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Disclose the existence of a contingent liability in the notes accompanying the financial statements if the liability is reasonably possible but not probable, or if the liability is probable, but you cannot estimate the amount. An entity must recognize a contingent liability when both (1) it is probable that a loss has been incurred and (2) the amount of the loss is reasonably estimable. In evaluating these two conditions, the entity must consider all relevant information that is available as of the date the financial statements are issued (or are available to be issued).

However, we should disclose such kind of information in the financial statement note. It tells the reader that there is a possible future economic benefit that may be flowing into the company in the future. The disclosure needs to describe the actual nature of contingent assets and it will let the reader make their own judgment. If the contingency is reasonably possible, it could occur but is not probable. Since this condition does not meet the requirement of likelihood, it should not be journalized or financially represented within the financial statements.

Contingent liability definition

The expense will reduce the company’s profit and contingent liability will be present on the balance sheet. Do not record or disclose the contingent liability if the probability of its occurrence is remote. Do not record or disclose a contingent liability if the probability of its occurrence is remote. Do not confuse these “firm specific” contingent liabilities with general business risks. General business risks include the risk of war, storms, and the like that are presumed to be an unfortunate part of life for which no specific accounting can be made in advance. Another way to establish the warranty liability could be an estimation of honored warranties as a percentage of sales.

• Contingent assets are assets that are likely to materialize if certain events arise.
• What about contingent assets/gains, like a company’s claim against another for patent infringement?
• These liabilities become contingent whenever their payment contains a reasonable degree of uncertainty.
• Almost 40% of business failures are caused due to inadequate financial management.
• Conversion of a contingent liability to an expense depends on a specific triggering event.
• Lawsuits, especially with huge companies, can be an enormous liability and significantly impact the bottom line.
• The journal entry would be to debit legal expense and credit to record the legal liability.

These disclosures should be considered advance warning of amounts that may later appear as formal liabilities in the financial statements. Disclose the existence of the contingent liability in the notes accompanying the financial statements if the liability is reasonably possible but not probable, or if the liability is probable, but you cannot estimate the amount. “Reasonably possible” means that the chance of the event occurring is more than remote but less than likely.

Two Financial Accounting Standards Board (FASB) Requirements for Recognition of a Contingent Liability

For example, when a company is fighting a legal battle and the opposite party has a stronger case, and the probability of losing is above 50%, it must be recorded in the books of accounts. Possible contingent liabilities include loss from damage to property or employees; most companies carry many types of insurance, so these liabilities are normally expressed in terms of insurance costs. 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. Future costs are expensed first, and then a liability account is credited based on the nature of the liability. In the event the liability is realized, the actual expense is credited from cash and the original liability account is similarly debited. The accrual account permits the firm to immediately post an expense without the need for an immediate cash payment.

However, a note to the financial statements may be needed to explain that a material adverse event arising subsequent to year end has occurred. What about business decision risks, like deciding to reduce insurance coverage because of the high cost of the insurance premiums? GAAP is not very clear on this subject; such disclosures are not required, but are not discouraged.

Examples of Contingent liabilities

This journal entry is to show that when there is a probability of future cost which can be reasonably estimated, the company needs to recognize and record it as an expense immediately. Likewise, the contingent liability is a payable account, in which the company will expect the outflow of resources containing economic benefits (e.g. cash out). A contingent liability is recorded in the accounting records if the contingency how to record a contingent liability 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. 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.

Under US GAAP, the low end of the range would be accrued, and the range disclosed. As you’ve learned, not only are warranty expense and warranty liability journalized, but they are also recognized on the income statement and balance sheet. The following examples show recognition of Warranty Expense on the income statement Figure 12.10 and Warranty Liability on the balance sheet Figure 12.11 for Sierra Sports.

First, following is the necessary journal entry to record the expense in 2019. Let’s expand our discussion and add a brief example of the calculation and application of warranty expenses. While a contingency may be positive or negative, we only focus on outcomes that may produce a liability for the company (negative outcome), since these might lead to adjustments in the financial statements in certain cases.

Conversion of a contingent liability to an expense depends on a specific triggering event. 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. Any liabilities that have a probability of occurring over 50% are categorized under probable contingencies. The company can make contingent liability journal entry by debiting the expense account and crediting the contingent liability account. The accounting of contingent liabilities is a very subjective topic and requires sound professional judgment.