Contingent Liability: What Is It, and What Are Some Examples?

So if a company has a strong cash flow position and can experience rapid growth earnings, it can probably avoid the impact being too large. Businesses need to plan for the worst case scenario while proactively hoping for the best in order to properly manage their cash flow. Planning for every eventuality is essential for sound financial management. Review each of the transactions and prepare any necessary journal entries for each situation. (Figure)Emperor Pool Services provides pool cleaning and maintenance services to residential clients.

• In his freetime, you’ll find Grant hiking and sailing in beautiful British Columbia.
• These liabilities can harm the company’s stock price because contingent liabilities can negatively impact the business’s future profitability.
• This is because of their connection with three discount accounting principles.
• The accrual account permits the firm to immediately post an expense without the need for an immediate cash payment.
• Such contingency is neither recorded on the financial statements nor disclosed to the investors by the management.

The most common accounting standards are the International Financial Reporting Standards (IFRS). However, many countries also follow their own reporting standards, such as the GAAP in the U.S. or the Russian Accounting Principles (RAP) in Russia. Although the recognition and reporting of the liabilities comply with different accounting standards, the main principles are close to the IFRS. It’s common that unpredictable events can happen in business, often creating losses. These potential losses are contingent liabilities that companies need to plan for and report to investors.

Conversely, if the injury occurred in Year 2, Year 1’s financial statements would not be adjusted no matter how bad the financial effect. 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.

Ultimately, this is why these situations or circumstances must get disclosed in the financial statements of a company. Within this principle, referring to the term material also refers to the liability being significant. Since some contingent liabilities can have a negative impact on the financial performance and health of a company, having knowledge of it can influence decision-making when it comes to financial statements. 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) and Warranty Liability on the balance sheet (Figure) for Sierra Sports.

Warranty Costs

This financial recognition and disclosure are recognized in the current financial statements. The income statement and balance sheet are typically impacted by contingent liabilities. Contingent liabilities are those that are likely to be realized if specific events occur.

The company estimates that a loss in the lawsuit could result in a financial setback of $2 million. 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.

• For example, if a company overestimates the likelihood that a contingent liability will be realized, it may record a liability that is larger than the actual amount that will be paid.
• Grant Gullekson is a CPA with over a decade of experience working with small owner/operated corporations, entrepreneurs, and tradespeople.
• Liabilities can help companies organize successful business operations and accelerate value creation.
• The liability may be disclosed in a footnote on the financial statements unless both conditions are not met.

They can be a tricky endeavor for both management and investors to navigate since the likelihood of them occurring isn’t guaranteed. 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.

Why Is Contingent Liability Recorded?

Contingent assets are possible assets whose existence will be confirmed by the occurrence or non-occurrence of uncertain future events that are not wholly within the control of the entity. Contingent assets are not recognised, but they are disclosed when it is more likely than not that an inflow of benefits will occur. However, when the inflow of benefits is virtually certain an asset is recognised in the statement of financial position, because that asset is no longer considered to be contingent.

In these cases, the outcome is balanced between likelihood and non-likelihood. While these potential obligations are less certain than probable ones, they still warrant attention and disclosure. Probable contingent liabilities represent situations where there is a significant likelihood of an event occurring, leading to a potential future obligation. These situations are both foreseeable and quantifiable, allowing companies to make informed financial preparations. There is only one scenario where a provision will not be recorded in the books of accounts. If the liability is probable (more likely than not) but it cannot be measured or estimated with any reliability then such liability has to be recorded as a contingent liability.

Lets us understand the concept of liquidated damages with the help of an example. The liquidated damages are written as legal contracts and are bound by the law. Contingent liability is coverage for losses to a third party for which the insured is vicariously liable. Contingencies may be positive as well as negative, but accounting practices only consider negative outcomes.

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A contingent liability that is expected to be settled in the near future is more likely to impact a company’s share price than one that is not expected to be settled for several years. 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. A warranty is another common contingent liability because the number of products returned under a warranty is unknown.

What Is the Journal Entry for Contingent Liabilities?

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The damages that need to be compensated by the party if and when there is a breach in the contract. The breach is usually a failure in the contract or not up to the mark performance by the party. Let’s say that the manufacturer has estimated that out of all the mobile phones produced, about 2,000 mobiles would be called back due to fault reasons. This principle plays an important role in ensuring reduced information asymmetry between the shareholders and the management. That standard replaced parts of IAS 10 Contingencies and Events Occurring after the Balance Sheet Date that was issued in 1978 and that dealt with contingencies.

The Reporting Requirements of Contingent Liabilities

If the estimated loss can only be defined as a range of outcomes, the U.S. approach generally results in recording the low end of the range. International accounting standards focus on recording a liability at the midpoint of the estimated unfavorable outcomes. Contingent liabilities can pose a threat to the reduction of net profitability and company assets. This means that they can potentially negatively impact the health and financial performance of a company.

For example, Sierra Sports has a one-year warranty on part repairs and replacements for a soccer goal they sell. Sierra Sports notices that some of its soccer goals have rusted screws that require replacement, but they have already sold goals with this problem to customers. There is a probability that someone who purchased the soccer goal may bring it in to have the screws replaced. Not only does the contingent liability meet the probability requirement, it also meets the measurement requirement. 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. A contingent liability is not recognised in the statement of financial position.

One is legally obligated or responsible for any damages done under the law. If the person or company in question does not take the responsibility, they may be legally sued. A liquidated damages compensation can help in safeguarding the party against future discrepancies. The company gives a certain guarantee to another stakeholder on behalf of their third party.

The full disclosure principle states that all necessary information that poses an impact on the financial strength of the company must be registered in the public filings. 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. This ensures that income or assets are not overstated, and expenses or liabilities are not understated. The IFRS Foundation is a not-for-profit, public interest organisation established to develop high-quality, understandable, enforceable and globally accepted accounting and sustainability disclosure standards.