A contingent liability is a potential loss that may occur at some point in the future, once various uncertainties have been resolved. This liability is not yet an actual, confirmed obligation. 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.
When to Recognize a Contingent Liability
There are three scenarios for contingent liabilities, all involving different accounting treatments. They are:
- High probability. 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. “Probable” means that the future event is likely to occur. You should also describe the liability in the footnotes that accompany the financial statements.
- Medium probability. 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.
- Low probability. Do not record or disclose the contingent liability if the probability of its occurrence is remote.
Examples of contingent liabilities are the outcome of a lawsuit, a government investigation, or the threat of expropriation. A warranty can also be considered a contingent liability, since there is uncertainty about the exact number of units that will be returned by customers for repair or replacement.
Example of a Contingent Liability
For example, ABC Company files a lawsuit against Unlucky Company for $500,000. Unlucky’s attorney feels that the suit is without merit, so Unlucky merely discloses the existence of the lawsuit in the notes accompanying its financial statements. Several months later, Unlucky’s attorney recommends that the company should settle out of court for $75,000; at this point, the liability is both probable and can be estimated, so Unlucky records a $75,000 liability. A possible entry for this transaction might be:
When Unlucky later pays ABC company in the out-of-court settlement, the final entry is:
Other Contingent Liability Issues
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.
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.