Red Mawashi's Blog

Whether the contingent liability becomes an actual liability depends on a future event occurring or contingent liabilities not occurring. Contingent Liabilities refer to the possible liability of the firm which may occur on some future date based on a contingent event that is beyond the company’s control. It is recorded by the company on its balance sheet only if it becomes evident that contingency is possible in the company and the amount of such liability can be estimated reasonably. Possible contingencies that are neither probable nor remote should be disclosed in the footnotes of the financial statements. Companies operating in the United States rely on the guidelines established in the generally accepted accounting principles (GAAP). A contingent liability is defined under GAAP as any potential future loss that depends on a “triggering event” to become an actual expense.

How confident are you in your long term financial plan?

• Contingent liabilities can pose a threat to the reduction of net profitability and company assets.
• Essentially, the effect that contingent liabilities have on an audit depends on their likelihood of occurring in the first place.
• Following are the necessary journalentries to record the expense in 2019 and the repairs in 2020.
• Although each involves its own peculiar problems, the basic accounting practices are consistent with those shown above.
• It is recorded by the company on its balance sheet only if it becomes evident that contingency is possible in the company and the amount of such liability can be estimated reasonably.

In that case, the company should record the minimum of the range as its contingent liability. It would record a journal entry to debit legal expense for $1 million and credit an accrued liability account for $1 million. Contingent liabilities are a type of liability that may be owed in the future as the result of a potential event. Assume that a company is facing a lawsuit from a rival firm for patent infringement. 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.

Contents

Therefore, contingent liabilities disclosure and representation of an estimated amount is significant. They directly or indirectly affect the cash flows of the business, which in turn have an impact on investors ‘return and liability towards creditors. Thus, it is implied that this liability amount should be taken into consideration while making strategic decision regarding investments and future plans. Contingent liabilities are possible obligations whose existence will be confirmed by uncertain future events that are not wholly within the control of the entity. 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.

Probable and Estimable

A business with high contingent liabilities may be seen as riskier, which could influence its borrowing costs and credit rating. 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.

• This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
• Contingent liabilities are potential obligations that may arise depending on the outcome of a future event.
• The accounting rules ensure that financial statement readers receive sufficient information.
• Assume, on the other hand, ABC Company’s settlement amount was likely to be between $1 million and $2 million– but no specific amount within that range is more likely than any other.
• Both represent possible losses and both depend on some uncertain future event.
• The income statement and balance sheet are typicallyimpacted by contingent liabilities.

When no particular amount within the range is thought to be more likely than any other, the firm should record the loss as the minimum figure in the range. For example, warranty liabilities related unearned revenue to established products typically involve reasonably estimable amounts, but those related to newly created products may not be estimable. 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).

• For example, a company involved in litigation would disclose the nature of the claims, the progress of the case, and the opinions of legal counsel.
• Because a contingent liability has the ability to negatively impact a company’s net assets and future profitability, it should be disclosed to financial statement users if it is likely to occur.
• Finally, during 2024, the company incurred $35,000 of warranty expenditures related to these printers.
• In thisinstance, Sierra could estimate warranty claims at 10% of itssoccer goal sales.
• In this case, a note disclosure is requiredin financial statements, but a journal entry and financialrecognition should not occur until a reasonable estimate ispossible.

Two classic examples of contingent liabilities include a company warranty and a lawsuit against the company. Both represent Bookstime possible losses and both depend on some uncertain future event. If a possibility of a loss to the company is remote, no disclosure is required per GAAP. However, the company should disclose the contingent liability information in its footnotes to the financial statements if the financial statements could otherwise be deemed misleading to financial statement users. As well, pending lawsuits are also considered contingent liabilities because the outcome of the lawsuit is entirely unknown.

This is consideredprobable but inestimable, because the lawsuit is very likely tooccur (given a settlement is agreed upon) but the actual damagesare unknown. No journal entry or financial adjustment in thefinancial statements will occur. Instead, Sierra Sports willinclude a note describing any details available about the lawsuit.When damages have been determined, or have been reasonablyestimated, then journalizing would be appropriate.