Contingent Liability Definition, Why to Record

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. Contingent liabilities adversely impact a company’s assets and net profitability.

  1. The legal implications of contingent liabilities necessitate having legal expertise onboard.
  2. In cases where the event triggering the liability becomes probable, the company would already have a plan in place.
  3. As you’ve learned, not only are warranty expense and warranty liability journalized, but they are also recognized on the income statement and balance sheet.
  4. The business projects a $5 million loss if the firm loses the case, but the legal department of the business believes the rival firm has a strong case.

Typically, contingent liabilities are not recorded as liabilities on the balance sheet which represents guaranteed obligations of a company. Because of the uncertainty of whether the potential liability will become a real one, it’s treated differently. When a contingent liability significantly increases in fair value, due to a higher chance of the event occurring or due to an increase in potential loss, it can significantly impact a company’s balance sheet.

Current Liabilities

If a court is likely to rule in favor of the plaintiff, whether because there is strong evidence of wrongdoing or some other factor, the company should report a contingent liability equal to probable damages. Contingent liabilities are liabilities that depend on the outcome of an uncertain event. Another reason behind why a possible contingency is not recorded in the books is because it cannot be expressed in monetary terms due to its limited likeliness of occurrence. As mentioned earlier, any contingency that does not satisfy the two yardsticks shall not be recorded in the books of a company. Contingent liabilities also play a crucial role when negotiating the terms of a merger or acquisition. If potential future obligations are significant, they might sway the balance of negotiations in favor of the buyer.

A warranty is considered contingent because the number of products that will be returned under a warranty is unknown. 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 contingent liabilities, because they should be considered when making strategic decisions about a company’s future. Like accrued liabilities and provisions, contingent liabilities are liabilities that may occur if a future event happens. Rather, when a contingent liability is recorded in the books of a company, that information becomes available to the shareholders and auditors as well. Hence, it can be construed that registering a contingent liability is to safeguard shareholders against probable losses.

Some examples of provisions

Following are the necessary journal
entries to record the expense in 2019 and the repairs in 2020. The
resources used in the warranty repair work could have included
several options, such as parts and labor, but to keep it simple we
allocated all of the expenses to repair parts inventory. Since the
company’s inventory of supply parts (an asset) went down by $2,800,
the reduction is reflected with a credit entry to repair parts
inventory. First, following is the necessary journal entry to
record the expense in 2019. A contingency occurs when a current situation
has an outcome that is unknown or uncertain and will not be
resolved until a future point in time.

In conclusion, the consideration of contingent liabilities is an essential part of mergers and acquisitions. Their presence can immensely affect the valuation of a business and structure the negotiation of the deal. This examination helps in determining the fair value of the target company and deciding whether or not the acquisition is financially viable. If these potential liabilities are significant, they might lead to a steep drop in the perceived value of the company being acquired. If some amount within the range of loss appears at the time to be a better estimate than any other amount within the range, that amount shall be accrued. When no amount within the range is a better estimate than any other amount, however, the minimum amount in the range should be accrued.

Using Knowledge of a Contingent Liability in Investing

Here, it is essential to note why a contingency is recorded in the books even when there is only a 50% chance of a liability arising. Contingent liabilities can pose a significant concern for a company’s risk management plan. These are potential financial obligations that only become actual liabilities upon the occurrence of a certain event. The unsure nature of these liabilities can make it challenging for businesses to manage them. In mergers and acquisitions, contingent liabilities play a prominent role as they represent potential future obligations that can directly impact the valuation of the targeted business and shape the negotiation of the deal. Both companies need to get involved in a thorough due diligence process before proceeding with a merger or acquisition.

Instead, contingent liabilities are disclosed in the notes to the financial statements if the potential obligation is reasonably possible. However, if the contingent liability is probable and the amount can be reasonably estimated, it gets reported as a liability in the financial statements, much like an actual liability. On the other hand, if a loss becomes probable and can be reasonably estimated, your company would report a contingent liability on the balance sheet and a loss on the income statement. If the amount fluctuates and you can estimate the revised amount with confidence, you should update the amount recorded in the financial statements accordingly.

Some examples of contingent liabilities include pending litigation (legal action), warranties, customer insurance claims, and bankruptcy. For our purposes, assume that Sierra Sports has a line of soccer
goals that sell for $800, and the company anticipates selling 500
goals this year (2019). Past experience for the goals that the
company has sold is that 5% of them will need to be repaired under
their three-year warranty program, and the cost of the average
repair is $200.

These obligations can become actual liability if the product fails to meet the warranty conditions. It requires the company to either replace, repair or refund the failed product, depending on the stipulations of the warranty. 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. Since this warranty expense allocation will probably be carried on for many years, adjustments in the estimated warranty expenses can be made to reflect actual experiences.

Pending lawsuits and product warranties are two examples of contingent liabilities. Contingent liabilities are recorded differently based on whether they are probable, reasonably possible, or remote. Possible contingency is not recorded in the books of accounts because it is very difficult to articulate the liability in monetary terms due to its limited occurrence. In our case, we make
assumptions about Sierra Sports and build our discussion on the
estimated experiences. Pending litigation involves legal claims against the business
that may be resolved at a future point in time.

UKEB adopts May 2020 amendments to IFRS Accounting Standards

Working through the vagaries of contingent accounting is sometimes challenging and inexact. Company management should consult experts or research prior accounting cases before making determinations. In the event of an audit, the company must be able to explain and defend its contingent accounting decisions. Contingent contingent liabilities in balance sheet liabilities are classified based on the scale of their probability, i.e. likeliness of an event occurring in the future. These events need to be quantified into monetary terms to be recorded in the books of a company. Establishing protocols and controls is another savvy strategy for dealing with these liabilities.

The same approach applies when the loss is probable, but it remains impossible to estimate the magnitude with any degree of certainty. Contingent assets will be recorded into the balance sheet when there is a certain of the future cash flow into the company. It mostly happens when the assets’ future economic benefits are not measured reliably. But when we can measure it reliably, it is time to record it into the balance sheet.

The buyer might demand a lower purchase price or specific contract terms to address these liabilities. We shall now delve into the various types of contingent liabilities and how they can affect a company’s financial position. When determining if the contingent liability should be recognized, there are four potential treatments to consider. The nature of contingent liability is important for deciding whether it is good or bad. One major difference between the two is that the latter is an amount you already owe someone, whereas the former is contingent upon the event occurring. The accrual account enables the company to record expenses without requiring an immediate cash payment.

Not only does the contingent
liability meet the probability requirement, it also meets the
measurement requirement. Contingent liabilities also include obligations that are not recognised because their amount cannot be measured reliably or because settlement is not probable. An entity recognises a provision if it is probable that an outflow of cash or other economic resources will be required to settle the provision. IAS 37 defines and specifies the accounting for and disclosure of provisions, contingent liabilities, and contingent assets. 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.