12 3 Define and Apply Accounting Treatment for Contingent Liabilities Principles of Accounting, Volume 1: Financial Accounting

If information as of the balance sheet date indicates a future loss for the company is probable and the amount is reasonably estimable, the company should record an accrual for the liability. The liability would be considered a short-term liability if the expected settlement date is within one year of the balance sheet date. If it is beyond the one year point, the liability would be considered a long-term liability. The amount that the company should accrue is either the most accurate estimate within a range or– if no amount within the potential range is more likely than the others– the minimum amount of the range.

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 a contingent liability that is probable and for which the dollar amount can be estimated should be possible” means that the chance of the event occurring is more than remote but less than likely. A contingent liability is a potential loss that may occur at some point in the future, once various uncertainties have been resolved.

What is a contingent liability?

Since the outcome of contingent liabilities cannot be known for certain, the probability of the occurrence of the contingent event is estimated and, if it is greater than 50%, then a liability and a corresponding expense are recorded. The recording of contingent liabilities prevents the understating of liabilities and expenses. If the contingent liability is considered remote, it is unlikely to occur and may or may not be estimable. This does not meet the likelihood requirement, and the possibility of actualization is minimal. In this situation, no journal entry or note disclosure in financial statements is necessary. A loss contingency which is possible but not probable will not be recorded in the accounts as a liability and a loss.

• If the liability is likely to occur and the amount can be reasonably estimated, the liability should be recorded in the accounting records of a firm.
• Our example only covered the warranty expenses anticipated from the 2019 sales.
• Record a contingent liability when it is probable that the loss will occur, and you can reasonably estimate the amount of the loss.
• No journal entry or financial adjustment in the financial statements will occur.

Internal financial statement users may need to know about the contingent liability to make strategic decisions about the direction of the company in the future. A contingent liability is a liability that may occur depending on the outcome of an uncertain future event. A contingent liability has to be recorded if the contingency is likely and the amount of the liability can be reasonably estimated. Both generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) require companies to record contingent liabilities. Pending lawsuits and product warranties are common contingent liability examples because their outcomes are uncertain.

IAS 12 — Accounting for uncertainties in income taxes

A contingent liability is a potential liability that may occur in the future, such as pending lawsuits or honoring product warranties. If the liability is likely to occur and the amount can be reasonably estimated, the liability should be recorded in the accounting records of a firm. 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.

An item is considered material if the knowledge of it could change the economic decision of users of the company’s financial statements. 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. Building a cash flow statement from scratch using a company income statement and balance sheet is one of the most fundamental finance exercises commonly used to test interns and full-time professionals at elite level finance firms.