What Is a Contingent Liability?
A contingent liability is a liability that may occur depending on the outcome of an uncertain future event. A contingent liability is recorded if the contingency is likely and the amount of the liability can be reasonably estimated. The liability may be disclosed in a footnote on the financial statements unless both conditions are not met.
- A contingent liability is a potential liability that may occur in the future, such as pending lawsuits or honoring product warranties.
- If the liability is likely to occur and the amount can be reasonably estimated, the liability should be recorded in the accounting records of a firm.
- Contingent liabilities are recorded to ensure that the financial statements are accurate and meet GAAP or IFRS requirements.
Understanding Contingent Liabilities
Pending lawsuits and product warranties are common contingent liability examples because their outcomes are uncertain. The accounting rules for reporting a contingent liability differ depending on the estimated dollar amount of the liability and the likelihood of the event occurring. The accounting rules ensure that financial statement readers receive sufficient information.
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.
Example of a Contingent Liability
Assume that a company is facing a lawsuit from a rival firm for patent infringement. The company's legal department thinks that the rival firm has a strong case, and the business estimates a $2 million loss if the firm loses the case. Because the liability is both probable and easy to estimate, the firm posts an accounting entry on the balance sheet to debit (increase) legal expenses for $2 million and to credit (increase) accrued expense for $2 million.
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.
Now assume that a lawsuit liability is possible but not probable and the dollar amount is estimated to be $2 million. Under these circumstances, the company discloses the contingent liability in the footnotes of the financial statements. If the firm determines that the likelihood of the liability occurring is remote, the company does not need to disclose the potential liability.
Both GAAP (generally accepted accounting principles) and IFRS (international financial reporting standards) require companies to record contingent liabilities in accordance with the three accounting principles: full disclosure, materiality, and prudence.
A warranty is another common contingent liability because the number of products returned under a warranty is unknown. Assume, for example, that a bike manufacturer offers a three-year warranty on bicycle seats, which cost $50 each. 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.
If, for example, the company forecasts that 200 seats must be replaced under warranty for $50, the firm posts a debit (increase) to warranty expense for $10,000 and a credit (increase) to accrued warranty liability for $10,000. At the end of the year, the accounts are adjusted for the actual warranty expense incurred.
Frequently Asked Questions
What Is a Contingent Liability?
A contingent liability is a liability that may occur depending on the outcome of an uncertain future event. Contingent liability as a term does not apply only to companies, but to individuals as well. A contingent liability has to be recorded if the contingency is likely and the amount of the liability can be reasonably estimated. Both GAAP (generally accepted accounting principles) and IFRS (international financial reporting standards) require companies to record contingent liabilities in accordance with the three accounting principles: full disclosure, materiality, and prudence.
What Are the Three Types of Contingent Liabilities?
GAAP (generally accepted accounting principles) recognizes three categories of contingent liabilities, namely probable, possible and remote. Probable contingent liabilities can be reasonably estimated and has to be reflected in the financial statements. Possible contingent liabilities are as likely to occur as not and need only be disclosed in the footnotes of financial statement. Remote contingent liabilities are extremely unlikely to occur and do not need to be included in financial statements.
What Are Examples of Contingent Liability?
A pending lawsuit is a common contingent liability example because its outcome is unknown. However, if a company's legal department thinks that the rival firm has a strong case, which means the contingent liability is probable, and they can estimate the loss, then the firm posts an entry on the balance sheet to account for the legal expenses as an accrued expense. A warranty is another common contingent liability because the number of products returned under a warranty is an unknown.