Where is a contingent liability recorded?

The contingent liability remains on the balance sheet until your company pays it off. 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.

This is the amount that a company would rationally pay to settle the obligation, or to transfer it to a third party, at the end of the reporting period. Warranties arise from products or services sold to customers that cover certain defects (see (Figure)). 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. There is an uncertainty that a claim will transpire, or bankruptcy will occur. If the contingencies do occur, it may still be uncertain when they will come to fruition, or the financial implications.

• Contingent liabilities must pass two thresholds before they can be reported in financial statements.
• Given the uncertainty about the timing or amount of future expenditures needed to settle legal claims, the recognition and measurement of a provision can often require companies to make significant judgments and assumptions.
• A legal claim might be settled between $400 and $600, with all outcomes within the range being equally possible.
• With IAS 371, IFRS has one-stop guidance to account for provisions, contingent assets and contingent liabilities.
• Contingent liabilities reflect amounts that your business might owe if a specific ‘triggering’ event happens in the future.

These obligations result from previous transactions or occurrences, and they are contingent on future events and indeterminate in nature. A “medium probability” contingency is one that satisfies either, but not both, of the parameters of a high probability contingency. These liabilities must be disclosed in the footnotes of the financial statements if either of the two criteria is true.

This shows us that the probability of occurrence of such an event is less than that of a possible contingency. 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. A loss contingency that is remote will not be recorded and it will not have to be disclosed in the notes to the financial statements.

The magnitude of the impact depends on the time of occurrence and the amount tied to the liability. One can always depict this type of liability on the company’s financial statements if there are any. It is disclosed in the footnotes of the financial statements as they have an enormous impact on the company’s financial conditions. Contingent assets are assets that are likely to materialize if certain events arise. These assets are only recorded in financial statements’ footnotes as their value cannot be reasonably estimated.

Why are Contingent Liabilities recorded?

The following examples show recognition of Warranty Expense on the income statement (Figure) and Warranty Liability on the balance sheet (Figure) for Sierra Sports. 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.

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. There are three scenarios for contingent liabilities, all involving different accounting treatments. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network.

• 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 liabilities will get recorded if it has a reasonable probability of occurring.
• Sometimes companies are unclear when they are required to report a contingent liability on their financial statements under U.S.
• 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.
• You should also describe the liability in the footnotes that accompany the financial statements.

In this journal entry, lawsuit payable account is a contingent liability, in which it is probable that a $25,000 loss will occur. This leads to the result of an increase of liability (credit) by $25,000 in the balance sheet. IFRS and US GAAP have many subtle differences when accounting for provisions (loss contingencies) for legal claims. 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.

LO 11.3 Define and Apply Accounting Treatment for Contingent Liabilities

This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. Similarly, the guidance in ASC 460 on accounting for guarantee liabilities, which has existed for two decades, is often difficult to apply because the determination of whether top 6 strategies to protect your income from taxes an arrangement constitutes a guarantee is complex. The accrual account permits the firm to immediately post an expense without the need for 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.

Contingent liabilities

Similarly, the knowledge of a contingent liability can influence the decision of creditors considering lending capital to a company. The contingent liability may arise and negatively impact the ability of the company to repay its debt. Reimbursement assets are not netted against the related provision (loss contingency) on the balance sheet. However, the expense and related reimbursement may be netted in profit or loss under both IFRS and US GAAP.

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An example might be a hazardous waste spill that will require a large outlay to clean up. 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.

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.

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. A loss contingency which is possible but not probable will not be recorded in the accounts as a liability and a loss. Our example only covered the warranty expenses anticipated from the 2019 sales. Since the company has a three-year warranty, and it estimated repair costs of $5,000 for the goals sold in 2019, there is still a balance of $2,200 left from the original $5,000. If it is determined that too much is being set aside in the allowance, then future annual warranty expenses can be adjusted downward.

Although contingent liabilities are necessarily estimates, they only exist where it is probable that some amount of payment will be made. This is why they need to be reported via accounting procedures, and why they are regarded as “real” liabilities. 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. 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.