Contingent Liability How to Use and Record Contingent Liabilities

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. IAS 37 defines and specifies the accounting for and disclosure of provisions, contingent liabilities, and contingent assets. According to the full disclosure principle, all significant, relevant facts related to the financial performance and fundamentals of a company should be disclosed in the financial statements.

• If the contingent liability is considered remote, it is unlikely to occur and may or may not be estimable.
• Estimating the costs of litigation or any liabilities resulting from legal action should be carefully noted.
• One common liquidity measure is the current ratio, and a higher ratio is preferred over a lower one.
• It’s important to note that this recorded liability doesn’t necessarily entail an immediate cash outflow.
• If the owner is reluctant to take responsibility for their product, the customer can sue the company.

A warranty can also be considered a contingent liability, since there is uncertainty about the exact number of units that will be returned by customers for repair or replacement. Considering and accounting for contingent liabilities requires a broad range of information and the ability to practice sound judgment. They can be a tricky endeavor for both management and investors to navigate since the likelihood of them occurring isn’t guaranteed.

These obligations have not occurred yet but there is a possibility of them occurring in the future. 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.

Example of a Contingent Liability

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) and Warranty Liability on the balance sheet (Figure) for Sierra Sports. 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.

This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. In addition, liabilities impact the company’s liquidity and, in the case of debt, capital structure. Contingent using cash flow surpluses for investment or to pay down debt liability can be assumed—for example, for losses arising from product or service failure—where the insurer has assumed liability by providing a performance warranty. A liability is something owed by someone—it sets up an obligation or a debt.

Under GAAP, a contingent liability is defined as any potential future loss that depends on a “triggering event” to turn into an actual expense. A warranty is considered contingent because the number of products that will be returned under a warranty is unknown. As part of the due diligence process, some potential investors look at a company’s prospectus, which must include all the information on its financial statements. Investors pay particular attention to items that reduce the company’s ability to generate profits, like contingent liabilities. Some events may eventually give rise to a liability, but the timing and amount is not presently sure.

However, poor management of liabilities may result in significant negative consequences, such as a decline in financial performance or, in a worst-case scenario, bankruptcy. 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)).

The full disclosure principle states that all necessary information that poses an impact on the financial strength of the company must be registered in the public filings. A great example of the application of prudence would be recognizing anticipated bad debts. Prudence can be helpful if certain liabilities might occur but aren’t certain; here contingent liabilities. Businesses need to plan for the worst case scenario while proactively hoping for the best in order to properly manage their cash flow. Planning for every eventuality is essential for sound financial management.

Amendments under consideration by the IASB

The magnitude of the impact depends on the time of occurrence and the amount tied to the liability. These obligations result from previous transactions or occurrences, and they are contingent on future events and indeterminate in nature. Any liabilities that have a probability of occurring over 50% are categorized under probable contingencies. It’s difficult to estimate or even quantify the impact that contingent liabilities could have because of their uncertain nature.

LO 11.3 Define and Apply Accounting Treatment for Contingent Liabilities

It is probable that funds will be spent and the amount can likely be estimated. 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. Contingent liabilities can pose a threat to the reduction of net profitability and company assets.

Measurement of provisions

Within the generally accepted accounting principles (GAAP) there are three main categories of contingent liabilities. Usually, the contingent liability will be outlined and disclosed in a footnote on the financial statement. It would not be disclosed in a footnote, however, if both conditions are not met. For a contingent liability to become relevant, it depends on its timing, its value can be estimated or is known, and whether or not it will become an actual liability. Both these examples underscore the intricate nature of contingent liabilities and how they guide financial decisions, ensuring transparency and accuracy in a company’s financial reporting. Estimation of contingent liabilities is another vague application of accounting standards.

This type of liability only gets recorded if the contingency is a possibility, and also if the total amount of the potential liability is reasonably and accurately estimated. A contingent liability hinges on uncertain future events and is recognized when both likelihood and estimated amount conditions are met. In contrast, an actual liability is a current obligation with a definite amount, necessitating immediate payment.

A footnote to the balance sheet may describe the nature and extent of the contingent liabilities. 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. Financial reporting standards require companies to disclose possible contingent liabilities in the footnotes of their financial statements.

How to Tell If a Contingent Liability Should Be Recognized

Some of the examples of such transactions can be insurance claims, oil spills, lawsuits. All these create a liability for the company and liabilities that are created in such situations are known as contingent liabilities. Unlike contingent liabilities, provisions are recorded in the books of accounts.

The accounting rules for the treatment of a contingent liability are quite liberal – there is no need to record a liability unless the risk of loss is quite high. Thus, you should review the disclosures accompanying a company’s financial statements to see if there are additional risks that have not yet been recognized. These disclosures should be considered advance warning of amounts that may later appear as formal liabilities in the financial statements. 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. Contingent assets are not recognised, but they are disclosed when it is more likely than not that an inflow of benefits will occur.