What Is a Contingent Liability?
A contingent liability is a liability that may occur depending on the outcome of an uncertain future event. Contingent liabilities are recorded if the contingency is likely and the amount of the liability can be reasonably estimated. The liability may be disclosed in a footnote on the financial statements unless both conditions are not met.
Key Takeaways
- A contingent liability is a potential liability that may occur in the future, such as pending lawsuits or honoring product warranties.
- If the liability is likely to occur and the amount can be reasonably estimated, the liability should be recorded in the accounting records of a firm.
- Contingent liabilities are recorded to ensure that the financial statements are accurate and meet requirements of generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS).
- GAAP recognizes three categories of contingent liabilities: probable, possible, and remote.
How Contingent Liabilities Work
Pending lawsuits and product warranties are common examples of contingent liabilities because their outcomes are uncertain. The accounting rules for reporting a contingent liability differ depending on the estimated dollar amount of the liability and the likelihood of the event occurring. The accounting rules ensure that financial statement readers receive sufficient information. A probable contingent liability that can be reasonably estimated is entered into the accounts even if the precise amount cannot be known.
When Do I Need to Be Aware of Contingent Liabilities?
If you run a business or oversee the accounts of one, awareness of contingent liabilities is essential. You’ll need to record them. Both GAAP (generally accepted accounting principles) and IFRS (International Financial Reporting Standards) require companies to record contingent liabilities in accordance with three accounting principles: full disclosure, materiality, and prudence.
A contingent liability must be recorded if the contingency is likely and the amount of the liability can be reasonably estimated. GAAP recognizes three categories of contingent liabilities:
- Probable contingent liabilities: can be reasonably estimated (and must be reflected within financial statements).
- Possible contingent liabilities: are as likely to occur as not (and need only be disclosed in the financial statement footnotes).
- Remote contingent liabilities: are extremely unlikely to occur (and do not need to be included in financial statements at all).
What Is Important to Know About Contingent Liabilities?
Contingent liabilities can adversely impact a company’s assets and net profitability. Consequently, knowledge of both contingencies and commitments is essential to financial statement users because they represent the encumbrance of potentially substantial resources during future periods, affecting future cash flows available to creditors and investors.
Contingent liabilities are important for potential lenders to a company, who will consider these liabilities when deciding on lending terms. Business leaders must also be aware of contingent liabilities, as they should be taken into account when making strategic decisions.
Example of a Contingent Liability
Assume a company is facing a lawsuit from a rival firm for patent infringement. The company’s legal department believes the rival firm has a strong case, and the business estimates a $2 million loss if they lose. Because the liability is both probable and easy to estimate, the firm posts an accounting entry to debit (increase) legal expenses for $2 million and to credit (increase) accrued expense for $2 million.
The accrual account allows the firm to post an expense immediately without needing an immediate cash payment. If the lawsuit results in a loss, a debit is applied to the accrued account (deduction) and cash is credited (reduced) by $2 million.
Now, assume a lawsuit liability is possible but not probable, and the dollar amount is estimated at $2 million. Under these circumstances, the company discloses the contingent liability in the financial statement footnotes. If the likelihood of the liability is remote, the company does not need to disclose the potential liability.
A warranty is another common contingent liability because the number of products returned under warranty is unknown. For example, if a bike manufacturer offers a three-year warranty on bicycle seats costing $50 each, and manufactures 1,000 seats per year, the firm needs to estimate the number of seats that may be returned under warranty annually.
If the company forecasts 200 seats must be replaced under warranty for $50, it posts a debit (increase) to warranty expense for $10,000 and a credit (increase) to accrued warranty liability for $10,000. Accounts are adjusted for the actual warranty expense incurred at year-end.
Quick Questions
What is a contingent liability?
A contingent liability is a liability that may occur depending on the outcome of an uncertain future event. It has to be recorded if the contingency is likely and the amount can be reasonably estimated. Both GAAP and IFRS mandate the recording of contingent liabilities.
What are the 3 types of contingent liabilities?
GAAP recognizes three categories: probable, possible, and remote. Probable contingent liabilities can be reasonably estimated and must be reflected within financial statements. Possible contingent liabilities are as likely to occur as not and only need to be disclosed in the financial statement footnotes. Remote contingent liabilities are extremely unlikely to occur and do not need to be included in financial statements.
What are examples of contingent liabilities?
Pending lawsuits and product warranties are common contingent liabilities. Lawsuits are contingent due to their unknown outcomes, while warranties are contingent because the number of returned products under warranty is unknown.
Is a contingent liability an actual liability?
Yes, when classified as probable. Due to their high probability, they are considered real and need to be reported via accounting procedures, making them “real” liabilities.
Conclusion
A contingent liability is a potential liability that may occur in the future, such as pending lawsuits or honoring product warranties. If the liability is likely and the amount can be reasonably estimated, it should be recorded in the accounting records. Contingent liabilities are integral to ensure financial statements are accurate and meet GAAP or IFRS requirements. GAAP recognizes three categories of contingent liabilities: probable, possible, and remote.
Related Terms: liability, GAAP, IFRS, accrued expenses, warranty, lawsuit.
References
- Financial Accounting Standards Board. “Summary of Statement No. 5”.
- International Financial Reporting Standards Foundation. “IAS 37 Provisions, Contingent Liabilities and Contingent Assets”.
- Lumen Financial Accounting. “Contingent Liabilities”.
