What Are Contingent Liabilities? Definition, Explanation, Examples

Such amounts are almost never recognized before settlement payments are actually received. Some events may eventually give rise to a liability, but the timing and amount is not presently sure. Such uncertain or potential obligations are known as contingent liabilities. Legal disputes give rise to contingent liabilities, environmental contamination events give rise to contingent liabilities, product warranties give rise to contingent liabilities, and so forth.

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The contingent liability may arise and negatively impact the ability of the company to repay its debt. According to the full disclosure principle, all significant, relevant facts related to the financial performance and fundamentals of a company should be disclosed in the financial statements. Each business transaction is recorded using the double-entry accounting method, with a credit entry to one account and a debit entry to another. Contingent liabilities, although not yet realized, are recorded as journal entries.

• Each business transaction is recorded using the double-entry accounting method, with a credit entry to one account and a debit entry to another.
• That standard replaced parts of IAS 10 Contingencies and Events Occurring after the Balance Sheet Date that was issued in 1978 and that dealt with contingencies.
• The accrual account permits the firm to immediately post an expense without the need for an immediate cash payment.

A contingent liability exists when it is only possible that the payment will be made. An automobile guarantee or other product warranties are examples of contingent liabilities that, are usually recorded on a company’s books. The accounting of contingent liabilities is a very subjective topic and requires sound professional judgment. Contingent liabilities can be a tricky concept for a company’s management, as well as for investors.

What Is Important to Know About Contingent Liability?

As an operating business, you’re always at risk for unpredictable occurrences. Something as simple as a slight shift in usual weather patterns could create unforeseen losses for your retail business, say if your shipment’s delivery depends on good weather. Let’s say an employer pays an employee “off the books” in cash and doesn’t report the income or the taxes, or pay the unemployment insurance for this employee. If the employee is laid off and tries to file an unemployment claim, the case may come before a state unemployment board. This creates a contingent liability, because the employer may have to pay an unknown amount for the claim, in addition to fines and interest.

Judicious use of a wide variety of techniques for the valuation of liabilities and risk weighting may be required in large companies with multiple lines of business. The materiality principle states that all important financial information and matters need to be disclosed in the financial statements. An item is considered material if the knowledge of it could change the economic decision of users of the company’s financial statements. An example might be a hazardous waste spill that will require a large outlay to clean up. It is probable that funds will be spent and the amount can likely be estimated.

Accounting For Contingent Liabilities

For a contingent liability to become an actual liability a future event must occur. A contingent liability is a potential obligation that depends on the occurrence or non-occurrence of one or more events in the future. If the event occurs, the company may be required to make a payment; if it does not occur, the company will not be required to make a payment. Contingent liabilities that are not probable and/or whose amount cannot be reasonably estimated are not accrued on the company’s books. Instead, they are usually disclosed in the footnotes to the financial statements. However, sometimes companies put in a disclosure of such liabilities anyway.

On the other hand, if it is only reasonably possible that the contingent liability will become a real liability, then a note to the financial statements is required. Likewise, a note is required when it is probable a loss has occurred but the amount simply cannot be estimated. Normally, accounting tends to be very conservative (when in doubt, book the liability), but this is not the case for contingent liabilities. Therefore, one should carefully read the notes to the financial statements before investing or loaning money to a company. Contingent liabilities are those that are likely to be realized if specific events occur.

Contingent liabilities must be recorded if: a. The future event is probable and the amount owed…

Generally, it is not recognized but only disclose in the financial statements. The accounting rules for the treatment of a contingent liability are quite liberal – there is no need to record a liability unless the risk of loss is quite high. Thus, you should review the disclosures accompanying a company’s financial statements to see if there are additional risks that have not yet been recognized. These disclosures should be considered advance warning of amounts that may later appear as formal liabilities in the financial statements. A contingent liability is a potential loss that may occur at some point in the future, once various uncertainties have been resolved. The exact status of a contingent liability is important when determining which liabilities to present in the balance sheet or in the attached disclosures.

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. Contingent liabilities are potential liabilities that may or may not occur depending on future events. Examples of contingent liabilities are the outcome of a lawsuit, a government investigation, and the threat of expropriation.

All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. The matching convention requires the recording of the expense in the period of the sale, not when the repair is made. Sophisticated analyses include techniques like options pricing methodology, expected loss estimation, and risk simulations of the impacts of changed macroeconomic conditions. Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.

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