In accounting, contingent liabilities are liabilities that may be incurred by an entity depending on the outcome of an uncertain future event[1] such as the outcome of a pending lawsuit. These liabilities are not recorded in a company’s accounts and shown in the balance sheet when both probable and reasonably estimable as ‘contingency’ or ‘worst case’ financial outcome. 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. A contingent liability is a liability that may occur depending on the outcome of an uncertain future event.
- For example, when a company is fighting a legal battle and the opposite party has a stronger case, and the probability of losing is above 50%, it must be recorded in the books of accounts.
- An example is a nuisance lawsuit where there is no similar case that was ever successful.
- Contingent liabilities must pass two thresholds before they can be reported in financial statements.
- If the contingent liability is considered remote, it is unlikely to occur and may or may not be estimable.
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- An example of determining a warranty liability based on a percentage of sales follows.
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. If it is determined that not enough is being accumulated, then the warranty expense allowance can be increased. These liabilities become contingent whenever their payment contains a reasonable degree of uncertainty. Only the contingent liabilities that are the most probable can be recognized as a liability on financial statements. Other contingencies are relegated to footnotes as long as uncertainty persists.
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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. A contingent liability threatens to reduce the company’s assets and net profitability and, thus, comes with the potential to negatively impact the financial performance and health of a company. Therefore, such circumstances or situations must be disclosed in a company’s financial statements, per the full disclosure principle.
Warranties arise from products or services sold to customers that cover certain defects (see Figure 12.8). Pending litigation involves legal claims against the business that may be resolved at a future point in time. The outcome of the lawsuit has yet to be determined but could have negative future impact on the business.
Is contingent liability an actual liability?
Contingent liabilities can be a tricky concept for a company’s management, as well as for investors. Judicious use of a wide variety of techniques for the valuation of liabilities and risk weighting may be required in large companies with multiple lines of business. 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 how to price business services in the footnotes of the financial statements if either of the two criteria is true. 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. Although it is not realized in the books of accounts, a contingent liability is credited to the accrued liabilities account in the journal.
When Do I Need to Be Aware of Contingent Liability?
Often, the longer the span of time it takes for a contingent liability to be settled, the less likely that it will become an actual liability. Any case with an ambiguous chance of success should be noted in the financial statements but do not need to be listed on the balance sheet as a liability. Even if the outcome is based on the probability of occurrence of the event, it is considered an actual liability. But it will be recorded in the books only if the probability is more than 50%.
The income statement and balance sheet are typically impacted by contingent liabilities. 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. A contingent liability can produce a future debt or negative obligation for the company. Some examples of contingent liabilities include pending litigation (legal action), warranties, customer insurance claims, and bankruptcy. A loss contingency that is probable or possible but the amount cannot be estimated means the amount cannot be recorded in the company’s accounts or reported as liability on the balance sheet. Instead, the contingent liability will be disclosed in the notes to the financial statements.
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Essentially, the effect that contingent liabilities have on an audit depends on their likelihood of occurring in the first place. As well, the impact on financial statements depends on the likelihood of the contingency occurring and the total amount of the transaction. Usually, the contingent liability will be outlined and disclosed in a footnote on the financial statement.
Google, a subsidiary of Alphabet Inc., has expanded from a search engine to a global brand with a variety of product and service offerings. Check out Google’s contingent liability considerations in this press release for Alphabet Inc.’s First Quarter 2017 Results to see a financial statement package, including note disclosures. Contingent liabilities are those that are likely to be realized if specific events occur.
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. The determination of whether a contingency is probable is based on the judgment of auditors and management in both situations. This means a contingent situation such as a lawsuit might be accrued under IFRS but not accrued under US GAAP.
An example is a nuisance lawsuit where there is no similar case that was ever successful. 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.
Company management should consult experts or research prior accounting cases before making determinations. In the event of an audit, the company must be able to explain and defend its contingent accounting decisions. The liability won’t significantly affect the stock price if investors believe the company has strong and stable cash flows and can withstand the damage. If the lawyer and the company decide that the lawsuit is frivolous, there won’t be any need to provide a disclosure to the public. 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.
Instead, only disclose the existence of the contingent liability, unless the possibility of payment is remote. There are three possible scenarios for contingent liabilities, all of which involve different accounting transactions. 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. 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.
Both represent possible losses to the company, and both depend on some uncertain future event. As well, pending lawsuits are also considered contingent liabilities because the outcome of the lawsuit is entirely unknown. This can come with estimated liability or a need to determine contingent liability legitimacy. Some events may eventually give rise to a liability, but the timing and amount is not presently sure. Legal disputes give rise to contingent liabilities, environmental contamination events give rise to contingent liabilities, product warranties give rise to contingent liabilities, and so forth.
In some cases, an analyst might show two scenarios in a financial model, one which incorporates the cash flow impact of contingent liabilities and another which does not. Since a contingent liability can potentially reduce a company’s assets and negatively impact a company’s future net profitability and cash flow, knowledge of a contingent liability can influence the decision of an investor. The materiality principle states that all important financial information and matters need to be disclosed in the financial statements. An item is considered material if the knowledge of it could change the economic decision of users of the company’s financial statements.
Under GAAP, a contingent liability is defined as any potential future loss that depends on a “triggering event” to turn into an actual expense. Such contingency is neither recorded on the financial statements nor disclosed to the investors by the management. This shows us that the probability of occurrence of such an event is less than that of a possible contingency. 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. If any potential liability surpasses the above two provided conditions, we can record the event in the books of accounts.
The nature of contingent liability is important for deciding whether it is good or bad. 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. The accrual account enables the company to record expenses without requiring an immediate cash payment. If the case is unsuccessful, $5 million in cash is credited (reduced), and the accruing account is debited. However, if there is more than a 50% chance of winning the case, according to the prudence principle, no benefits would be recorded on the books of accounts.
