“Reasonably possible” means that the chance of the event occurring is more than remote but less than likely. Contingent liabilities are a type of liability that may be owed in the future as the result of a potential event. Such contingency is neither recorded on the financial statements nor disclosed to the investors by the management. This shows us that the probability of occurrence of such an event is less than that of a possible contingency. If any potential liability surpasses the above two provided conditions, we can record the event in the books of accounts.
The warranty liability account will be reduced when the warranties are paid out to the customers. For example, Vacuum Inc. will debit the warranty liability account $500 and credit either cash– in the case of a full refund– or inventory– in the case of a replacement– in the amount of $500. It will end up reducing both a liability account and an asset account at that point. 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.
Contingent Liability Accounting
At first, the contingency liability is expressed in form of an expense in the loss and profit account and then it is mentioned in the balance sheet. The Unique Selling Point of Masong’s phone is a complete Replacement warranty within 1 year. If there is any software issue, then Masong promises to completely replace the mobile phones in the market.
- 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.
- Austin has been working with Ernst & Young for over four years, starting as a senior consultant before being promoted to a manager.
- Do not record or disclose the contingent liability if the probability of its occurrence is remote.
- This shows us that the probability of occurrence of such an event is less than that of a possible contingency.
- Business leaders should also be aware of contingent liabilities, because they should be considered when making strategic decisions about a company’s future.
- An example is litigation against the entity when it is uncertain whether the entity has committed an act of wrongdoing and when it is not probable that settlement will be needed.
The word contingent or contingency means “possible, but not certain to occur”. So, according to the definition, contingent liabilities are those liabilities that may or may not be incurred by a business depending on the outcome of a future event. The existence of this kind of liability is completely dependent on the occurrence of a probable event in future. Companies operating in the United States rely on the guidelines established in the generally accepted accounting principles (GAAP).
IAS 37—Contingent Liabilities: Definition, Examples and Accounting
The chance of the future event that will trigger the liability should be likely and the amount of liability can be measured properly. IAS 37 standard sets out the recognition, measurement and disclosure requirements of provisions, and it also deals with contingent assets and contingent liabilities. This course explains the concept and accounting treatment of provisions, contingent liabilities and contingent assets according to IAS 37 using practical examples and interim tests to enhance understanding. A contingent liability is not recognised in the statement of financial position.
Sometimes the breach in copyright infringement can lead to contingent liabilities. Supposing the company is coming up with a new product to launch in the market and the product is still in the development stage. The company may need to consult with suppliers and other designers outside the company and this may require a legal contract before the business is done.
Understanding the impact
But if neither condition is met, the company is under no obligation to report or disclose the contingent liability, barring unusual circumstances. In the case of possible contingencies, commentary is necessary on the liabilities in the footnotes section of the financial filings to disclose the risk to existing and potential investors. 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.
- Items can be considered to have a monetary value if their inclusion or exclusion has an impact on the business.
- The outcome of a long-pending lawsuit, a government investigation into organizations affairs, a threat of expropriation etc. some of the common examples of contingent liabilities.
- In this case, both the certainty of the future event and the expected loss amount is unknown, so the contingent liability can’t be recorded in the books and should be mentioned in footnotes.
- One can always depict this type of liability on the company’s financial statements if there are any.
- 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).
- If the contingency satisfies the above-presented methods then they can be presented in books.
- A contingent liability should be recorded on the company’s books if the liability is probable and the amount can be reasonably estimated.
Therefore, such circumstances or situations must be disclosed in a company’s financial statements, per the full disclosure principle. A contingent liability is recorded in the accounting records if the contingency contingent liabilities example is probable and the related amount can be estimated with a reasonable level of accuracy. Other examples include guarantees on debts, liquidated damages, outstanding lawsuits, and government probes.