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The Reporting Requirements of Contingent Liabilities
Contingent liabilities are liabilities that depend on the outcome of an uncertain event. These obligations are likely to become liabilities in the future.
Contingent liabilities must pass two thresholds before they can be reported in financial statements. First, it must be possible to estimate the value of the contingent liability. If the value can be estimated, the liability must have more than a 50% chance of being realized. Qualifying contingent liabilities are recorded as an expense on the income statement and a liability on the balance sheet.
If the contingent loss is remote, meaning it has less than a 50% chance of occurring, the liability should not be reflected on the balance sheet. Any contingent liabilities that are questionable before their value can be determined should be disclosed in the footnotes to the financial statements.
Key Takeaways
- Contingent liabilities are obligations that will become liabilities if certain events occur in the future.
- To be a contingent liability, it must be possible to estimate its value and have more than a 50% chance of being realized.
- Journal entries are recorded for contingent liabilities, with a credit to the accrued liability account and a debit to the liability-related expense account.
- There are three GAAP-specified categories of contingent liabilities: probable, possible, and remote, each with different compliance guidelines.
- GAAP requires contingent liabilities that are likely to occur and can be reasonably estimated to be recorded in financial statements.
Contingent Liabilities
Two classic examples of contingent liabilities include a company warranty and a lawsuit against the company. Both represent possible losses to the company, yet both depend on some uncertain future event.
Suppose a lawsuit is filed against a company, and the plaintiff claims damages up to $250,000. It’s impossible to know whether the company should report a contingent liability of $250,000 based solely on this information. Here, the company should rely on precedent and legal counsel to ascertain the likelihood of damages.
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.
If a court is likely to rule in favor of the plaintiff, whether because there is strong evidence of wrongdoing or some other factor, the company should report a contingent liability equal to probable damages. This is true even if the company has liability insurance.
If the lawsuit is frivolous, there may be no need for disclosure. 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.
Journal Entries
A business accounting journal is used to record all business transactions. Each business transaction is recorded using the double-entry accounting method, with a credit entry to one account and a debit entry to another. Contingent liabilities, although not realized, are recorded as journal entries.
Contingent liabilities require a credit to the accrued liability account and a debit to the expense account. Once the obligation is realized, the balance sheet’s liability account is debited and the cash account is credited. Also, an entry is made in the associated expense of the income statement.
GAAP Compliance
Companies operating in the United States rely on the guidelines established in the generally accepted accounting principles (GAAP). Under GAAP, a contingent liability is defined as any potential future loss that depends on a “triggering event” to turn into an actual expense.
It’s important that shareholders and lenders be warned about possible losses—an otherwise sound investment might look foolish after an undisclosed contingent liability is realized.
There are three GAAP-specified categories of contingent liabilities: probable, possible, and remote. Probable contingencies are likely to occur and can be reasonably estimated. Possible contingencies do not have a more-likely-than-not chance of being realized but are not necessarily considered unlikely either. Remote contingencies aren’t likely to occur and aren’t reasonably possible.
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.
Any probable contingency needs to be reflected in the financial statements—no exceptions. Remote contingencies should never be included. Possible contingencies—those that are neither probable nor remote—should be disclosed in the footnotes of the financial statements.
What Are the GAAP Accounting Rules for Contingent Liabilities?
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.
What Are Contingent Liabilities in Accounting?
Contingent liabilities are liabilities that may occur if a future event happens.
What Is the Journal Entry for Contingent Liabilities?
For contingent liabilities, a credit is made to the accrued liability account and a debit is made to the debt’s expense account.
Where Are Contingent Liabilities Shown on the Financial Statement?
Contingent liabilities are shown as liabilities on the balance sheet and as expenses on the income statement.
The Bottom Line
Contingent liabilities are those that are likely to be realized if specific events occur. These liabilities are categorized as being likely to occur and estimable, likely to occur but not estimable, or not likely to occur. Generally accepted accounting principles (GAAP) require contingent liabilities that can be estimated and are more likely to occur to be recorded in a company’s financial statements.