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. 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. 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. There is a probability that someone who purchased the soccer goal may bring it in to have the screws replaced.

An example is litigation against the entity when it is uncertain whether the entity has committed an act of wrongdoing and when it is not probable that settlement will be needed. Estimation of contingent liabilities is another vague application of accounting standards. Under GAAP, the listed amount must be “fair and reasonable” to avoid misleading investors, lenders, or regulators.

• Here, instead of providing for damages in financial statements, ACE Ltd should disclose it by way of notes to the financial statement.
• Since the outcome is possible, the contingent liability is disclosed in Sierra Sports’ financial statement notes.
• Contingent liability is one of the most subjective, contentious and fluid concepts in contemporary accounting.
• Initially, when the customer had reported it to, the company refused to accept the claim and therefore, the customer has filed a legal claim against them.

But it will be recorded in the books only if the probability is more than 50%. Contingent liabilities are recorded on the P&L statement and the balance sheet if the probability of occurrence is more than 50%. 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. 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.

How is contingent liability shown on the balance sheet?

The ability to estimate a loss is described as known, reasonably estimable, or not reasonably estimable. Pending lawsuits and product warranties are common contingent liability examples because their outcomes are uncertain. The accounting rules for reporting a contingent liability differ depending on the estimated dollar amount of the liability and the likelihood of the event occurring. The accounting rules ensure that financial statement readers receive sufficient information. Contingent liabilities are recorded if the contingency is likely and the amount of the liability can be reasonably estimated. The liability may be disclosed in a footnote on the financial statements unless both conditions are not met.

Contingent liabilities are liabilities that may occur if a future event happens. 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.

Some events may eventually give rise to a liability, but the timing and amount is not presently sure. Such uncertain or potential obligations are known as contingent liabilities. Legal disputes give rise to contingent liabilities, environmental contamination events give rise to contingent liabilities, product warranties give rise to contingent liabilities, and so forth. Such contingency is neither recorded on the financial statements nor disclosed to the investors by the management.

Definition of Contingent Liabilities

When determining if the contingent liability should be recognized, there are four potential treatments to consider. If a company is sued by a former employee for $500,000 for age discrimination, the company has a contingent liability. However, if the company is not found guilty, the company will not have any liability. Examples of Contingent Liability
A company’s supplier is unable to obtain a bank loan.

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. IAS 37 defines and specifies the accounting for and disclosure of provisions, contingent liabilities, and contingent assets. Future costs are expensed first, and then a liability account is credited based on the nature of the liability. In the event the liability is realized, the actual expense is credited from cash and the original liability account is similarly debited.

FAQs About Contingent Liability

Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory. These materials were downloaded from PwC’s Viewpoint (viewpoint.pwc.com) under license. 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. 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.

Any probable contingency needs to be reflected in the financial statements—no exceptions. Possible contingencies—those that are neither probable nor remote—should be disclosed in the footnotes of the financial statements. 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. Here, instead of providing for damages in financial statements, ACE Ltd should disclose it by way of notes to the financial statement. The reason is that the future occurrence of an event may or may not turn into a liability.

Contingent Liability Accounting

There are three possible scenarios for contingent liabilities, all of which involve different accounting transactions. Contingent liabilities are those liabilities that tend to occur in the future depending on an outcome. It may or may not be disclosed in a footnote unless it meets both conditions. Some of the common contingent liabilities examples are product warranties, pending investigations, and potential lawsuits.

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A contingent liability is a potential obligation that may arise from an event that has not yet occurred. A contingent liability is not recognized in a company’s financial statements. Instead, only disclose the existence of the contingent liability, unless the possibility of payment is remote.

Revision Notes

This means that they can potentially negatively impact the health and financial performance of a company. Ultimately, this is why these situations or circumstances must get disclosed in the financial statements of a company. 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. 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.

A possible liability or a potential loss that may or may not occur based on the result of an unexpected future event or circumstance is known as a contingent liability. These liabilities will get recorded if the liability has a reasonable probability of occurrence. 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. A warranty is another common contingent liability because the number of products returned under a warranty is unknown. Assume, for example, that a bike manufacturer offers a three-year warranty on bicycle seats, which cost $50 each.

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 what is capital definition types and structure note disclosures. A contingent liability is a potential 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.