April 11, 2024

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What is Contingent Liability? 

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Last Updated on April 28, 2022 by Journal Fact

A contingent liability might develop as a result of the outcome of an uncertain future event. A Contingent Liability is documented if the contingency is likely and the quantity of responsibility can be accurately predicted. Unless these conditions are met, the liability may be mentioned in the financial statements as a footnote.

Contingent Liabilities Explained

Because the results of pending cases and product guarantees are unclear, they are typical examples of contingent liability. The accounting standards for reporting a contingent liability fluctuate depending on the liability’s projected cash amount and the likelihood of the event occurring. Accounting regulations ensure that viewers of financial statements obtain adequate information.

What Are the Different Kinds of Contingent Liabilities?

GAAP classifies contingent liabilities into probable, feasible, and remote categories. It is possible to evaluate potential contingent liabilities (and must be reflected within financial statements). Possible contingent liabilities are equally likely to occur (and must only be reported in financial statement footnotes). In contrast, remote contingent liabilities are unlikely to happen (and do not need to be included in financial statements).

What Are Some Contingent Liabilities?

Pending lawsuits and warranties are both examples of frequent contingent liabilities. Because the outcome of pending lawsuits is undetermined, they are classified as contingent. Because the amount of products returned under guarantee is doubtful, a warranty is considered contingent.

An example of a liability

Assume a company is being sued for patent infringement by a competitor. The corporation’s legal staff believes the competitor firm has a solid case, and the company predicts a $2 million loss if the case is lost. Because the liability is both probable and straightforward to predict. The firm sets a balance-sheet accounting item to debit (raise) legal expenses by $2 million and credit (increase) accrued expenses by $2 million. 

The accrual account enables the company to post a cost without a cash payment immediately. If the litigation results in a loss, a debit (deduction) is placed to the accumulated account, and cash is credited (reduced) by $2 million. Assume that legal responsibility is possible but unlikely and that the monetary value is judged to be $2 million. 

The corporation discloses the contingent obligation in the financial statements’ footnotes in these cases. If the company considers that the possibility of the liability occurring is remote, it is not required to disclose the potential risk. Another typical type of contingent liability is a warranty because the number of products returned under warranty is unknown. 

Assume, for example, that a bike manufacturer provides a three-year contract on $50 bicycle seats. If a company produces 1,000 bicycle seats per year and offers a warranty per seat, the company must predict the number of seats that may be returned under warranty each year. If, for example, the company estimates that 200 seats would need to be replaced under warranty for $50, the company adds a $10,000 debit (increase) to warranty expense and a $10,000 credit (increase) to accrued warranty liability. The accounts are modified at the end of the year to reflect the incurred warranty expense. Visit here to know what is a Cost Sheet?

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