12 3 Define and Apply Accounting Treatment for Contingent Liabilities Principles of Accounting, Volume 1: Financial Accounting

It all depends on the type of liability and the event that ends up occurring. The basic nature of contingent liability is important to know, recognize, and understand. There are three primary conditions that need to be met for a contingent liability to exist. The outcome of the pending obligation is known and the value can be reasonably estimated.

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  • A contingency occurs when a current situation has an outcome that is unknown or uncertain and will not be resolved until a future point in time.
  • Remote (not likely) contingent liabilities are not to be included in any financial statement.
  • Here, it becomes necessary to notify it to shareholders and other users of financial statements because the outcome will have an impact on investment related decisions.
  • First, it must be possible to estimate the value of the contingent liability.

A contingent liability is a potential loss that may occur at some point in the future, once various uncertainties have been resolved. The exact status of a contingent liability is important when determining which liabilities to present in the balance sheet or in the attached disclosures. It is of interest to a financial analyst, who wants to understand the probability of such an issue becoming a full liability of a business, which could impact its status as a going concern. As well, pending lawsuits are also considered contingent liabilities because the outcome of the lawsuit is entirely unknown.

For example, investors might determine that a company is financially stable enough to absorb potential losses from a contingent liability and still decide to invest in it. But a contingent liability needs to be large enough to be able to truly affect a company’s share price. Although it is not realized in the books of accounts, a contingent liability is credited to the accrued liabilities account in the journal. Even if the outcome is based on the probability of occurrence of the event, it is considered an actual liability.

How Do Liabilities Become Contingent Liabilities?

Contingent liabilities adversely impact a company’s assets and net profitability. The company sets an accounting entry to debit (increase) legal expenses for $5 million and credit (raise) accrued expenses for $5 million on the balance sheet because the liability is probable and simple to estimate. Let’s expand our discussion and add a brief example of the calculation and application of warranty expenses. The analysis of contingent liabilities, especially when it comes to calculating the estimated amount, is sophisticated and detailed. To make sure a business’s financial reports comply with regulations, a public accounting firm must assess these reports.

  • Therefore, it is also important to describe the liability in the footnotes that accompany the financial statements.
  • In this situation, no journal entry or note disclosure in financial statements is necessary.
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  • A great example of the application of prudence would be recognizing anticipated bad debts.
  • A subjective assessment of the probability of an unfavorable outcome is required to properly account for most contingences.
  • When no amount within the range is a better estimate than any other amount, however, the minimum amount in the range should be accrued.

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If the contingency is reasonably possible, it could occur but is not probable. Since this condition does not meet the requirement of likelihood, it should not be journalized or financially represented within the financial statements. Rather, it is disclosed in the notes only with any available details, financial or otherwise. A contingent liability is not recognised in the statement of financial position.

IAS 37 Provisions, Contingent Liabilities and Contingent Assets

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. GAAP accounting rules require probable contingent liabilities—ones that can be estimated and are likely to occur—to be recorded in financial statements. Contingent liabilities that are likely to occur but cannot be estimated should be included in a financial statement’s footnotes. Remote (not likely) contingent liabilities are not to be included in any financial statement. Contingent liabilities must pass two thresholds before they can be reported in financial statements.

Reporting Requirements of Contingent Liabilities and GAAP Compliance

Contingent liabilities also can negatively affect share price, depending on the probability of the event and other factors. If the company has a strong cash flow and its earnings are high, the liability may not be as important. That said, there can be a variety of techniques to use to help evaluate contingent liabilities and weigh their risk. These can include expected loss estimation, risk simulations of impacts, and pricing methodology. 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.

Finally, how a loss contingency is measured varies between the two options as well. Under US GAAP, the low end of the range would be accrued, and the range disclosed. 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. The company would record this warranty liability of $120 ($1,200 × 10%) to Warranty Liability and Warranty Expense accounts. Contingent liabilities also include obligations that are not recognised because their amount cannot be measured reliably or because settlement is not probable.

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.

However, unless the possibility of an outflow of economic resources is remote, a contingent liability is disclosed in the notes. An entity recognises a provision if it is probable the fed monetized more than half the massive federal pandemic debt that an outflow of cash or other economic resources will be required to settle the provision. If an outflow is not probable, the item is treated as a contingent liability.

Items can be considered to have a monetary value if their inclusion or exclusion has an impact on the business. 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). 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.

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