Contingent liability definition
/What is a Contingent Liability?
A contingent liability is a potential obligation that may arise depending on the outcome of a future event. The obligation is uncertain because it depends on circumstances that have not yet been resolved. Common examples include pending lawsuits, loan guarantees, and product warranties. Depending on the likelihood and measurability of the obligation, it may be disclosed or recognized in the financial statements.
Accounting for Contingent Liabilities
There are three possible scenarios for contingent liabilities, all of which involve different accounting transactions. They are noted below:
Record a contingent liability. Record a contingent liability when it is probable that a 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.
Disclose a contingent liability. Disclose the existence of a 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.
Do not disclose a contingent liability. Do not record or disclose a contingent liability if the probability of its occurrence is remote.
Related AccountingTools Courses
Examples of Contingent Liabilities
Examples of contingent liabilities are as follows:
The outcome of a lawsuit
A government investigation
The threat of expropriation
A warranty can be considered a contingent liability
For example, a customer files a lawsuit against a business, claiming that its product broke, causing $500,000 of damage. The organization’s attorney believes that the customer will win in court, and believes that the firm will have to pay the full $500,000. Because this outcome is both probable and easy to estimate, the company’s controller records an expense of $500,000. If the attorney had instead felt that the loss was only possible, rather than probable, then there would be no need to record the expense; instead, the controller would merely disclose the issue in the footnotes accompanying the firm’s financial statements.
FAQs
What is the difference between a provision and a contingent liability?
A provision is a liability recognized on the balance sheet when a present obligation exists, payment is probable, and the amount can be reasonably estimated. A contingent liability is a possible obligation that depends on uncertain future events and is disclosed in the notes unless the likelihood of payment is remote.