What is a Contingent Liability?
A contingent liability is a potential obligation that may arise from an event that has not yet occurred. A contingent liability is not recognized in a company’s financial statements. Instead, only disclose the existence of the contingent liability, unless the possibility of payment is remote.
There are three possible scenarios for contingent liabilities, all of which involve different accounting transactions. They are noted below.
Example of a Contingent Liability
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.
The accrual account permits the firm to immediately post an expense without the need for an immediate cash payment. If the lawsuit results in a loss, a debit is applied to the accrued account (deduction) and cash is credited (reduced) by $2 million.
Now assume that a lawsuit liability is possible but not probable and the dollar amount is estimated to be $2 million. Under these circumstances, the company discloses the contingent liability in the footnotes of the financial statements. If the firm determines that the likelihood of the liability occurring is remote, the company does not need to disclose the potential liability.
A warranty is another common contingent liability because the number of products returned under a warranty is unknown. Assume, for example, that a bike manufacturer offers a three-year warranty on bicycle seats, which cost $50 each.
If the firm manufactures 1,000 bicycle seats in a year and offers a warranty per seat, the firm needs to estimate the number of seats that may be returned under warranty each year.
If, for example, the company forecasts that 200 seats must be replaced under warranty for $50, the firm posts a debit (increase) to warranty expense for $10,000 and a credit (increase) to accrued warranty liability for $10,000. At the end of the year, the accounts are adjusted for the actual warranty expense incurred.
Record a Contingent Liability
Record a contingent liability when it is probable that a loss will occur, and you can reasonably estimate the amount of the loss. If you can only estimate a range of possible amounts, then record that amount in the range that appears to be a better estimate than any other amount; if no amount is better, then record the lowest amount in the range.
“Probable” means that the future event is likely to occur. You should also describe the liability in the footnotes that accompany the financial statements.
Disclose a Contingent Liability
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. “Reasonably possible” means that the chance of the event occurring is more than remote but less than likely.
What Are the 3 Types of Contingent Liabilities?
GAAP recognizes three categories of contingent liabilities—probable, possible, and remote. Probable contingent liabilities can be reasonably estimated (and must be reflected within financial statements). Possible contingent liabilities are as likely to occur as not (and need only be disclosed in the financial statement footnotes) and remote contingent liabilities are extremely unlikely to occur (and do not need to be included in financial statements at all).