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.