A contingent liability is an existing condition or set of circumstances involving uncertainty regarding possible business loss, according to guidelines from the Financial Accounting Standards Board (FASB). In the Statement of Financial Accounting Standards No. 5, it says that a firm must distinguish between losses that are probable, reasonably probable or remote. There are strict and sometimes vague disclosure requirements for companies claiming contingent liabilities.
How Do Liabilities Become Contingent Liabilities?
Contingent liabilities are sometimes referred to as "loss contingencies" by the FASB. The concept of a contingent liability is centered around the two primary aspects of an accounting liability: that they are present responsibilities and obligations to other entities.
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.
How to Tell If a Contingent Liability Should Be Recognized
Contingent liability is one of the most subjective, contentious and fluid concepts in contemporary accounting.
There are two distinct hurdles when determining if a contingent liability should be recognized:
- The timing of the possible liability
- The degree of confidence an external obligation will be realized
This is why the FASB created three categories of contingency: probable, reasonably probable and remote. Only those classified as probable can be officially recognized.
Accrual for Contingent Liabilities
It does not make any sense to immediately realize a contingent liability – immediate realization signifies the financial obligation has occurred with certainty. Instead, the FASB requires contingent liabilities to be accrued.
Future costs are expensed first, and then a liability account is credited based on the nature of the liability. In the event the liability is realized, the actual expense is credited from cash and the original liability account is similarly debited.
Check for Disclosures in the Footnotes
If a contingent liability is deemed probable, it must be directly reported in the financial statements. Nevertheless, generally accepted accounting principles, or GAAP, only require contingencies to be recorded as unspecified expenses.
Any details are contained within disclosures in the footnotes. FASB Statement of Financial Accounting Standards No. 5 requires any obscure, confusing or misleading contingent liabilities to be disclosed until the offending quality is no longer present.
Estimating Contingent Liabilities
Estimation of contingent liabilities is another vague application of accounting standards. Under GAAP, the listed amount must be "fair and reasonable" to avoid misleading investors, lenders or regulators. Estimating the costs of litigation or any liabilities resulting from legal action should be carefully noted.
Lawsuits, especially with huge companies, can be an enormous liability and significantly impact the bottom line. Companies that underestimate the impact of legal fees or fines will be non-compliant with GAAP.
What Are Some Common Examples?
Possible contingent liabilities include loss from damage to property or employees; most companies carry many types of insurance, so these liabilities are normally expressed in terms of insurance costs.
Banks that issue standby letters of credit or similar obligations carry contingent liabilities. All creditors, not just banks, carry contingent liabilities equal to the amount of receivables on their books.
Warranties and lawsuits are commonplace in the business environment. Both are considered contingent liabilities.