We undertake various activities to support the consistent application of IFRS Standards, which includes implementation support for recently issued Standards. We do this because the quality of implementation and application of the Standards affects the benefits that investors receive from having a single set of global standards. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.
The most basic example of a contingent liability is a pending lawsuit from a previous event. For example, a hang gliding manufacturer could be sued because their equipment was faulted and caused serious injuries to a small number of their customers. There is no way to know the outcome of the lawsuit or even when the suit will be settled.
By providing for contingent liabilities, it gives an opportunity for businesses to asses and be prepared for the situation. Even if the outcome is based on the probability of occurrence of the event, it is considered an actual liability. But it will be recorded in the books only if the probability is more than 50%. Contingent liabilities are recorded on the P&L statement and the balance sheet if the probability of occurrence is more than 50%. A possible contingency is when the event might or might not happen, but the chances are less than that of a probable contingency, i.e., less than 50%.
Record a contingent liability when it is probable that the 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. You should also describe the liability in the footnotes that accompany the financial statements. Record a contingent liability when it is probable that a loss will occur, and you can reasonably estimate the amount of the loss. Now assume that a lawsuit liability is possible but not probable and the dollar amount is estimated to be $2 million.
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Imagine a business being sued for copyright infringement by a rival business. The business projects a $5 million loss if the firm loses the case, but the legal department of the business believes the rival firm has a strong case. As the name suggests, if there are very slight chances of the liability occurring, the US GAAP considers calling it a remote contingency.
- Do not confuse these “firm specific” contingent liabilities with general business risks.
- Although the recognition and reporting of the liabilities comply with different accounting standards, the main principles are close to the IFRS.
- Let’s say a mobile phone manufacturer produces many mobiles and sells them with a brand warranty of 1 year.
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. Rather, it is disclosed in the notes only with any available details, financial or otherwise. Another way to establish the warranty liability could be an estimation of honored warranties as a percentage of sales. In this instance, Sierra could estimate warranty claims at 10% of its soccer goal sales. Any case with an ambiguous chance of success should be noted in the financial statements but do not need to be listed on the balance sheet as a liability.
Medium Probability of Loss
Contingent liabilities are those that are likely to be realized if specific events occur. These liabilities are categorized as being likely to occur and estimable, likely to occur but not estimable, or not likely to occur. Generally accepted accounting principles (GAAP) require contingent liabilities that can be estimated and are more likely to occur to be recorded in a company’s financial statements. Contingent liability refers to those liabilities that can incur as an entity and depends on the outcomes of the pending lawsuit. Such liabilities are not recorded in the company’s account and are shown in the company’s balance sheet when they are reasonably and probably estimated as a “worst-case” or “contingency” in the outcome. The extent and nature of the contingent liability can be explained by a footnote.
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The opinions of analysts are divided in relation to modeling contingent liabilities. One of their customers has filed the legal claim against the company for delivering the product which was defective. Supposing the new technology developed by a certain tech company is used or launched by another company without prior permission, it is counted as stealing one property. This may lead to serious legal problems and the company that developed the technology can press charges against the other party. Supposing a business is selling a certain kind of product, any damage that it can be caused to the buyer before and after it leaves the manufacturing unit is the full responsibility of the owner. If the owner is reluctant to take responsibility for their product, the customer can sue the company.
Pending lawsuits are considered contingent because the outcome is unknown. A warranty is considered contingent because the number of products that will be returned under a warranty is unknown. As part of the due diligence process, some potential investors look at a company’s prospectus, which must include all the information on its financial statements. Investors pay particular attention to items that reduce the company’s ability to generate profits, like contingent liabilities.
Our example only covered the warranty expenses anticipated from the 2019 sales. Since the company has a three-year warranty, and it estimated repair costs of $5,000 for the goals sold in 2019, there is still a balance of $2,200 left from the original $5,000. However, its actual experiences could be more, the same, or less than $2,200.
Contingent liabilities are those liabilities that tend to occur in the future depending on an outcome. It may or may not be disclosed in a footnote unless it meets both conditions. Some of the common contingent liabilities examples are product warranties, pending investigations, and potential lawsuits. Google, a subsidiary what are source documents in accounting of Alphabet Inc., has expanded from a search engine to a global brand with a variety of product and service offerings. Check out Google’s contingent liability considerations in this press release for Alphabet Inc.’s First Quarter 2017 Results to see a financial statement package, including note disclosures.
Possible contingency is not recorded in the books of accounts because it is very difficult to articulate the liability in monetary terms due to its limited occurrence. There are three primary conditions that need to be met for a contingent liability to exist. The outcome of the pending obligation is known and the value can be reasonably estimated.
A liability is something owed by someone—it sets up an obligation or a debt. Review each of the transactions and prepare any necessary journal entries for each situation. The liability won’t significantly affect the stock price if investors believe the company has strong and stable cash flows and can withstand the damage.
However, if there is more than a 50% chance of winning the case, according to the prudence principle, no benefits would be recorded on the books of accounts. A great example of the application of prudence would be recognizing anticipated bad debts. Prudence can be helpful if certain liabilities might occur but aren’t certain; here contingent liabilities. As this concept hovers around ambiguity and uncertainty about the amount of money one should set aside for the expense, here are two questions one must ask before accounting for any potential unforeseen obligation.