These liabilities can harm the company’s stock price because contingent liabilities can negatively impact the business’s future profitability. The magnitude of the impact depends on the time of occurrence and the amount tied to the liability. 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. Contingent liabilities are possible obligations whose existence will be confirmed by uncertain future events that are not wholly within the control of the entity. An example is litigation against the entity when it is uncertain whether the entity has committed an act of wrongdoing and when it is not probable that settlement will be needed. Essentially, the effect that contingent liabilities have on an audit depends on their likelihood of occurring in the first place.

We have another Q&A that discusses the recording of contingent liabilities. Here, “Reasonably possible” means that the chance for occurrence of an event is more than remote but less than likely. Provisions are a sum of money that is set aside in order to cover a probable expense that will happen in future.

The full disclosure principle states that all necessary information that poses an impact on the financial strength of the company must be registered in the public filings. A great example of the application of prudence would be recognizing anticipated bad debts. Prudence can be helpful if certain liabilities might occur but aren’t certain; here contingent liabilities.

As a result, it is shown as a footnote in the balance sheet and not recognized in par with other components of financial statements. 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. You should also describe the liability in the footnotes that accompany the financial statements.

How is contingent liability shown on the balance sheet?

Let’s say a mobile phone manufacturer produces many mobiles and sells them with a brand warranty of 1 year. The principle of prudence is a crucial principle that states that a company must not record future anticipated gains into the books of accounts, but any expected losses must be accounted for. First, let’s look at the probability the lawsuit will have a negative outcome. Reasonably probable means the event could occur and a remote probability means the event will most likely not occur. Grant Gullekson is a CPA with over a decade of experience working with small owner/operated corporations, entrepreneurs, and tradespeople. He specializes in transitioning traditional bookkeeping into an efficient online platform that makes preparing financial statements and filing tax returns a breeze.

Any liabilities arising in such a situation is known as a contingent liability. Contingent liabilities are also important for potential lenders to a company, who will take these liabilities into account when deciding on their lending terms. Business leaders should also be aware of contingent liabilities, because they should be considered when making strategic decisions about a company’s future. Therefore, it is also important to describe the liability in the footnotes that accompany the financial statements.

  • There is only one scenario where a provision will not be recorded in the books of accounts.
  • However, if the company is not found guilty, the company will not have any liability.
  • A warranty is considered contingent because the number of products that will be returned under a warranty is unknown.
  • Nevertheless, generally accepted accounting principles, or GAAP, only require contingencies to be recorded as unspecified expenses.

In the example of ACE Ltd, the claim will materialize into monetary outflow for the company and the company should reliably estimate such amount. Initially, when the customer had reported it to, the company refused to accept the claim and therefore, the customer has filed a legal claim against them. Pirating a movie or a music album is also another example of copyright infringement. Copyright infringement is referred to as the use of copyright-protected material without prior permission from the copyright holder. Any use, duplication, or publication of the copyrighted material without the permission of the owner can lead to serious legal charges. In a situation where the real damages are difficult to ascertain, a liquidated damage amount seems appropriate and accepted by both parties.

Why Is Contingent Liability Recorded?

If some amount within the range of loss appears at the time to be a better estimate than any other amount within the range, that amount shall be accrued. When no amount within the range is a better estimate than any other amount, however, the minimum amount in the range should be accrued. Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee (“DTTL”), its network of member firms, and their related entities.

As well, the impact on financial statements depends on the likelihood of the contingency occurring and the total amount of the transaction. The full disclosure principle requires that any relevant and significant facts that are related to financial performance must be disclosed in the company’s financial statements. Within the generally accepted accounting principles (GAAP) there are three main categories of contingent liabilities. 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.

LO 11.3 Define and Apply Accounting Treatment for Contingent Liabilities

They are probable and estimable, probable and inestimable, reasonably possible, and remote. This second entry recognizes an honored warranty for a soccer goal based on 10% of sales from the period. Get instant access to lessons taught by experienced private equity pros and bulge bracket investment bankers including financial statement modeling, DCF, M&A, LBO, Comps and Excel Modeling.

The damages that need to be compensated by the party if and when there is a breach in the contract. The breach is usually a failure in the contract or not up to the mark performance by the party. 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. This principle plays an important role in ensuring reduced information asymmetry between the shareholders and the management. My Accounting Course  is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers. That standard replaced parts of IAS 10 Contingencies and Events Occurring after the Balance Sheet Date that was issued in 1978 and that dealt with contingencies.

IAS 12 — Accounting for uncertainties in income taxes

A possible liability or a potential loss that may or may not occur based on the result of an unexpected future event or circumstance is known as a contingent liability. These liabilities will get recorded if the liability has a reasonable probability of occurrence. A probable liability or potential loss that may or may not occur because of an unexpected future event after-tax income or circumstance is referred to as contingent liability. These liabilities will get recorded if it has a reasonable probability of occurring. As well, pending lawsuits are also considered contingent liabilities because the outcome of the lawsuit is entirely unknown. This can come with estimated liability or a need to determine contingent liability legitimacy.

Some examples of provisions

The outcome of the lawsuit has yet to be determined but could have negative future impact on the business. What if you know the loss or debt will occur but it has not happened yet? These are questions businesses must ask themselves when exploring contingencies and their effect on liabilities.

Review each of the transactions and prepare any necessary journal entries for each situation. (Figure)Emperor Pool Services provides pool cleaning and maintenance services to residential clients. Review each of the transactions, and prepare any necessary journal entries for each situation.