You should also describe the liability in the footnotes that accompany the financial statements. The existence of the liability is uncertain and usually, the amount is uncertain because contingent liabilities depend (or are contingent) on some future event occurring or not occurring. Examples include liabilities arising from lawsuits, discounted notes receivable, income tax disputes, penalties that may be assessed because of some past action, and failure of another party to pay a debt that a company has guaranteed. When liabilities are contingent, the company usually is not sure that the liability exists and is uncertain about the amount. Contingent liabilities are those that are likely to be realized if specific events occur. These liabilities are categorized as being likely to occur and estimable, likely to occur but not estimable, or not likely to occur.
- Since there is a past precedent for lawsuits of this nature but no establishment of guilt or formal arrangement of damages or timeline, the likelihood of occurrence is reasonably possible.
- An example is a nuisance lawsuit where there is no similar case that was ever successful.
- It is of interest to a financial analyst, who wants to understand the probability of such an issue becoming a full liability of a business, which could impact its status as a going concern.
- The accounting of contingent liabilities is a very subjective topic and requires sound professional judgment.
- These assets are only recorded in financial statements’ footnotes as their value cannot be reasonably estimated.
- 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.
Google, a subsidiary of Alphabet Inc., has expanded from a search engine to a global brand with a variety of product and service offerings. Like many other companies, contingent liabilities are carried on Google’s balance sheet, report expenses related to these contingencies on its income statement, and note disclosures are provided to explain its contingent liability treatments. 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.
2 Recognition of provisions
In the event of an audit, the company must be able to explain and defend its contingent accounting decisions. Contingent liabilities are liabilities that depend on the outcome of an uncertain event. This second entry recognizes an honored warranty for a soccer goal based on 10% of sales from the period. Warranties arise from products or services sold to customers that cover certain defects (see Figure 12.8). It is unclear if a customer will need to use a warranty, and when, but this is a possibility for each product or service sold that includes a warranty. The same idea applies to insurance claims (car, life, and fire, for example), and bankruptcy.
A warranty can also be considered a contingent liability, since there is uncertainty about the exact number of units that will be returned by customers for repair or replacement. 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 in the footnotes of the financial statements if either of the two criteria is true. A contingent liability that is expected to be settled in the near future is more likely to impact a company’s share price than one that is not expected to be settled for several years. 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. The materiality principle states that all important financial information and matters need to be disclosed in the financial statements.
How are Contingent Liabilities Recorded?
It’s impossible to know whether the company should report a contingent liability of $250,000 based solely on this information. Here, the company should rely on precedent and legal counsel to ascertain the likelihood of damages. 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.
If it does not meet both of these criteria, the contingent liability may still need to be recorded as a disclosure in the footnotes to the financial statements. A company should always aim to present its financial statements fairly and accurately based on the information it has available as of the balance sheet date. Record a contingent liability when it is probable that the loss will occur, and you can reasonably estimate the amount of the loss. If you can only estimate a range of possible amounts, then record that amount in the range that appears to be a better estimate than any other amount; if no amount is better, then record the lowest amount in the range.
Chapter 11: Current Liabilities
ABC Company’s legal team believes the chance of a negative outcome for ABC is probable. They estimate the potential legal settlement to be between $1 million and $2 million– with the most likely settlement amount being $1.25 million. In this case, the company should record a contingent liability on the books in the amount of $1.25 million. If the contingency is reasonably possible, it could occur but is not probable. Since this condition does not meet the requirement of likelihood, it should not be journalized or financially represented within the financial statements. Rather, it is disclosed in the notes only with any available details, financial or otherwise.
If the lawsuit results in a loss, a debit is applied to the accrued account (deduction) and cash is credited (reduced) by $2 million. Contingent liabilities are also important for potential lenders to a company, who will take these liabilities into account when deciding on their lending terms. Business leaders should also be aware of a contingent liability that is probable and for which the dollar amount can be estimated should be contingent liabilities, because they should be considered when making strategic decisions about a company’s future. Contingent liabilities are recorded differently based on whether they are probable, reasonably possible, or remote. Do not record or disclose the contingent liability if the probability of its occurrence is remote.
Product warranties will be recorded at the time of the products’ sales by debiting Warranty Expense and crediting to Warranty Liability for the estimated amount. A warranty is considered contingent because the number of products that will be returned under a warranty is unknown. 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. 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.