Contingent Liabilities Explained: Definition, Examples, Practice & Video Lessons

In this instance, Sierra could estimate warranty claims at 10% of its soccer goal sales. As you’ve learned, not only are warranty expense and warrantyliability journalized, but they are also recognized on the incomestatement and balance sheet. The following examples showrecognition of Warranty Expense on the income statement Figure 12.10and Warranty Liability on the balance sheetFigure 12.11 for Sierra Sports.

Journal Entries

But if chances of a contingent liability are possible but are not likely to arise soon, estimating its value is not possible. Such loss contingencies never get recorded in the financial statements. This journal entry is to show that when there is a probability of future cost which can be reasonably estimated, the company needs to recognize and record it as an expense immediately.

A contingent liability journal entry should debit (increase) expense s and credit (increase) liabilities if the liability’s occurrence is probable and can be estimated. If the liability’s occurrence is not probable, the entity should only disclose it in the notes to the financial statements. Assume, on the other hand, ABC Company’s settlement amount was likely to be between $1 million and $2 million– but no specific amount within that range is more likely than any other. In that case, the company should record the minimum of the range as its contingent liability. It would record a journal entry to debit legal expense for $1 million and credit an accrued liability for $1 million.

• They should also ensure that any recognized contingent liabilities are appropriately measured and recorded in accordance with ing standards.
• A contingent liability is a potential obligation or liability that may arise from a future event or circumstance.
• Environmental clean-up costs are another type of contingent liability, which companies must estimate and record when the damage is probable and the loss can be reasonably estimated.
• Let’s continue to use Sierra Sports’ soccer goal warranty as our example.
• However, its actual experiences could be more, the same, or less than $2,200.

Your Financial ing tutor

The footnote disclosure should include the nature of the lawsuit, the timing of when it expects a settlement decision, and the potential amount– either the range or the exact amount if it is identifiable. If the likelihood of a negative lawsuit outcome is remote, the company does not need to disclose anything in the footnotes. When a liability is remote, the likelihood of occurrence is minimal, and neither recognition in financial statements nor disclosure in notes is required.

As stated above, companies can only recognize contingent liabilities if the likelihood is probable or higher. Usually, it means the chances of these liabilities occurring must be 50% or more. If the likelihood is lower, companies must still disclose the contingent liability. However, ing standards do not require the recognition of these liabilities. Contingent liabilities should only be recorded in the s when a probable future event is likely to occur and the amount can be reasonably estimated.

Product

Someexamples of contingent liabilities include pending litigation(legal action), warranties, customer insurance claims, andbankruptcy. Other the other hand, loss from lawsuit is an expense that the company needs to recognize (debit) in the current ing period as it is a result of the past event (i.e. lawsuit). If the contingent liability journal entry above is not recorded, the ABC’s total liabilities and expenses will be both understated by $25,000. 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 ing principles (GAAP) require contingent liabilities that can be estimated and are more likely to occur to be recorded in a company’s financial statements.

It could also be determined by the potentialfuture, known financial outcome. Product warranties are a common example of contingent liability, where a company creates a liability for potential costs of repairs or replacements under the warranty. This is typically recorded by debiting Warranty Expense and crediting Warranty Liability. The matching principle of ing states that expenses should be recorded in the same period as their related revenues. In the case of warranties, a contingent liability is required because it represents an amount that is not fully earned by a company at the time of sale. The expense of the potential warranties must offset the revenue in the period of sale.

Maybe the lawsuit there’s a chance we’ll end up paying out a $1,000,000 but it could actually only be like $200,000 or some different amount of money. So we’re either going to know the amount that we’re going to have to pay out or reasonably estimate that amount or we’re not going to be able to estimate it at all, right? If we know or could reasonably estimate or if we can’t estimate at all, okay? So let’s see what happens with these two criteria in the different categories. So the most the time that we accrue liability, there’s only one time we accrue a liability.

