Since it has the potential to affect the company’s Cash flow and net income negatively, one has to take important steps to decide the impact of these contingencies. So the mobile manufacturer will record a contingent liability in the P&L statement and the balance sheet, an amount at which the 2,000 mobile phones were made. Another fantastic example of contingent liability would be product warranties. Let’s say a mobile phone manufacturer produces many mobiles and sells them with a brand warranty of 1 year. The principle of prudence is a crucial principle that states that a company must not record future anticipated gains into the books of accounts, but any expected losses must be accounted for. Grant Gullekson is a CPA with over a decade of experience working with small owner/operated corporations, entrepreneurs, and tradespeople.

• Businesses need to plan for the worst case scenario while proactively hoping for the best in order to properly manage their cash flow.
• Under GAAP, the listed amount must be “fair and reasonable” to avoid misleading investors, lenders, or regulators.
• No journal entry or financial adjustment in the financial statements will occur.
• Considering and accounting for contingent liabilities requires a broad range of information and the ability to practice sound judgment.

If a court is likely to rule in favor of the plaintiff, whether because there is strong evidence of wrongdoing or some other factor, the company should report a contingent liability equal to probable damages. This second entry recognizes an honored warranty for a soccer
goal based on 10% of sales from the period. When determining if the contingent liability should be
recognized, there are four potential treatments to consider.

IAS 12 — Accounting for uncertainties in income taxes

The outcome of the pending obligation is known and the value can be reasonably estimated. A contingent liability is an amount that you may have an obligation in the future depending on certain events. As well, there are three primary principles that outline and indicate whether or not a contingent liability is recorded. These are the prudence principle, the materiality principle, and the full disclosure principle. A contingent liability is not recognised in the statement of financial position. However, unless the possibility of an outflow of economic resources is remote, a contingent liability is disclosed in the notes.

There are sometimes significant risks that are simply not in the liability section of the balance sheet. Most recognized contingencies are those meeting the rather strict criteria of “probable” and “reasonably estimable.” One exception occurs for contingencies assumed in a business acquisition. Some events may eventually give rise to a liability, but the timing and amount is not presently sure. 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. Contingent assets are possible assets whose existence will be confirmed by the occurrence or non-occurrence of uncertain future events that are not wholly within the control of the entity.

Is contingent liability an actual liability?

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. 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 12.10and Warranty Liability on the balance sheet

Figure 12.11 for Sierra Sports. If the warranties are honored, the company should know how
much each screw costs, labor cost required, time commitment, and
any overhead costs incurred.

Examples

A contingent liability is an existing condition or set of circumstances involving uncertainty regarding possible business loss, according to guidelines from the Financial Accounting Standards Board (FASB). In the Statement of Financial Accounting Standards No. 5, it says that a firm must distinguish between losses that are probable, reasonably probable or remote. There are strict and sometimes vague disclosure requirements for companies claiming contingent liabilities.

For our purposes, assume that Sierra Sports has a line of soccer
goals that sell for $800, and the company anticipates selling 500
goals this year (2019). Past experience for the goals that the
company has sold is that 5% of them will need to be repaired under
their three-year warranty program, and the cost of the average
repair is $200. To simplify our example, we concentrate strictly on
the journal entries for the warranty expense recognition and the
application of the warranty repair pool. If the company sells 500
goals in 2019 and 5% need to be repaired, then 25 goals will be
repaired at an average cost of $200.

Pending litigation involves legal claims against the business that may be resolved at a future point in time. The outcome of the lawsuit has yet to be determined but could have negative future impact on the business. It does not make any sense to immediately realize a contingent liability – immediate realization signifies the financial obligation has occurred with certainty. A warranty is considered contingent because the number of products that will be returned under a warranty is unknown. The accounting of contingent liabilities is a very subjective topic and requires sound professional judgment.

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. Possible contingencies are just disclosed to the investors by the management during the Annual general meetings (AGMs). This can help encourage clarity between the company’s shareholders and investors and reduce any potential con activities. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. 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.

This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. Contingent liability is one of the most subjective, contentious and fluid concepts in contemporary accounting. Find comprehensive guides to help you face your most pressing accounting and reporting challenges with clarity and confidence. Sophisticated analyses include techniques like options pricing methodology, expected loss estimation, and risk simulations of the impacts of changed macroeconomic conditions. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.

It is unclear if a customer will need to use a
warranty, and when, but this is a possibility for each product or
service sold that includes a warranty. The same idea applies to
insurance claims (car, life, and fire, for example), and
bankruptcy. There is an uncertainty that a claim will transpire, or
bankruptcy will occur. If the contingencies do occur, it may still
be uncertain when they will come to fruition, or the financial
implications.

In our case, we make assumptions about Sierra Sports and build our discussion on the estimated experiences. Warranties arise from products or services sold to customers that cover certain defects (see Figure 12.8). 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. Future costs are expensed first, and then a liability account is credited based on the nature of the liability.

Accounting Guidelines for Contingent Liabilities

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. Within this principle, referring to the term material also refers to the liability being significant. Since some contingent liabilities can have a negative impact on the financial performance and health of a company, having knowledge of it can influence decision-making when it comes to financial statements. For a financial figure to be reasonably estimated, it could be based on past experience or industry standards (see Figure 12.9).

Educational material on applying IFRSs to climate-related matters updated

They can be a tricky endeavor for both management and investors to navigate since the likelihood of them occurring isn’t guaranteed. Do not confuse these “firm specific” contingent liabilities with general business risks. General business risks include the risk of war, storms, and what is a three-way match in accounts payable gep glossary the like that are presumed to be an unfortunate part of life for which no specific accounting can be made in advance. Contingent liabilities also include obligations that are not recognised because their amount cannot be measured reliably or because settlement is not probable.

Educational material on applying IFRSs to climate-related matters

If the estimated loss can only be defined as a range of outcomes, the U.S. approach generally results in recording the low end of the range. International accounting standards focus on recording a liability at the midpoint of the estimated unfavorable outcomes. At the end of the year, the accounts are adjusted for the actual warranty expense incurred. 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. Contingent liabilities should be analyzed with a serious and skeptical eye, since, depending on the specific situation, they can sometimes cost a company several millions of dollars. Sometimes contingent liabilities can arise suddenly and be completely unforeseen.