A contingent liability has to be recorded if the contingency is likely and the amount of the liability can be reasonably estimated. Both generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) require companies to record contingent liabilities. 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. A contingent liability can produce a future debt or negative obligation for the company.

Our example
only covered the warranty expenses anticipated from the 2019 sales. Since the company has a three-year warranty, and it estimated
repair costs of $5,000 for the goals sold in 2019, there is still a
balance of $2,200 left from the original $5,000. If
it is determined that too much is being set aside in the allowance,
then future annual warranty expenses can be adjusted downward. If
it is determined that not enough is being accumulated, then the
warranty expense allowance can be increased. A potential or contingent liability that is both probable and the amount can be estimated is recorded as 1) an expense or loss on the income statement, and 2) a liability on the balance sheet. Assume that a company is facing a lawsuit from a rival firm for patent infringement.

1. Companies that underestimate the impact of legal fees or fines will be non-compliant with GAAP.
2. Our example only covered the warranty expenses anticipated from the 2019 sales.
3. Second, improper recognition can impact the company’s future profitability, as the company may be unprepared for the financial burden when the contingent liability becomes definite.
4. Since the outcome is possible, the
   contingent liability is disclosed in Sierra Sports’ financial
   statement notes.
5. The company would record this warranty
   liability of $120 ($1,200 × 10%) to Warranty Liability and Warranty
   Expense accounts.

So the company needs to estimate the warranty expense and record it into the financial statement. The journal entry is debiting warranty expense and credit contingent liability. This journal entry is to show that when there is a probability of future cost which can be reasonably estimated, the company needs to recognize and record it as an expense immediately. Likewise, the contingent liability is a payable account, in which the company will expect the outflow of resources containing economic benefits (e.g. cash out). In financial reporting, actual liabilities are recognized and recorded in the books of the company at their present amount. Since they represent true obligations due to past transactions or events, they are considered firm liabilities.

IAS 12 — Accounting for uncertainties in income taxes

As such, competent management of these social contingent liabilities is indicative of the firm’s social sustainability. It shows an understanding of long-term societal impact and a preparedness for potential costs that might arise. If a company pledges that it will contribute to social programs as part of its CSR endeavors, it may face contingent liabilities. For example, if a firm commits to funding a community development project contingent on the project’s approval by municipal authorities, the commitment represents a contingent liability. In conclusion, while contingent liabilities present a significant financial risk, proactive and strategic risk management can go a long way in mitigating these risks. By focusing on financial planning, establishing protocols, taking insurance cover, and leveraging legal knowledge, firms can substantially reduce their financial exposure from these potential liabilities.

The income statement and balance sheet are typically
impacted by contingent liabilities. Sierra Sports may have more litigation in the future surrounding the soccer goals. These lawsuits have not yet been filed or are in the very early stages of the litigation process. 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. Since the outcome is possible, the contingent liability is disclosed in Sierra Sports’ financial statement notes.

In conclusion, measuring contingent liabilities involves determining the fair value and present obligation of future events, both of which are subject to estimations and judgement. Significant changes in these can materially affect a company’s financial statements, hence proper evaluation is essential. The following examples show recognition of Warranty Expense on the income statement Figure 12.10 and Warranty Liability on the balance sheet Figure 12.11 for Sierra Sports. For a financial figure to be reasonably estimated, it could be based on past experience or industry standards (see Figure 12.9). Contingent liabilities reflect amounts that your business might owe if a specific ‘triggering’ event happens in the future. Sometimes companies are unclear when they are required to report a contingent liability on their financial statements under U.S.

What are the Different Types of Contingent Liabilities?

Let’s expand our discussion and add a brief example of the
calculation and application of warranty expenses. The key principle established by the Standard is that a provision should be recognised only when there is a liability i.e. a present obligation resulting from past events. According to both the International Financial Reporting Standards (IFRF) and generally accepted accounting principles (GAAP), it is imperative to recognize and disclose contingent liabilities appropriately. If the contingent liability is considered remote, it is unlikely to occur and may or may not be estimable. This does not meet the likelihood requirement, and the possibility of actualization is minimal.

Qualifying contingent liabilities are recorded as an expense on the income statement and a liability on the balance sheet. They are dependent upon a certain future event or outcome, which https://accounting-services.net/ is uncertain at the present time. Due to their uncertain nature, accounting standards dictate that contingent liabilities are not recorded in the financial statements straightaway.

Why are Contingent Liabilities Recorded?

In this situation, no
journal entry or note disclosure in financial statements is
necessary. Pending lawsuits and product warranties are common contingent liability examples because their outcomes are uncertain. The accounting rules for reporting a contingent liability differ depending on the estimated dollar amount of the liability and the likelihood of the event occurring. The accounting rules ensure that financial statement readers receive sufficient information. The likelihood of occurrence and the measurement requirement are the FASB required conditions. A contingent liability must be recognized and disclosed if there is a probable liability determination before the preparation of financial statements has occurred, and the company can reasonably estimate the amount of loss.

First and foremost, companies should engage in strong financial planning and forecasting. By doing so, they can hypothetically account for these liabilities in their financial forecasts. In cases where the event triggering the liability becomes probable, the company would already have a plan in place. Dealing with such potential liabilities can result in contractual adjustments such as indemnity clauses where the seller guarantees to cover the costs if the liabilities occur. Conversely, if the buyer assumes these liabilities, they may negotiate a lower price or require a larger percentage of the purchase price be held in escrow until potential liabilities are resolved.

Mitigating Financial Risks

These adjustments are commonly reflected within the notes on financial statements, alerting shareholders to potential financial risks. While a contingency may be positive or negative, we only focus on outcomes that may produce a liability for the company (negative outcome), since these might lead to adjustments in the financial statements in certain cases. If a loss from a contingent liability is reasonably possible but not probable, it should be recorded as a disclosure in the footnotes to the financial statements. The company should record the nature of the contingent liability and give an estimate or range of estimates for the potential loss. If a contingent liability is deemed probable, it must be directly reported in the financial statements.

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. To simplify our example, we concentrate strictly on the journal entries contingent liabilities in balance sheet for the warranty expense recognition and the application of the warranty repair pool. If the company sells 500 goals in 2019 and 5% need to be repaired, then 25 goals will be repaired at an average cost of $200. The average cost of $200 × 25 goals gives an anticipated future repair cost of $5,000 for 2019. Assume for the sake of our example that in 2020 Sierra Sports made repairs that cost $2,800.

The full disclosure principle states that all necessary information that poses an impact on the financial strength of the company must be registered in the public filings. IFRS Sustainability Standards are developed to enhance investor-company dialogue so that investors receive decision-useful, globally comparable sustainability-related disclosures that meet their information needs. The IFRS Foundation is a not-for-profit, public interest organisation established to develop high-quality, understandable, enforceable and globally accepted accounting and sustainability disclosure standards. Contingent liability is one of the most subjective, contentious and fluid concepts in contemporary accounting. Modeling contingent liabilities can be a tricky concept due to the level of subjectivity involved.

The liability may be disclosed in a footnote on the financial statements unless both conditions are not met. Google, a subsidiary of Alphabet Inc., has expanded from a search engine to a global brand with a variety of product and service offerings. 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.