Contingent Liability Definition, Example and FAQs

The matching principle of accounting 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. 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 account for $1 million.

  • In such scenarios, until a resolution is achieved, the business needs to report this as a contingent liability.
  • Contingent liabilities are shown as liabilities on the balance sheet and as expenses on the income statement.
  • As part of the due diligence process, the acquiring company investigates the target company’s financial condition, including its contingent liabilities.
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You should check to have the appropriate insurance which covers your contract liabilities. In the case of contingent liabilities, you may need to obtain some additional insurance for your business. More generally, you may be a business owner providing a warranty on the condition of a product or service. If your product or service falls short of your statement of fact, you run the risk of the customer claiming you have made an untrue statement.

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If a contingent loss becomes probable and estimable, a provision must be recognized, negatively impacting profits. If a contingent asset is virtually certain, it may be recognized, increasing profits. If the amount cannot be reasonably estimated but the obligation is still probable, a general description must be disclosed in the financial statement footnotes instead.

  • A guarantee, in the context of a contract, is a promise by a third party to compensate for future losses.
  • The party that made the damages either suffer legal action or have to go through with the compensation demanded by the other party.
  • If the lawsuit results in a loss, a debit is applied to the accrued account (deduction) and cash is credited (reduced) by $2 million.
  • This means there is uncertainty about recording such a liability in the financial accounts.

Some of the examples of such transactions can be insurance claims, oil spills, lawsuits. All these create a liability for the company and liabilities that are created in such situations are known as contingent liabilities. Both companies need to get involved in a thorough due diligence process before proceeding with a merger or acquisition. A type of contingent liability, warranty obligations, are present when a company guarantees that their product would work for a certain period or meet certain standards.

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Finally, during 2019, the company incurred $35,000 of warranty expenditures related to these printers. The matching convention requires the recording of the expense in the period of the sale, not when the repair is made. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. 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. An example of this principle is when a $ 100 invoice to a company with net assets of $ 5 billion would be immaterial, but a $ 50 million invoice to the same company would be materialistic.

Probable

Contingencies may be positive as well as negative, but accounting practices only consider negative outcomes. Supposing the new technology developed by a certain tech company is used or launched by another setting up payroll for small business company without prior permission, it is counted as stealing one property. This may lead to serious legal problems and the company that developed the technology can press charges against the other party.

How do companies account for contingent liabilities?

Provisions are liabilities recorded on the balance sheet because their future payout is more certain. In contrast, contingent liabilities are disclosed in footnotes due to uncertainty around the timing and amount of settlement. Though not recorded as liabilities, analyzing contingent liabilities helps stakeholders better assess the company’s overall financial position and exposure to potential losses.

It can be recorded only if estimation is possible; otherwise, disclosure is necessary. Do not record or disclose a contingent liability if the probability of its occurrence is remote. Contingent liabilities should be analyzed with a serious and skeptical eye, since, depending on the specific situation, they can sometimes cost a company several millions of dollars. Sometimes contingent liabilities can arise suddenly and be completely unforeseen.

When a contingent liability becomes a present obligation, it is recorded in the balance sheet as a provision. This recognition can increase a company’s liabilities, decrease its net assets and potentially reduce its net profit in the current period. Contingent liabilities refer to potential obligations that may arise depending on the outcome of a future event. An automobile guarantee or other product warranties are examples of contingent liabilities that, are usually recorded on a company’s books. 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.

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