What is a contingent liability?

If the firm manufactures 1,000 bicycle seats in a year and offers a warranty per seat, the firm needs to estimate the number of seats that may be returned under warranty each year. The full disclosure principle requires that any relevant and significant facts that are related to financial performance must be disclosed in the company’s financial statements. 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.

This can come with estimated liability or a need to determine contingent liability legitimacy. If the contingent liability is considered remote, it is unlikely to occur and may or may not be estimable. This does not meet the likelihood requirement, and the possibility of actualization is minimal. In this situation, no journal entry or note disclosure in financial statements is necessary.

Such amounts are almost never recognized before settlement payments are actually received. Some of the best contingent liability examples include warranties and pending lawsuits. Warranty liability is considered to be a contingent liability since it’s often unknown how many products could be returned under a warranty. The materiality principle outlines that any and all important financial information and matters must be disclosed in a company’s financial statements. For an item or event to be considered to be material, it means that having knowledge of it occurring could change certain economic decisions for those that use the company’s financial statements. One can always depict this type of liability on the company’s financial statements if there are any.

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).
Possible contingencies—those that are neither probable nor remote—should be disclosed in the footnotes of the financial statements.
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In the event of an audit, the company must be able to explain and defend its contingent accounting decisions.
These liabilities can harm the company’s stock price because contingent liabilities can negatively impact the business’s future profitability.

Each business transaction is recorded using the double-entry accounting method, with a credit entry to one account and a debit entry to another. Contingent liabilities, although not yet realized, are recorded as journal entries. Contingent liabilities are also important for potential lenders to a company, who will take these liabilities into account when deciding on their lending terms.

Contingent Liability: What Is It, and What Are Some Examples?

Contingent liabilities are those liabilities that are not included in the financial statement of the company. They fall under obligations that have not occurred yet but can occur shortly. As it is not a liable component, it is not included in the accounting system of the company. Contingent liabilities meaning also signifies the fact that they change according to the amount of money estimated and their likelihood of occurring in the future. The accounting rules make sure that the readers of the financial statement receive enough information. These liabilities can harm the company’s stock price because contingent liabilities can negatively impact the business’s future profitability.

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.
Following are the necessary journal entries to record the expense in 2019 and the repairs in 2020.
If the contingent liability is considered remote, it is unlikely to occur and may or may not be estimable.
Assume for the sake of our example that in 2020 Sierra Sports made repairs that cost $2,800.
Record a contingent liability when it is probable that a loss will occur, and you can reasonably estimate the amount of the loss.

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. The reason is that the event (“the injury itself”) giving rise to the loss arose in Year 1. Conversely, if the injury occurred in Year 2, Year 1’s financial statements would not be adjusted no matter how bad the financial effect. However, a note to the financial statements may be needed to explain that a material adverse event arising subsequent to year end has occurred.

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. 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.

The Reporting Requirements of 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. The average cost of $200 × 25 goals gives an anticipated future repair cost of $5,000 for 2019.

What Is Contingent Liability?

There are strict and sometimes vague disclosure requirements for companies claiming contingent liabilities. Two classic examples of contingent liabilities include a company warranty and a lawsuit against the company. Both represent possible losses to the company, and both depend on some uncertain future event. At the end of the year, the accounts are adjusted for the actual warranty expense incurred. The outcome of a long-pending lawsuit, a government investigation into organizations affairs, a threat of expropriation etc. some of the common examples of contingent liabilities.

Definition of Contingent Liabilities

This is considered probable but inestimable, because the lawsuit is very likely to occur (given a settlement is agreed upon) but the actual damages are unknown. No journal entry or financial adjustment in the financial statements will occur. Instead, Sierra Sports will include a note describing any details available about the lawsuit. When damages have been determined, or have been reasonably estimated, then journalizing would be appropriate. If the contingent liability is probable and inestimable, it is likely to occur but cannot be reasonably estimated.

How Contingent Liabilities Work

They can be a tricky endeavor for both management and investors to navigate since the likelihood of them occurring isn’t guaranteed. It’s difficult to estimate or even quantify the impact how to calculate absolute liquid ratio or cash ratio with equations test of liquidity 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.

Contingent Liability Accounting

Business leaders should also be aware of contingent liabilities, because they should be considered when making strategic decisions about a company’s future. Do not confuse these “firm specific” contingent liabilities with general business risks. General business risks include the risk of war, storms, and the like that are presumed to be an unfortunate part of life for which no specific accounting can be made in advance.