Contingent Liability How to Use and Record Contingent Liabilities

When lenders arrange loans with their
corporate customers, limits are typically set on how low certain
liquidity ratios (such as the current ratio) can go before the bank
can demand that the loan be repaid immediately. If the warranties are honored, the company should know how
much each screw costs, labor cost required, time commitment, and
any overhead costs incurred. This amount could be a reasonable
estimate for the parts repair cost per soccer goal. Since not all
warranties may be honored (warranty expired), the company needs to
make a reasonable determination for the amount of honored
warranties to get a more accurate figure. For example, Sierra Sports has a one-year warranty on part
repairs and replacements for a soccer goal they sell.

The term contingent liability is used for
liabilities where there is a possible obligation or a present obligation that
may, but probably will not, require an outflow of resources. Such a distinction
is very important as contingent liabilities are not recognized
as liabilities in the statement of
financial position, but disclosed in the notes to the financial statements. GAAP accounting rules require probable contingent liabilities—ones that can be estimated and are likely to occur—to be recorded in financial statements. Contingent liabilities that are likely to occur but cannot be estimated should be included in a financial statement’s footnotes. Remote (not likely) contingent liabilities are not to be included in any financial statement.

What Are the GAAP Accounting Rules for Contingent Liabilities?

There is an uncertainty that a claim will transpire, or
bankruptcy will occur. If the contingencies do occur, it may still
be uncertain when they will come to fruition, or the financial
implications. A Contingent Asset is an economic gain that may come into existence in near future as a result of some past action. The existence of such assets is completely uncertain and beyond the control of the entity. If a court is likely to rule in favor of the plaintiff, whether because there is strong evidence of wrongdoing or some other factor, the company should report a contingent liability equal to probable damages. In all these situations, a past event has occurred that may give rise to liability depending on some future event.

Warranties arise from products or services sold to customers
that cover certain defects (see
Figure 12.8). It is unclear if a customer will need to use a
warranty, and when, but this is a possibility for each product or
service sold that includes a warranty. The same idea applies to
insurance claims (car, life, and fire, for example), and
bankruptcy.

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Provisions are usually recognized at the end of
each reporting period and will be raised through reversing journal vouchers. This means that the journals will be automatically reversed at the start of the
next reporting period. (b) a possible obligation whose existence will be
confirmed only by the occurrence or non-occurrence of one or more
uncertain future events not wholly within the control of the UN. To be recorded on the balance sheet, the likelihood of the loss needs to be probable and the amount of the future payment needs to be known. An example of determining a warranty liability based on a
percentage of sales follows. The sales price per soccer goal is
$1,200, and Sierra Sports believes 10% of sales will result in
honored warranties.

Each claim will be reviewed on a
case-by-case basis to determine the movements in the case in 20X1 and the
appropriate Umoja accounting entries described. Now that all relevant information has been
received and reviewed, the Accounts Division can determine the accounting
impact based on the information provided by OLA. Further
details regarding the calculation of the unwinding of discounted provisions can
be found in Corporate Guidance on Provisions,
Contingent Liabilities and Contingent Assets. For large populations of similar
obligations, a weighted outcome should be used. Should there be a
continuous range of values of equal possibility, the mid-point
should be used. For accounting policies relating to
specific types of provisions, please refer to section 10 of the Corporate
Guidance on Provisions,
Contingent Liabilities and Contingent Assets.

How are the journal entries and legal entries recorded for contingent liabilities?

A provision should be recognized when the recognition criteria in section 2.1.1
above are met. Where a provision is no longer required
(i.e. where the provision recognition criteria are no longer met), it should
be reversed. A provision can be fully or partially reversed
depending on the specific circumstances. Provisions should be discounted to the
present value of the outflows required to settle the obligation where the
effect of the time value of money is material.

In order for a contingent liability to be recorded as a journal entry it must be probable and reasonably estimable. The accrual involves debiting and increasing a loss account and crediting and increasing a liability account. Where a material adjusting event is identified, the
amounts in the financial statements for the reporting period should be
adjusted to reflect the adjusting event.

