Where is a contingent liability recorded?

how to record contingent liability

These lawsuits have not yet been filed or are in the very early stages of the litigation process. Since there is a past precedent for lawsuits of this nature but no establishment of guilt or formal arrangement of damages or timeline, the likelihood of occurrence is reasonably possible. Since the outcome is possible, the contingent liability is disclosed in Sierra Sports’ financial statement notes.

One common liquidity measure is the current ratio, and a higher ratio is preferred over a lower one. This ratio—current assets divided by current liabilities—is lowered by an increase in current liabilities (the denominator increases while we assume that the numerator remains the same). When lenders arrange loans with their corporate customers, limits are typically set on how low certain liquidity ratios (such as the current ratio) can go before the bank can demand that the loan be repaid immediately.

Estimating Contingent Liabilities

There is a probability that someone who purchased the soccer goal may bring it in to have the screws replaced. Not only does the contingent liability meet the probability requirement, it also meets the measurement requirement. The company sets an accounting entry to debit (increase) legal expenses for $5 million and credit (raise) accrued expenses for $5 million on the balance sheet because the liability is probable and simple to estimate. A possible contingency is when the event might or might not happen, but the chances are less than that of a probable contingency, i.e., less than 50%. This liability is not required to be recorded in the books of accounts, but a disclosure might be preferred.

  1. Let’s expand our discussion and add a brief example of the calculation and application of warranty expenses.
  2. For our purposes, assume that Sierra Sports has a line of soccer goals that sell for $800, and the company anticipates selling 500 goals this year (2019).
  3. One major difference between the two is that the latter is an amount you already owe someone, whereas the former is contingent upon the event occurring.
  4. Some events may eventually give rise to a liability, but the timing and amount is not presently sure.

As you’ve learned, not only are warranty expense and warranty liability journalized, but they are also recognized on the income statement and balance sheet. The following examples show recognition of Warranty Expense on the income statement Figure 12.10 and Warranty Liability on the balance sheet Figure 12.11 for Sierra Sports. Even if the outcome is based on the probability of occurrence of the event, it is considered an actual liability. These liabilities can harm the company’s stock price because contingent liabilities can negatively impact the business’s future profitability.

What Is a Contingent Liability?

In essence, as long as Sierra Sports sells the goals or other equipment and provides a warranty, it will need to account for the warranty expenses in a manner similar to the one we demonstrated. Although it is not realized in the books of accounts, a contingent liability is credited to the accrued liabilities account in the journal. One can always depict this type of liability on the company’s financial statements if there are any. It is disclosed in the footnotes of the financial statements as they have an enormous impact on the company’s financial conditions. A Contingent Liability is a possible liability or a potential loss that may or may not occur based on the result of an unexpected future event or circumstance.

how to record contingent liability

If the liability is likely to occur and the amount can be reasonably estimated, the liability should be recorded in the accounting records of a firm. Google, a subsidiary of Alphabet Inc., has expanded from a search engine to a global brand with a variety of product and service offerings. Check out Google’s contingent liability considerations in this press release for Alphabet Inc.’s First Quarter are sales discounts reported as an expense 2017 Results to see a financial statement package, including note disclosures. Contingent liabilities must pass two thresholds before they can be reported in financial statements. 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.

Applicability of Contingent liabilities in investing

Contingent liabilities are shown as liabilities on the balance sheet and as expenses on the income statement. The business is exempt from disclosing the possible liability if it considers that the risk of it happening is remote. An example of this principle is when a $ 100 invoice to a company with net assets of $ 5 billion would be immaterial, https://www.quick-bookkeeping.net/ultimate-profit-tracker-for-your-business/ but a $ 50 million invoice to the same company would be materialistic. Let’s say that the manufacturer has estimated that out of all the mobile phones produced, about 2,000 mobiles would be called back due to fault reasons. Possible contingencies are just disclosed to the investors by the management during the Annual general meetings (AGMs).

This shows us that the probability of occurrence of such an event is less than that of a possible contingency. A loss contingency that is remote will not be recorded and it will not have to be disclosed in the notes to the financial statements. An example is a nuisance lawsuit where there is no similar case that was ever successful.

These liabilities will get recorded if the liability has a reasonable probability of occurrence. Any probable contingency needs to be reflected in the financial statements—no exceptions. Possible contingencies—those that are neither probable nor remote—should be disclosed in the footnotes of the financial statements. Future costs are expensed first, and then a liability account is credited based on the nature of the liability. In the event the liability is realized, the actual expense is credited from cash and the original liability account is similarly debited. A warranty is considered contingent because the number of products that will be returned under a warranty is unknown.

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.

Finally, how a loss contingency is measured varies between the two options as well. Under US GAAP, the low end of the range would be accrued, and the range disclosed. Liquidity and solvency are measures of a company’s ability to pay debts as they come due. Liquidity measures evaluate a company’s ability to pay current debts as they come due, while solvency measures evaluate the ability to pay debts long term.

This is considered probable but inestimable, because the lawsuit is very likely to occur (given a settlement is agreed upon) but the actual damages are unknown. No journal entry or financial adjustment in the financial statements will occur. Instead, Sierra Sports will include a note describing any details available about the lawsuit. When damages have been determined, or have been reasonably estimated, then journalizing would be appropriate. For our purposes, assume that Sierra Sports has a line of soccer goals that sell for $800, and the company anticipates selling 500 goals this year (2019).

Like accrued liabilities and provisions, contingent liabilities are liabilities that may occur if a future event happens. 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.


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