Reporting Requirements of Contingent Liabilities and GAAP Compliance

Now assume that a lawsuit liability is possible but not probable and the dollar amount is estimated to be $2 million. Under these circumstances, the company discloses the contingent liability the rules of working with tax returns for unexperienced accountants in the footnotes of the financial statements. If the firm determines that the likelihood of the liability occurring is remote, the company does not need to disclose the potential liability.

An example of such liability is a court case, only if the company loses the court case, contingent liability will actually be realized. Under this scenario, contingent Liability is recorded only when it is probable that the loss will occur, and you can reasonably estimate the amount of loss. According to the full disclosure principle, all significant, relevant facts related to the financial performance and fundamentals of a company should be disclosed in the financial statements. Do not record or disclose the contingent liability if the probability of its occurrence is remote. By nature, contingent liabilities are uncertain and for a business, these are the future expenses or outflows that might occur.

What is ‘Contingent Liability’

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. The companies or even individuals who develop new work or products can register for copyright so that they can take benefit from the profits and retain the original ownership. 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.

The word contingent or contingency means “possible, but not certain to occur”. So, according to the definition, contingent liabilities are those liabilities that may or may not be incurred by a business depending on the outcome of a future event. The existence of this kind of liability is completely dependent on the occurrence of a probable event in future. A contingent liability is not recognised in the statement of financial position. However, unless the possibility of an outflow of economic resources is remote, a contingent liability is disclosed in the notes.

• If a law suit is expected to go against the company and it will attract a penalty of $500,000, then the management will set aside this amount and utilize the remaining cash in the business.
• Contingent liabilities are shown as liabilities on the balance sheet and as expenses on the income statement.
• Any use, duplication, or publication of the copyrighted material without the permission of the owner can lead to serious legal charges.
• According to the full disclosure principle, all significant, relevant facts related to the financial performance and fundamentals of a company should be disclosed in the financial statements.

For this reason, the contingent liability can’t be recorded in the books, but can be shown in the Foot Notes. Definition of Contingent Liability
A contingent liability is a potential liability that may or may not become an actual liability. Whether the contingent liability becomes an actual liability depends on a future event occurring or not occurring. If the recognition criteria for a contingent liability are met, entities should accrue an estimated loss with a charge to income.

Integrated Reporting

These scenarios are often referred to as types of contingent liabilities. Similarly, the knowledge of a contingent liability can influence the decision of creditors considering lending capital to a company. The contingent liability may arise and negatively impact the ability of the company to repay its debt. There are three scenarios for contingent liabilities, all involving different accounting treatments. If a company is sued by a former employee for $500,000 for age discrimination, the company has a contingent liability. However, if the company is not found guilty, the company will not have any liability.

Examples of Contingent Liability
A company’s supplier is unable to obtain a bank loan. The company agrees to guarantee that the supplier’s bank loan will be repaid. As a result of the company’s guarantee, the bank makes the loan to the supplier.

Contingent liabilities adversely impact a company’s assets and net profitability. A contingent liability is a potential loss that may occur at some point in the future, once various uncertainties have been resolved. The exact status of a contingent liability is important when determining which liabilities to present in the balance sheet or in the attached disclosures. It is of interest to a financial analyst, who wants to understand the probability of such an issue becoming a full liability of a business, which could impact its status as a going concern.

What is a Contingent Liability?

Under GAAP, a contingent liability is defined as any potential future loss that depends on a “triggering event” to turn into an actual expense. Contingent assets are assets that are likely to materialize if certain events arise. These assets are only recorded in financial statements’ footnotes as their value cannot be reasonably estimated. The outcome of a long-pending lawsuit, a government investigation into organizations affairs, a threat of expropriation etc.  some of the common examples of contingent liabilities. However, sometimes companies put in a disclosure of such liabilities anyway. A warranty is another common contingent liability because the number of products returned under a warranty is unknown.

Now we need to comment upon the above transaction and their impact on the books of accounts of the electroplate company. A provision is measured at the amount that the entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time. 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. Suppose a lawsuit is filed against a company, and the plaintiff claims damages up to $250,000.

Even the reporting of contingent liabilities ensure that the government organizations, non-government organizations & other companies are ready for meeting any emergency that may occur in the future. 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.

FAQs on Contingent Liability

If, for example, the company forecasts that 200 seats must be replaced under warranty for $50, the firm posts a debit (increase) to warranty expense for $10,000 and a credit (increase) to accrued warranty liability for $10,000. At the end of the year, the accounts are adjusted for the actual warranty expense incurred. When you record a liability in the accounting records, this does not mean that you are also setting aside funds to pay for the liability when it must eventually be paid – recording a contingent liability has no impact on cash flow. Examples of contingent liabilities are the outcome of a lawsuit, a government investigation, or the threat of expropriation.

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 possible” means that the chance of the event occurring is more than remote but less than likely. An entity must recognize a contingent liability when both (1) it is probable that a loss has been incurred and (2) the amount of the loss is reasonably estimable. In evaluating these two conditions, the entity must consider all relevant information that is available as of the date the financial statements are issued (or are available to be issued).

About the IFRS Foundation

These liabilities can be reported in the balance sheet of the company if the amount of the liability can be reasonably estimated and there are high chances of the occurrence of the event that would result in the creation of a liability. If the chances are less than 50%then the disclosure in the footnotes to the financial statements is required to be given and if the chances are remote (very less) then no disclosure is made. Examples of contingent liabilities are the pending law suits against the company, bank guarantees, etc. Pending lawsuits and product warranties are common contingent liability examples because their outcomes are uncertain. The accounting rules for reporting a contingent liability differ depending on the estimated dollar amount of the liability and the likelihood of the event occurring.

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• As a general guideline, the impact of contingent liabilities on cash flow should be incorporated in a financial model if the probability of the contingent liability turning into an actual liability is greater than 50%.
• On 26 June 2023 the ISSB issued its inaugural standards—IFRS S1 and IFRS S2—ushering in a new era of sustainability-related disclosures in capital markets worldwide.
• The CEO of Masong is worried about the bug and he is planning to replace all the Alpha III phones in the market.

To further simplify, the loss due to future events is not likely to happen but not necessarily be considered as unlikely. It could be a situation where the liability is probable, but the amount couldn’t be estimated. Therefore, it is also important to describe the liability in the footnotes that accompany the financial statements. 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.

Contingent liabilities meaning also signifies the fact that they change according to the amount of money estimated and their likelihood of occurring in the future. The accounting rules make sure that the readers of the financial statement receive enough information. IAS 37 defines and specifies the accounting for and disclosure of provisions, contingent liabilities, and contingent assets.

We have another Q&A that discusses the recording of contingent liabilities. Even the creditors/lenders can get influenced after knowing the existence of the contingent liability in the books of the company they are planning to deal with. Patent wars that usually happen between Top brands give a clear-cut explanation. Let’s suppose that Apple files a case of a patent violation on Samsung and Samsung not only realizes that it may have to pay for violations but also estimates how much in total. In this case, Samsung will record the estimated amount in their books of accounts as a Contingent Liability.

At first, the contingency liability is expressed in form of an expense in the loss and profit account and then it is mentioned in the balance sheet. Contingent liabilities are liabilities that may occur if a future event happens. Working through the vagaries of contingent accounting is sometimes challenging and inexact. Company management should consult experts or research prior accounting cases before making determinations. In the event of an audit, the company must be able to explain and defend its contingent accounting decisions.