Loading the player...

What is 'Contingent Liability'

A contingent liability is a potential liability that may occur depending on the outcome of an uncertain future event. A contingent liability is recorded in the accounting records if the contingency is probable and the amount of the liability can be reasonably estimated. If both conditions are not met, the liability may be disclosed in a footnote on the financial statements or not reported at all.

BREAKING DOWN 'Contingent Liability'

Pending lawsuits and product warranties are common examples of contingent liabilities because their outcome is uncertain. The accounting rules for reporting a contingent liability differ based on an estimate of the dollar amount and the probability that the event might occur, and these rules are in place to ensure that financial statement readers receive sufficient information.

How to Record 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 can be reasonably estimated, 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 is used so that the firm can immediately post an expense without the need for an immediate cash payment. If the lawsuit results in a loss, the accrued expense account is debited (reduced) and cash is credited (reduced) by $2 million.

Examples of Other Accounting Entries

Assume that the 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 liability is remote, the company does not need to disclose the potential liability.

Factoring in Warranty Liability

A warranty is another common contingent liability because the number of products returned under a warranty cannot be known with certainty. 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 at a cost of $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.

RELATED TERMS
  1. Contingent Asset

    A contingent asset is a potential economic benefit dependent ...
  2. Long-Term Liabilities

    In accounting, a section of the balance sheet that lists obligations ...
  3. Adjusted Liabilities

    Adjusted liabilities are used in the insurance industry to show ...
  4. Contingent Payment Sale

    A type of installment sale in which either the price or payment ...
  5. Warranty

    A warranty is a form of guarantee that a manufacturer offers ...
  6. Joint Liability

    Joint liability denotes the obligation of two or more partners ...
Related Articles
  1. Investing

    Reviewing Liabilities On The Balance Sheet

    As an experienced or new analyst, liabilities tell a deep story of how a company finances, plans and accounts for money it will need to pay at a future date.
  2. Personal Finance

    Extended Warranties: Should You Take The Bait?

    Avoid shelling out for these policies and you could save hundreds of dollars.
  3. Managing Wealth

    Everything You Need To Know About Warranties

    Warranties are often considered when purchasing gifts. When should you purchase warranties and for what?
  4. Investing

    Do You Need A Home Warranty?

    A home warranty may sound like a great form of protection against expensive, unforeseen home repairs. But is it worth it?
  5. Insights

    Warranties That Aren't Worth It And Why

    Buying the retail warranty on your laptop might work out in your favor, but not every warranty will give you a good return.
  6. Investing

    Contingency Clauses In Home Purchase Contracts

    Here, we introduce widely used contingency clauses in home purchase contracts and how they can benefit both Buyers and Sellers.
  7. Investing

    Spotting Creative Accounting on the Balance Sheet

    Companies have used creative accounting as a way of manipulating their balance sheets.
  8. Taxes

    Deferred Tax Liability

    Deferred tax liability is a tax that has been assessed or is due for the current period, but has not yet been paid. The deferral arises because of timing differences between the accrual of the ...
RELATED FAQS
  1. What are the official FASB guidelines regarding contingent liabilities

    Learn how the Financial Accounting Standards Board, or FASB, treats the recognition, estimation and disclosure of contingent ... Read Answer >>
  2. How are contingent liabilities reflected on a balance sheet

    Find out how to identify, treat and report contingent liabilities on the balance sheet. See how the U.S. GAAP requires contingent ... Read Answer >>
  3. How important are contingent liabilities in an audit?

    Read about the importance of contingent liabilities during an audit, why audits are necessary and how contingent liabilities ... Read Answer >>
  4. Do tax liabilities appear in the financial statements?

    Find out how taxes are shown on the balance sheet, the income statement and the cash flow statement, and why taxes are an ... Read Answer >>
  5. What kinds of derivatives are types of contingent claims?

    Read about contingent claim derivatives, such as options contracts, whereby the payout of the transaction is dependent on ... Read Answer >>
Hot Definitions
  1. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  2. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  3. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  4. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  5. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
  6. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained in a company’s financial statements.
Trading Center