12 3: Define and Apply Accounting Treatment for Contingent Liabilities Business LibreTexts

If the loss is reasonably possible but not probable, the company must disclose the nature of the litigation and the potential loss range. However, when disclosing contingencies related to pending litigation, it’s important to avoid revealing the company’s legal strategies. In such cases, the company must recognize a liability on the balance sheet and record an expense in the income statement.

Any contingent liabilities that are questionable before their value can be determined should be disclosed in the footnotes to the financial statements. Tax authorities require businesses with multiple entities to consolidate financial statements for accurate reporting. A consolidated balance sheet ensures your company’s compliance, prevents double taxation, and makes audits and filings smoother. Additionally, it helps your business meet Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) requirements, reducing the risk of non-compliance penalties. If a contingent liability is not recognized on the balance sheet, it can give a misleading impression of the company’s financial health.

Contingent liabilities are potential financial obligations that a company may have to pay in the future, depending on the outcome of an uncertain event. Unlike regular liabilities, contingent liabilities are not recorded as current obligations on the balance sheet but are disclosed in the notes to financial statements. These liabilities arise from situations where the outcome, and therefore the liability, will only be determined by a future event, such as a lawsuit, guarantee, or warranty claim. Businesses need to recognize and account for contingent liabilities because they can impact the company’s financial position and future cash flows. For instance, a company must estimate a contingent liability for pending litigation if the outcome is probable and the loss can be reasonably estimated. In such cases, the company must recognize a liability on the balance sheet and record an expense in the income statement.

This serves as a central hub for recording and adjusting financial information, ensuring proper organization before finalizing the consolidated statement. Establishing protocols and controls is another savvy strategy for dealing with these liabilities. Companies should put up policies to prevent or even limit the occurrence of triggering events. The fair value of a contingent liability can be quite challenging to determine. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice.

How to Report Contingent Liabilities in Financial Statements

By being aware of contingent liabilities in balance sheet and managing contingent liabilities, businesses can be better protected from unexpected losses. Managing and accounting for contingent liabilities can be complex and requires careful analysis and judgement. Companies should consult with legal and financial advisors to ensure that they are properly identifying and managing these liabilities. Other potential examples include guarantees, indemnification obligations, and environmental liabilities. 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.

What Are Examples of Contingent Liability?

In addition to fair value, the measure of ‘present obligation’ is also crucial in the accounting for contingent liabilities. Present obligation refers to the commitment of an entity that would lead to an outflow of resources. However, the commitment will only actualize when a certain uncertain future event occurs. A contingent liability is a potential financial obligation that may occur in the future depending on the outcome of a specific event, such as a pending lawsuit.

• Since not allwarranties may be honored (warranty expired), the company needs tomake a reasonable determination for the amount of honoredwarranties to get a more accurate figure.
• They could be lawsuits, warranty claims, product liabilities, environmental cleanup costs, or any unforeseen expenses that may arise in the future.
• It requires the company to either replace, repair or refund the failed product, depending on the stipulations of the warranty.
• However, some companies may be reluctant to recognize contingent liabilities because they lower earnings and increase liabilities, potentially raising a red flag for stakeholders.
• 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.

Two Financial Accounting Standards Board (FASB) Requirements

Let us see the example where a person has purchased a motorcycle from a showroom and has a two-year warranty for the engine and the motorcycle. If the engine fails to work within six months of the purchase, the company has to replace the engine. When determining if the contingent liability should berecognized, there are four potential treatments to consider. Banks that issue standby letters of credit or similar obligations carry contingent liabilities.

• Managing and accounting for contingent liabilities can be complex and requires careful analysis and judgement.
• 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.
• Clear and accurate reporting of contingent liabilities does more than tick regulatory checkboxes—it lays the foundation for better decision-making and risk management.
• In general, contingent liabilities can significantly impact a company’s financial statements if they are not properly managed and accounted for.
• Companies estimate the outcomes of future events, based on the best information available at that time.

It does not know the exact number of vacuums that will be returned under the warranty, so the amount must be estimated. Using historical averages, it estimates that 5% of those, or 500 vacuums will be returned under warranty per year. Vacuum Inc. should record a debit to warranty expense for $250,000 and a credit to a warranty liability account for $250,000. The matching principle of accounting states that expenses should be recorded in the same period as their related revenues. In the case of warranties, a contingent liability is required because it represents an amount that is not fully earned by a company at the time of sale. The expense of the potential warranties must offset the revenue in the period of sale.

When damages have been determined, or have been reasonably estimated, then journalizing would be appropriate. 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. This financial recognition and disclosure are recognized in the current financial statements. The income statement and balance sheet are typically impacted by contingent liabilities.

By transferring risk to an insurance company, firms can manage their potential losses. The cost of insurance premiums is often far less than the possible financial impact of the unrestrained liability. As a general rule, contingent liabilities, whether recognized or not, must be disclosed.

In that case, the company should record the minimum of the range as its contingent liability. It would record a journal entry to debit legal expense for $1 million and credit an accrued liability account for $1 million. Assume that a company is facing a lawsuit from a rival firm for patent infringement.

Current Liabilities

An example of determining a warranty liability based on a percentage of sales follows. The sales price per soccer goal is $1,200, and Sierra Sports believes 10% of sales will result in honored warranties. The company would record this warranty liability of $120 ($1,200 × 10%) to Warranty Liability and Warranty Expense accounts. If the event is probable and the financial impact can be reasonably estimated, you must recognize it as a liability on the balance sheet and include it in your income statement expenses.

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. Google, a subsidiary ofAlphabet Inc., has expanded froma search engine to a global brand with a variety of product andservice offerings. Check outGoogle’s contingent liabilityconsiderations in this pressrelease for Alphabet Inc.’s First Quarter 2017 Results to see afinancial statement package, including note disclosures.

Companies operating in the United States rely on the guidelines established in the generally accepted accounting principles (GAAP). A contingent liability is defined under GAAP as any potential future loss that depends on a “triggering event” to become an actual expense. Contingent assets are assets that are likely to materialize if certain events arise. These assets are only recorded in financial statements’ footnotes because their value can’t be reasonably estimated. Another way to establish the warranty liability could be an estimation of honored warranties as a percentage of sales. In this instance, Sierra could estimate warranty claims at 10% of its soccer goal sales.

Why are Contingent Liabilities Recorded?

Thismeans a contingent situation such as a lawsuit might be accruedunder IFRS but not accrued under US GAAP. Finally, how a losscontingency is measured varies between the two options as well. Under US GAAP, thelow end of the range would be accrued, and the range disclosed. An actual liability is a confirmed obligation that must be settled, while a contingent liability is a potential obligation based on a future event. It does not make any sense to immediately realize a contingent liability – immediate realization signifies the financial obligation has occurred with certainty.

3: Define and Apply Accounting Treatment for Contingent Liabilities

Both have implications for financial statements, but they are treated differently. Both companies need to get involved in a thorough due diligence process before proceeding with a merger or acquisition. The purpose of these notes is to provide shareholders and potential investors with a comprehensive understanding of all liabilities that could have a significant impact on the company’s financial statements.