Contingent Liability How to Use and Record Contingent Liabilities

how to record contingent liability

Only the contingent liabilities that are the most probable can be recognized as a liability on financial statements. Other contingencies are relegated to footnotes as long as uncertainty persists. 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. If it is determined that too much is being set aside in the allowance, then future annual warranty expenses can be adjusted downward.

how to record contingent liability

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.

Reporting Requirements of Contingent Liabilities and GAAP Compliance

Likewise, a note is required when it is probable a loss has occurred but the amount simply cannot be estimated. Normally, accounting tends to be very conservative (when in doubt, book the liability), but this is not the case for contingent liabilities. Therefore, one should carefully read the notes to the financial statements before investing or loaning money to a company. Now assume that a lawsuit liability is possible but not probable and the dollar amount is estimated to be $2 million.

Assume, for example, that a bike manufacturer offers a three-year warranty on bicycle seats, which cost $50 each. If the firm manufactures 1,000 bicycle seats in a year and offers a warranty per seat, the firm needs to estimate the number of seats that may be returned under warranty each year. 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.

Under these circumstances, the company discloses the contingent liability in the footnotes of the financial statements. If the firm determines that the likelihood of the liability occurring is remote, the company does not need to disclose the potential liability. Sierra Sports may have more litigation in the future surrounding the soccer goals.

  1. An example might be a hazardous waste spill that will require a large outlay to clean up.
  2. Any probable contingency needs to be reflected in the financial statements—no exceptions.
  3. The average cost of $200 × 25 goals gives an anticipated future repair cost of $5,000 for 2019.
  4. Estimation of contingent liabilities is another vague application of accounting standards.

Contingent liabilities adversely impact a company’s assets and net profitability. 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.

Such amounts are almost never recognized before settlement payments are actually received. 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.

Recording a Contingent Liability

Contingent liability is a potential obligation that may or may not become an actual liability in the future. In this case, the company needs to account for contingent liability by making proper journal entry if the potential future cost is probable (i.e. likely to occur) and its amount can be reasonably estimated. A contingent liability is a potential liability that may occur in the future, such as pending lawsuits or honoring product warranties.

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. 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. 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.

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. As the name suggests, if there are very slight chances of the liability occurring, the US GAAP considers calling it a remote contingency. Contingent liabilities are classified into three types by the US GAAP based on the probability of their occurrence. This ensures that income or assets are not overstated, and expenses or liabilities are not understated.

What Are the GAAP Accounting Rules for Contingent Liabilities?

The reason is that the event (“the injury itself”) giving rise to the loss arose in Year 1. Conversely, if the injury occurred in Year 2, Year 1’s financial statements would not be adjusted no matter how bad the financial effect. However, a note to the financial statements may be needed to explain that a material adverse event arising subsequent to year end has occurred. Two classic examples of contingent liabilities include a company warranty and a lawsuit against the company.

If it is determined that not enough is being accumulated, then the warranty expense allowance can be increased. 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 free construction service invoice template into an actual expense. 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).

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. 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. Possible contingent liabilities include loss from damage to property or employees; most companies carry many types of insurance, so these liabilities are normally expressed in terms of insurance costs. The accrual account permits the firm to immediately post an expense without the need for an immediate cash payment.

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. 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. Product warranties are often cited as a contingent liability that meets both of the required conditions (probable and the amount can be estimated). Product warranties will be recorded at the time of the products’ sales by debiting Warranty Expense and crediting to Warranty Liability for the estimated amount.

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