• Whilst IPSAS does not specify a
  precise numerical threshold, this is generally accepted as having a probability
  of greater than 50% of occurring.
• 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.
• “Reasonably possible” is defined in vague terms as existing when “the chance of the future event or events occurring is more than remote but less than likely” (paragraph 3).

The amount of the provision is based on the best estimate of the amount that the company will ultimately be required to pay. An automobile guarantee or other product warranties are examples of contingent liabilities that, are usually recorded on a company’s books. Not surprisingly, many companies contend that future adverse effects from all loss contingencies are only reasonably possible so that no actual amounts are reported.

IAS 37 — Changes in decommissioning, restoration, and similar liabilities

If the contingent liability journal entry above is not recorded, the ABC’s total liabilities and expenses will be both understated by $25,000. According to the FASB, if there is a probable liability
determination before the preparation of financial statements has
occurred, there is a likelihood of occurrence, and
the liability must be disclosed and recognized. This financial
recognition and disclosure are recognized in the current financial
statements. The income statement and balance sheet are typically
impacted by contingent liabilities.

Since the
company’s inventory of supply parts (an asset) went down by $2,800,
the reduction is reflected with a credit entry to repair parts
inventory. First, following is the necessary journal entry to
record the expense in 2019. A contingency occurs when a current situation
has an outcome that is unknown or uncertain and will not be
resolved until a future point in time. A contingent liability can
produce a future debt or negative obligation for the company. Some
examples of contingent liabilities include pending litigation
(legal action), warranties, customer insurance claims, and
bankruptcy. Record a contingent liability when it is probable that the loss will occur, and you can reasonably estimate the amount of the loss.

The accounting of contingent liabilities is a very subjective topic and requires sound professional judgment. Contingent liabilities can be a tricky concept for a company’s management, as well as for investors. Judicious use of a wide variety of techniques for the valuation of liabilities and risk weighting may be required in large companies with multiple lines of business. According to the full disclosure current liabilities definition & example principle, all significant, relevant facts related to the financial performance and fundamentals of a company should be disclosed in the financial statements. The determination of whether a contingency is probable is based
on the judgment of auditors and management in both situations. This
means a contingent situation such as a lawsuit might be accrued
under IFRS but not accrued under US GAAP.

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Often, the longer the span of time it takes for a contingent liability to be settled, the less likely that it will become an actual liability. The materiality principle states that all important financial information and matters need to be disclosed in the financial statements. An item is considered material if the knowledge of it could change the economic decision of users of the company’s financial statements.

• Sometimes contingent liabilities can arise suddenly and be completely unforeseen.
• A contingent liability is recorded in the accounting records if the contingency is probable and the amount of the liability can be reasonably estimated.
• This is considered
  probable but inestimable, because the lawsuit is very likely to
  occur (given a settlement is agreed upon) but the actual damages
  are unknown.
• Contingent liabilities, although not yet realized, are recorded as journal entries.
• In plain English, a liability is something you or another entity owes another party.

Only relevant expenditure
should be offset against a provision (i.e. only those costs for which
the provision was originally intended can result in the ‘utilization’ of the provision). Whilst the individually most likely outcome may also
often form the best estimate, other outcomes should also be considered
as these may also impact the overall measurement of the provision. In our example, you have a liability because you need to pay your brother $100 in the future. Just a quick glance on the balance sheet of any publicly-traded company will show that there are various liability accounts.

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The accounting rules for the treatment of a contingent liability are quite liberal – there is no need to record a liability unless the risk of loss is quite high. Thus, you should review the disclosures accompanying a company’s financial statements to see if there are additional risks that have not yet been recognized. These disclosures should be considered advance warning of amounts that may later appear as formal liabilities in the financial statements.

Under GAAP, a contingent liability is defined as any potential future loss that depends on a “triggering event” to turn into an actual expense. The disclosure requirements for contingent liabilities are set forth in accounting standards. In general, companies must disclose the nature of the contingency and the expected timing and amount of any potential payments.