Contingent Liability Definition & Examples

Contingent liabilities are possible obligations whose existence will be confirmed by uncertain future events that are not wholly within the control of the entity. An example is litigation against the entity when it is uncertain whether the entity has committed an act of wrongdoing and when it is not probable that settlement will be needed. 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. If it is determined that too much is being set aside in the allowance, then future annual warranty expenses can be adjusted downward. If it is determined that not enough is being accumulated, then the warranty expense allowance can be increased.

Assume that Sierra Sports is sued by one of the customers who purchased the faulty soccer goals. A settlement of responsibility in the case has been reached, but the actual damages have not been determined and cannot 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. No journal entry or financial adjustment in the financial statements will occur. Instead, Sierra Sports will include a note describing any details available about the lawsuit.

Contingent Liabilities FAQs

Until the lawsuit is resolved, the company faces uncertainty regarding the financial impact. ABC Company’s legal team believes the chance of a negative outcome for ABC is probable. They estimate the potential legal settlement to be between $1 million and $2 million– with the most likely settlement amount being $1.25 million. In this case, the company should record a contingent liability on the books in the amount of $1.25 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. A probable contingent liability that can be reasonably estimated is entered into the accounts even if the precise amount cannot be known. Pending lawsuits and product warranties are two examples of contingent liabilities. The factor of uncertainty, where the outcome is out of the company’s control for the most part, is one of the core attributes of contingent liabilities.

What Are the GAAP Accounting Rules for Contingent Liabilities?

If it does not meet both of these criteria, the contingent liability may still need to be recorded as a disclosure in the footnotes to the financial statements. A company should always aim to present its financial statements fairly and accurately based on the information it has available as of the balance sheet date. Caution is needed in making judgements under conditions of uncertainty, so that income or assets are not overstated and expenses or liabilities are not understated. However, uncertainty does not justify the creation of excessive provisions or a deliberate overstatement of liabilities. For example, if the projected costs of a particularly adverse outcome are estimated on a prudent basis, that outcome is not then deliberately treated as more probable than is realistically the case.

To elaborate upon the prior section, the different types of contingency liabilities are described in more detail here. While these sorts of conditional financial commitments are not guaranteed, per se, the odds are likely stacked against the company. Initially, when the customer had reported it to, the company refused to accept the claim and therefore, the customer has filed a legal claim against them. contingent liabilities example One of their customers has filed the legal claim against the company for delivering the product which was defective. A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice.

3: Define and Apply Accounting Treatment for Contingent Liabilities

When damages have been determined, or have been reasonably estimated, then journalizing would be appropriate. While a contingency may be positive or negative, we only focus on outcomes that may produce a liability for the company (negative outcome), since these might lead to adjustments in the financial statements in certain cases. Positive contingencies do not require or allow the same types of adjustments to the company’s financial statements as do negative contingencies, since accounting standards do not permit positive contingencies to be recorded. 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.

And the past event is the company delivering the defective product and turning down the claim of the customer. For information pertaining to the registration status of 11 Financial, please contact the state securities regulators for those states in which 11 Financial maintains a registration filing. A copy of 11 Financial’s current written disclosure statement discussing 11 Financial’s business operations, services, and fees is available at the SEC’s investment adviser public information website – from 11 Financial upon written request. Past experience indicates that a certain percentage of products will be defective, and past experience can also be used to reasonably estimate the amount of the future expenditure required by the warranty. The business is exempt from disclosing the possible liability if it considers that the risk of it happening is remote. As the name suggests, if there are very slight chances of the liability occurring, the US GAAP considers calling it a remote contingency.

Ask Any Financial Question

The sales price per soccer goal is$1,200, and Sierra Sports believes 10% of sales will result inhonored warranties. The company would record this warrantyliability of $120 ($1,200 × 10%) to Warranty Liability and WarrantyExpense accounts. Since this condition does not meet the requirement oflikelihood, it should not be journalized or financially representedwithin the financial statements. Rather, it is disclosed in thenotes only with any available details, financial or otherwise. If the warranties are honored, the company should know howmuch each screw costs, labor cost required, time commitment, andany overhead costs incurred.