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 “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. Both GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) require companies to record contingent liabilities, due to their connection with three important accounting principles. A warranty is considered contingent because the number of products that will be returned under a warranty is unknown.

Contingent Liabilities That Are Accrued

• A contingent liability can be very challenging to articulate in monetary terms.
• An example of determining a warranty liability based on a percentage of sales follows.
• There are strict and sometimes vague disclosure requirements for companies claiming contingent liabilities.
• 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.
• Let’s expand our discussion and add a brief example of the calculation and application of warranty expenses.
• A warranty is another common contingent liability because the number of products returned under a warranty is unknown.

Other examples include guarantees on debts, liquidated damages, outstanding lawsuits, and government probes. Assume that a company is facing a lawsuit from a rival firm for patent infringement. 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.

• One can always depict this type of liability on the company’s financial statements if there are any.
• Therefore, such circumstances or situations must be disclosed in a company’s financial statements, per the full disclosure principle.
• The liability may be disclosed in a footnote on the financial statements unless both conditions are not met.
• In all these situations, a past event has occurred that may give rise to liability depending on some future event.
• It is disclosed in the footnotes of the financial statements as they have an enormous impact on the company’s financial conditions.
• In simple words, contingent liabilities are those obligations that will arise in future due to certain events that took place in the past or will be taking place in future.
• Since it presently is not possible to determine the outcome of these matters, no provision has been made in the financial statements for their ultimate resolution.

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This amount could be a reasonable estimate for the parts repair cost per soccer goal. Since not all warranties may be honored (warranty expired), the company needs to make a reasonable determination for the amount of honored warranties to get a more accurate figure. For https://www.bookstime.com/articles/contingent-liabilities example, Sierra Sports has a one-year warranty on part repairs and replacements for a soccer goal they sell. Sierra Sports notices that some of its soccer goals have rusted screws that require replacement, but they have already sold goals with this problem to customers.

Ask Any Financial Question

• IAS 37 defines and specifies the accounting for and disclosure of provisions, contingent liabilities, and contingent assets.
• 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.
• A “medium probability” contingency is one that satisfies either, but not both, of the parameters of a high probability contingency.
• 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.
• Some of the examples of such transactions can be insurance claims, oil spills, lawsuits.
• 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.
• 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.

It is unclear if a customer will need to use a warranty, and when, but this is a possibility for each product or service sold that includes a warranty. The same idea applies to insurance claims (car, life, and fire, for example), and bankruptcy. If the contingencies do occur, it may still be uncertain when they will come to fruition, or the financial implications. Contingent liabilities are shown as liabilities on the balance sheet and as expenses on the income statement. Contingent liabilities are liabilities that depend on the outcome of an uncertain event.

What disclosure requirements are there for 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. Sometimes contingent liabilities can arise suddenly and be completely unforeseen. The $4.3 billion liability for Volkswagen related to its 2015 emissions scandal is one such contingent liability example.

Is contingent liability an actual liability?

Instead, Sierra Sports will include a note describing any details available about the lawsuit. When damages have been determined, or have been reasonably estimated, then journalizing would be appropriate. Contingent liabilities must pass two thresholds before they can be reported in financial statements. If the value can be estimated, the liability must have more than a 50% chance of being realized.

Pending litigation involves legal claims against the business that may be resolved at a future point in time. The outcome of the lawsuit has yet to be determined but could have negative future impact on the business. These are questions businesses must ask themselves when exploring contingencies and their effect on liabilities. Suppose a lawsuit is filed against a company, and the plaintiff claims damages up to $250,000. It’s impossible to know whether the company should report a contingent liability of $250,000 based solely on this information. Here, the company should rely on precedent and legal counsel to ascertain the likelihood of damages.

Lawsuits, especially with huge companies, can be an enormous liability and significantly impact the bottom line. Companies that underestimate the impact of legal fees or fines will be non-compliant with GAAP. It will help students develop an understanding of the concept of contingent liabilities. Contingent liability can be assumed—for example, for losses arising from product or service failure—where the insurer has assumed liability by providing a performance warranty.

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. The principle of prudence is a crucial principle that states that a company must not record future anticipated gains into the books of accounts, but any expected losses must be accounted for. For probable contingencies, the potential loss must be quantified and reflected on the financial statements for the sake of transparency. Based on the outcome of the underlying event that is set to occur in the future, the financial obligation can be “triggered” and cause the company to be held accountable to issue a conditional payment (or fee).