Contingent Liability: Meaning, Accounting Treatment and 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. 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.

• But it will be recorded in the books only if the probability is more than 50%.
• An estimated liability is certain to occur—so, an amount is always entered into the accounts even if the precise amount is not known at the time of data entry.
• Contingent liabilities can pose a threat to the reduction of net profitability and company assets.
• The new product the company is launching may still be kept discreet as the breach in secrecy may result in huge losses for the company.

In his freetime, you’ll find Grant hiking and sailing in beautiful British Columbia. 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. Another way to establish the warranty liability could be an estimation of honored warranties as a percentage of sales.

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.

What is a Contingent Liability?

We endeavor to ensure that the information on this site is current and accurate but you should confirm any information with the product or
service provider and read the information they can provide. Contingent liability is one of the most subjective, contentious and fluid concepts in contemporary accounting. 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. The companies or even individuals who develop new work or products can register for copyright so that they can take benefit from the profits and retain the original ownership. In a situation where the real damages are difficult to ascertain, a liquidated damage amount seems appropriate and accepted by both parties.

It’s difficult to estimate or even quantify the impact that contingent liabilities could have because of their uncertain nature. Plus, the impact they could have will also depend on how sound the company is in its financial obligations. 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. An example of determining a warranty liability based on a percentage of sales follows. The sales price per soccer goal is $1,200, and Sierra Sports believes 10% of sales will result in honored warranties.

Now in the current financial year, the subsidiary company went through a financial crisis and is almost on the verge of bankruptcy. Now the company must consider this as a provision or even as a liability and pass the necessary accounting entries to recognize this. In the practical world, there are many transactions that occur whose final outcome is not always known at the time.

• If it is determined that not enough is being accumulated, then the warranty expense allowance can be increased.
• This second entry recognizes an honored warranty for a soccer goal based on 10% of sales from the period.
• First, it must be possible to estimate the value of the contingent liability.
• No journal entry or financial adjustment in the financial statements will occur.

A contingent liability is a liability that may occur depending on the outcome of an uncertain future event. A contingent liability has to be recorded if the contingency is likely and the amount of the liability can be reasonably estimated. Both generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) require companies to record contingent liabilities.

Examples of Contingent Liabilities in Accounting are

In this instance, Sierra could estimate warranty claims at 10% of its soccer goal sales. These are questions businesses must ask themselves when exploring contingencies and their effect on liabilities. One major difference between the two is that the latter is an amount you already owe someone, whereas the former is contingent upon the event occurring. Liabilities are related to the financial obligations or debts that a person or a company has to another entity. There are numerous different categories of liabilities, each with special characteristics and implications for the creditor and debtor.

IAS 37 Provisions, Contingent Liabilities and Contingent Assets

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. These liabilities become contingent whenever their payment contains a reasonable degree of uncertainty. 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. However, sometimes companies put in a disclosure of such liabilities anyway.

Contingent liabilities

This ratio—current assets divided by current liabilities—is lowered by an increase in current liabilities (the denominator increases while we assume that the numerator remains the same). When lenders arrange loans with their corporate customers, limits are typically set on how low certain liquidity ratios (such as the current ratio) can go before the bank can demand that the loan be repaid immediately. 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. Do not record or disclose the contingent liability if the probability of its occurrence is remote. A provision is measured at the amount that the entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time.

Integrated Reporting

An estimated liability is certain to occur—so, an amount is always entered into the accounts even if the precise amount is not known at the time of data entry. Grant Gullekson is a CPA with over a decade of experience working with small what is an ein number owner/operated corporations, entrepreneurs, and tradespeople. He specializes in transitioning traditional bookkeeping into an efficient online platform that makes preparing financial statements and filing tax returns a breeze.

The likelihood of loss is described as probable, reasonably possible, or remote. The ability to estimate a loss is described as known, reasonably estimable, or not reasonably estimable. A contingent liability is a potential future debt that depends on the occurrence or non-occurrence of one or more uncertain future events.

In order to safeguard your company’s finances and reputation, you must take both existing and potential obligations into consideration when you engage into a contract. When determining if the contingent liability should be recognized, there are four potential treatments to consider. 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. Imagine a business being sued for copyright infringement by a rival business. The business projects a $5 million loss if the firm loses the case, but the legal department of the business believes the rival firm has a strong case. The most common example of a remote contingency would be a frivolous lawsuit.