Contingent Liabilities Meaning, Examples, and Accounting Entries

If the value can be estimated, the liability must have more than a 50% chance of being realized. Qualifying contingent liabilities are recorded as an expense on the income statement and a liability on the balance sheet. 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.

Instead, the contingent liability will be disclosed in the notes to the financial statements. According to FASB Statement No. 5, if the liability is probable and the amount can be reasonably estimated, companies should record contingent liabilities in the accounts. However, since most contingent liabilities may not occur and the amount often cannot be reasonably estimated, the accountant usually does not record them in the accounts.

What Are the GAAP Accounting Rules for Contingent Liabilities?

There is a probability that someone who purchased the soccer goal may bring it in to have the screws replaced. Not only does the contingent liability meet the probability requirement, a contingent liability that is probable and for which the dollar amount can be estimated should be it also meets the measurement requirement. The accrual account permits the firm to immediately post an expense without the need for an immediate cash payment.

However, its actual experiences could be more, the same, or less than $2,200. If it is determined that too much is being set aside in the allowance, then future annual warranty expenses can be adjusted downward. If it is determined that not enough is being accumulated, then the warranty expense allowance can be increased. Product warranties are often cited as a contingent liability that meets both of the required conditions (probable and the amount can be estimated).

Four Potential Treatments for Contingent Liabilities

If the potential for a negative outcome from the lawsuit is reasonably possible but not probable, the company should disclose the information in the footnotes to its financial statement. 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. If the expected settlement date is within the upcoming year, the liability would be classified under the short-term liability section of the balance sheet. 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.

Any contingent liabilities that are questionable before their value can be determined should be disclosed in the footnotes to the financial statements. If the contingent liability is probable and inestimable, it is likely to occur but cannot be reasonably estimated. In this case, a note disclosure is required in financial statements, but a journal entry and financial recognition should not occur until a reasonable estimate is possible. Let’s expand our discussion and add a brief example of the calculation and application of warranty expenses. 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.

Learning OUTCOMES

Since this warranty expense allocation will probably be carried on for many years, adjustments in the estimated warranty expenses can be made to reflect actual experiences. Also, sales for 2020, 2021, 2022, and all subsequent years will need to reflect the same types of journal entries for their sales. In essence, as long as Sierra Sports sells the goals or other equipment and provides a warranty, it will need to account for the warranty expenses in a manner similar to the one we demonstrated.

• If the likelihood of a negative lawsuit outcome is remote, the company does not need to disclose anything in the footnotes.
• Under US GAAP, the low end of the range would be accrued, and the range disclosed.
• Warranties arise from products or services sold to customers that cover certain defects (see Figure 12.8).
• First, following is the necessary journal entry to record the expense in 2019.
• These liabilities are categorized as being likely to occur and estimable, likely to occur but not estimable, or not likely to occur.
• 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.
• A contingent liability is a liability that may occur depending on the outcome of an uncertain future event.

If the firm determines that the likelihood of the liability occurring is remote, the company does not need to disclose the potential liability. The key principle established by the Standard is that a provision should be recognised only when there is a liability i.e. a present obligation resulting from past events. The Standard thus aims to ensure that only genuine obligations are dealt with in the financial statements – planned future expenditure, even where authorised by the board of directors or equivalent governing body, is excluded from recognition.

When determining if the contingent liability should be recognized, there are four potential treatments to consider. 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. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more.