Reporting Requirements of Contingent Liabilities and GAAP Compliance

what is a contingent liability

Companies operating in the United States rely on the guidelines established in the generally accepted accounting principles (GAAP). Under GAAP, a contingent liability is defined as any potential future loss that depends on a “triggering event” to turn into an actual expense. Two classic examples of contingent liabilities include a company warranty and a lawsuit against the company. Both represent possible losses to the company, and both depend on some uncertain future event. A contingent liability is an existing condition or set of circumstances involving uncertainty regarding possible business loss, according to guidelines from the Financial Accounting Standards Board (FASB). In the Statement of Financial Accounting Standards No. 5, it says that a firm must distinguish between losses that are probable, reasonably probable or remote.

  1. Therefore, such circumstances or situations must be disclosed in a company’s financial statements, per the full disclosure principle.
  2. The accounting rules ensure that financial statement readers receive sufficient information.
  3. Contingent liabilities are also important for potential lenders to a company, who will take these liabilities into account when deciding on their lending terms.
  4. 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.

A great example of the application of prudence would be recognizing anticipated bad debts. Prudence can be helpful if certain liabilities might occur but aren’t certain; here contingent liabilities. For contingent liabilities, the accounting treatment is different from most other types of more standard liabilities. Loss contingencies are accrued if determined to be probable and the liability can be estimated. But unlike IFRS, the bar to qualify as “probable” is set higher at a likelihood of 80%. On that note, a company could record a contingent liability and prepare for the worst-case scenario, only for the outcome to still be favorable.

What Are Contingent Liabilities in Accounting?

Generally accepted accounting principles (GAAP) require contingent liabilities that can be estimated and are more likely to occur to be recorded in a company’s financial statements. A contingent liability is a potential obligation that may arise from an event that has not yet occurred. Instead, only disclose the existence of the contingent liability, unless the possibility of payment is remote. There are three possible scenarios for contingent liabilities, all of which involve different accounting transactions.

A contingency describes a scenario wherein the outcome is indeterminable at the present date and will remain uncertain for the time being. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. Let’s say that the manufacturer has estimated that out of all the mobile phones produced, about 2,000 mobiles would be called back due to fault reasons. This principle plays an important role in ensuring reduced information asymmetry between the shareholders and the management. Master accounting topics that pose a particular challenge to finance professionals.

IAS 37 — Changes in decommissioning, restoration, and similar liabilities

If any potential liability surpasses the above two provided conditions, we can record the event in the books of accounts. Some examples of such liabilities would be product warranties, lawsuits, bank guarantees, and changes in government policies. Some common examples of contingent liabilities are pending lawsuits and product warranties because each scenario is characterized by uncertainty, yet still poses a credible threat. The company sets an accounting entry to debit (increase) legal expenses for $5 million and credit (raise) accrued expenses for $5 million on the balance sheet because the liability is probable and simple to estimate.

what is a contingent liability

The reason contingent liabilities are recorded is to adhere to the standards established by IFRS and GAAP, and for the company’s financial statements to be accurate. Prudence is a key accounting concept that makes sure that assets and income are not overstated, and liabilities and expenses are not understated. The recording of contingent liabilities prevents the understating of liabilities and expenses. If the contingent loss is remote, meaning it has less than a 50% chance of occurring, the liability should not be reflected on the balance sheet.

Contingent Liabilities Accounting Treatment (U.S. GAAP)

The principle of materiality states that all items with some monetary value must be accounted into the books of accounts. Items can be considered to have a monetary value if their inclusion or exclusion has an impact on the business. If the contingent loss is deemed remote—specifically, with less than a 50% probability of occurrence under IFRS—the formal disclosure and recognition labor efficiency variance formula cause on the balance sheet is not necessary. The factor of uncertainty, where the outcome is out of the company’s control for the most part, is one of the core attributes of contingent liabilities. Contingent liabilities should be analyzed with a serious and skeptical eye, since, depending on the specific situation, they can sometimes cost a company several millions of dollars.

It can be recorded only if estimation is possible; otherwise, disclosure is necessary. The recognition of contingent liabilities on the financial statements (and footnotes) is to present investors, lenders, and others with reliable financial statements that contain accurate, conservative information. 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. 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. Although it is not realized in the books of accounts, a contingent liability is credited to the accrued liabilities account in the journal.

This can help encourage clarity between the company’s shareholders and investors and reduce any potential con activities. An example of this principle is when a $ 100 invoice to a company with net assets of $ 5 billion would be immaterial, but a $ 50 million invoice to the same company would be materialistic. In short, the expense must be recorded in the period of the corresponding sale, as opposed to the period in which the repair is made. For example, the percentage of defective products with a warranty should be derived from past customer transaction data.

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. 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. A warranty is considered contingent because the number of products that will be returned under a warranty is unknown. At the end of the year, the accounts are adjusted for the actual warranty expense incurred. Contingent assets are assets that are likely to materialize if certain events arise.

Even though they are only estimates, due to their high probability, contingent liabilities classified as probable are considered real. This is why they need to be reported via accounting procedures, and why they are regarded as “real” liabilities. A probable contingent liability that can be reasonably estimated is entered into the accounts even if the precise amount cannot be known. Any case with an ambiguous chance of success should be noted in the financial statements but do not need to be listed on the balance sheet as a liability. FASB Statement of Financial Accounting Standards No. 5 requires any obscure, confusing or misleading contingent liabilities to be disclosed until the offending quality is no longer present. However, if there is more than a 50% chance of winning the case, according to the prudence principle, no benefits would be recorded on the books of accounts.

To elaborate upon the prior section, the different types of contingency liabilities are described in more detail here. While these sorts of conditional financial commitments are not guaranteed, per se, the odds are likely stacked against the company. Access and download collection of free Templates to help power your productivity and performance. Sophisticated analyses include techniques like options pricing methodology, expected loss estimation, and risk simulations of the impacts of changed macroeconomic conditions.

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