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What Are Contingent Liabilities? Definition, Explanation, Examples

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.

Probable but Not Estimable Contingencies

• All of our content is based on objective analysis, and the opinions are our own.
• It should be observed that the uncertainty about effect does not relate to the cause but to the results of that event.
• For example, Sierra Sports has a one-year warranty on partrepairs and replacements for a soccer goal they sell.
• Pending lawsuits and product warranties are two examples of contingent liabilities.
• If information as of the balance sheet date indicates a future loss for the company is probable and the amount is reasonably estimable, the company should record an accrual for the liability.
• Contingent liabilities are possible obligations whose existence will be confirmed by uncertain future events that are not wholly within the control of the entity.
• Google, a subsidiary ofAlphabet Inc., has expanded froma search engine to a global brand with a variety of product andservice offerings.

The transparency of financial statements is enhanced by the disclosure of contingent liabilities, which provides stakeholders with a comprehensive view of potential financial exposures. These disclosures are governed by accounting standards that dictate the level of detail required in the notes accompanying the financial statements. Companies must disclose the nature of the contingent liability, an estimate of its financial impact, and the uncertainties involved. This information allows investors and creditors to make informed judgments about the company’s future cash flows and financial health.

Disclosure

There are few cases in which there would be no justification for recognizing a warranty liability on the basis that virtual accountant the amount cannot be estimated. Another way to establish the warranty liability could be anestimation of honored warranties as a percentage of sales. In thisinstance, Sierra could estimate warranty claims at 10% of itssoccer goal sales. If the warranties are honored, the company should know howmuch each screw costs, labor cost required, time commitment, andany overhead costs incurred. This amount could be a reasonableestimate for the parts repair cost per soccer goal.

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Contingent liabilities must pass two thresholds before they can be reported in financial statements. The liability must have more than a 50% chance of being realized if the value can be estimated. Qualifying contingent liabilities are recorded as an expense on the income statement and as a liability on the balance sheet. A contingent liability is a potential retained earnings liability that may occur in the future, such as pending lawsuits or honoring product warranties. If the liability is likely to occur and the amount can be reasonably estimated, the liability should be recorded in the accounting records of a firm.

It’s impossible to know whether the company should report a contingent liability of $250,000 based solely on this information. The company should rely on precedent and legal counsel to ascertain the likelihood of damages. In all these situations, a past event has occurred that may give rise to liability depending on some future event. Furthermore, in many cases, the actual payee of the liability is not known until the future event occurs. Generally, the amount of these liabilities must be estimated; the actual amount cannot be determined until the event that confirms the liability occurs. That said, there can be a variety of techniques to use to help evaluate contingent liabilities and weigh their risk.

Probable and Estimable

• For instance, a significant contingent liability may lead to a higher discount rate in a discounted cash flow model, reflecting the increased risk to future cash flows.
• Companies are reluctant to provide these disclosures because they may simply invite investigation or litigation.
• IFRS Accounting Standards are, in effect, a global accounting language—companies in more than 140 jurisdictions are required to use them when reporting on their financial health.
• The disclosure requirements for contingent liabilities are set forth in accounting standards.
• The basic nature of contingent liability is important to know, recognize, and understand.

If the contingent liability is consideredremote, it is unlikely to contingent liabilities occur and may or may notbe estimable. This does not meet the likelihood requirement, andthe possibility of actualization is minimal. In this situation, nojournal entry or note disclosure in financial statements isnecessary.

Contingent liability

The average cost of $200 × 25goals gives an anticipated future repair cost of $5,000 for 2019.Assume for the sake of our example that in 2020 Sierra Sports maderepairs that cost $2,800. Following are the necessary journalentries to record the expense in 2019 and the repairs in 2020. Theresources used in the warranty repair work could have includedseveral options, such as parts and labor, but to keep it simple weallocated all of the expenses to repair parts inventory. Since thecompany’s inventory of supply parts (an asset) went down by $2,800,the reduction is reflected with a credit entry to repair partsinventory.

• Gain insight into the role of contingent liabilities in financial health, including recognition, measurement, and reporting practices for informed decisions.
• The average cost of $200 × 25goals gives an anticipated future repair cost of $5,000 for 2019.Assume for the sake of our example that in 2020 Sierra Sports maderepairs that cost $2,800.
• Banks that issue standby letters of credit or similar obligations carry contingent liabilities.
• GAAP adopts the position that the effect (loss) and the amount should be reported as if they were known at the statement date.
• The loss can result in the impairment of an asset (such as bad debt losses on receivables) or the creation of a liability (such as guaranteeing the loans of a subsidiary company).

The footnote disclosure should include the nature of the lawsuit, the timing of when it expects a settlement decision, and the potential amount– either the range or the exact amount if it is identifiable. If the likelihood of a negative lawsuit outcome is remote, the company does not need to disclose anything in the footnotes. Some of the best contingent liability examples include warranties and pending lawsuits. Warranty liability is considered to be a contingent liability since it’s often unknown how many products could be returned under a warranty.