has to be recorded if the contingency is likely and the amount of the liability can be reasonably estimated. Both generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) require companies to record contingent liabilities. In accounting, contingent liabilities are liabilities that may be incurred by an entity depending on the outcome of an uncertain future event[1] such as the outcome of a pending lawsuit. These liabilities are not recorded in a company’s accounts and shown in the balance sheet when both probable and reasonably estimable as ‘contingency’ or ‘worst case’ financial outcome.
The company’s legal department thinks that the rival firm has a strong case, and the business estimates a $2 million loss if the firm loses the case. Because the liability is both probable and easy to estimate, the firm posts an accounting entry on the balance sheet to debit (increase) legal expenses for $2 million and to credit (increase) accrued expense for $2 million. For example, a customer files a lawsuit against a business, claiming that its product broke, causing $500,000 of damage. The organization’s attorney believes that the customer will win in court, and believes that the firm will have to pay the full $500,000.
Any liabilities that have a probability of occurring over 50% are categorized under probable contingencies. An entity recognises a provision if it is probable that an outflow of cash or other economic resources will be required to settle the provision. The accounting of contingent liabilities is a very subjective topic and requires sound professional judgment. Contingent liabilities can be a tricky concept for a company’s management, as well as for investors. Judicious use of a wide variety of techniques for the valuation of liabilities and risk weighting may be required in large companies with multiple lines of business.
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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. 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 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.
Sophisticated analyses include techniques like options pricing methodology, expected loss estimation, and risk simulations of the impacts of changed macroeconomic conditions. Modeling contingent liabilities can be a tricky concept due to the level of subjectivity involved. The opinions of analysts are divided in relation to modeling contingent liabilities. Contingent liability is one of the most subjective, contentious and fluid concepts in contemporary accounting. Historical data often serves as the precedent by which the percentage assumption is set, i.e. to estimate the future liability incurred for purposes of internal planning. The business is exempt from disclosing the possible liability if it considers that the risk of it happening is remote.
Contingent liabilities
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. 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.
Contingent Liability
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. This principle plays an important role in ensuring reduced information asymmetry between the shareholders and the management. In April 2001 the International Accounting Standards Board adopted IAS 37 Provisions, Contingent Liabilities and Contingent Assets, which had originally been issued by the International Accounting Standards Committee in September 1998. That standard replaced parts of IAS 10 Contingencies and Events Occurring after the Balance Sheet Date that was issued in 1978 and that dealt with contingencies. Master accounting topics that pose a particular challenge to finance professionals.
Since a contingent liability can potentially reduce a company’s assets and negatively impact a company’s future net profitability and cash flow, knowledge of a contingent liability can influence the decision of an investor. The materiality principle states that all important financial information and matters need to be disclosed in the financial statements. An item is considered material if the knowledge of it could change the economic decision of users of the company’s financial statements. Both GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) require companies to record contingent liabilities, due to their connection with three important accounting principles.
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.
Possible contingencies are just disclosed to the investors by the management during the Annual general meetings (AGMs). Contingent liabilities are classified into three types by the US GAAP based on the probability of their occurrence. The IFRS Foundation is a not-for-profit, public interest organisation established to develop high-quality, understandable, enforceable and globally accepted accounting and sustainability disclosure standards.
Because this outcome is both probable and easy to estimate, the company’s controller records an expense of $500,000. 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. Contingent assets are possible assets whose existence will be confirmed by the occurrence or non-occurrence of uncertain future events that are not wholly within the control of the entity. Contingent assets are not recognised, but they are disclosed when it is more likely than not that an inflow of benefits will occur. However, when the inflow of benefits is virtually certain an asset is recognised in the statement of financial position, because that asset is no longer considered to be contingent.