Not only does the contingent liability meet the probability requirement, it also meets the measurement requirement. Pending litigation involves legal claims against the business that may be resolved at a future point in time. The outcome of the lawsuit has yet to be determined but could have negative future impact on the business. Pending litigation involves legal claims against the businessthat may be resolved at a future point in time. The outcome of thelawsuit has yet to be determined but could have negative futureimpact on the business. A contingency is an uncertainty that has financial implications attached to it.

ing Treatment of Liabilities

Recognized contingent liabilities are classified as current or non-current on the balance sheet, depending on the expected timing of resource outflows. For example, warranty liabilities for recently sold products are typically classified as current, while long-term environmental obligations are non-current. Proper classification aids in assessing liquidity and solvency, key indicators of financial stability. Companies must ensure contingent liabilities are neither overstated nor understated to avoid distorting financial ratios like the current ratio or debt-to-equity ratio. This process involves revisiting underlying assumptions and estimates.

So if we know it’s probable that we’re going to have to pay out $1,000,000 in this lawsuit, well we’re going to have a liability. We’re going to take legal expense for a $1,000,000 and we’re going to have a liability on our balance sheet for that $1,000,000 that we’re accruing. Now not only do we accrue a liability, but we disclose it in the footnotes. We’re going to have this liability, this contingent liability and then we’re going to say in the footnotes contingent liability journal entry a little more information about it.

• A loss contingency which is possible but not probable will not be recorded in the s as a liability and a loss.
• To record a contingent liability, an entity should debit an expense and credit a liability if the liability’s occurrence is probable and can be estimated.
• If the likelihood is lower, companies must still disclose the contingent liability.
• And then if the payment is remote, so maybe it’s a lawsuit that just started and there’s gonna be a long legal battle and we don’t really know what’s gonna happen.
• This financialrecognition and disclosure are recognized in the current financialstatements.

Another way to establish the warranty liability could be anestimation of honored warranties as a percentage of sales. In thisinstance, Sierra could estimate warranty claims at 10% of itssoccer goal sales. Let’s continue to use Sierra Sports’ soccer goal warranty as ourexample. If the warranties are honored, the company should know howmuch each screw costs, labor cost required, time commitment, andany overhead costs incurred. This amount could be a reasonableestimate for the parts repair cost per soccer goal. Since not allwarranties may be honored (warranty expired), the company needs tomake a reasonable determination for the amount of honoredwarranties to get a more accurate figure.

Discover how contingent liability affects your business, learn to manage and mitigate risks with our expert guide for business owners. This section will explore the intricacies involved in recognizing these liabilities, including scenarios where they might arise and how companies should record them in their ing books. For the past 52 years, Harold Averkamp (A, MBA) hasworked as an ing supervisor, manager, consultant, university instructor, and innovator in teaching ing online. For the past 52 years, Harold Averkamp (A, MBA) has worked as an ing supervisor, manager, consultant, university instructor, and innovator in teaching ing online. For example, the company ABC Ltd. has an outstanding lawsuit which is likely that it will lose with the amount that can be reasonably estimated to be $25,000.

Companies must estimate contingent liabilities for pending litigation if the outcome is probable and the loss can be reasonably estimated. It does not know the exact number of vacuums that will be returned under the warranty, so the amount must be estimated. Using historical averages, it estimates that 5% of those, or 500 vacuums will be returned under warranty per year.

Vacuum Inc. should record a debit to warranty expense for $250,000 and a credit to a warranty liability for $250,000. Contingent liabilities are a type of liability that may be owed in the future as the result of a potential event. A contingent liability would involve a potential loss to the business. If a range of possible outcomes exists, the best estimate within that range should be recognized. If no amount is more likely than others, the minimum amount in the range is recorded.

This second entry recognizes an honored warranty for a soccergoal based on 10% of sales from the period. When determining if the contingent liability should berecognized, there are four potential treatments to consider. 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. This entry adjusts the accrued liability to reflect the updated estimate of the loss.

There is an uncertainty that a claim will transpire, or bankruptcy will occur. If the contingencies do occur, it may still be uncertain when they will come to fruition, or the financial implications. Warranties arise from products or services sold to customersthat cover certain defects (see Figure 12.8). It is unclear if a customer will need to use awarranty, and when, but this is a possibility for each product orservice sold that includes a warranty. The same idea applies toinsurance claims (car, life, and fire, for example), andbankruptcy.