Accounting For Contingent Liabilities

Kyoto’s Furniture is a large corporation selling home furniture. It recently discovered one of its top-selling suppliers needs financial assistance to stay in business. The company takes out a bank loan of $600,000 to give to its supplier and has the supplier pay back the loan incrementally. If the supplier cannot repay the loan, Kyoto’s Furniture will have to pay for it, which would be an enormous expense for the company. This is important information for investors and others to know, so they can make personal financial decisions.

The non-defaulting may file a case and obtain a judgment for the number of liquidated damages; on the other hand, the defaulting party may record/disclose a contingent liability in his books of accounts. In that case, if Y ltd fails to make a payment, then X ltd has to make the payment to the bank; therefore, X Ltd has to disclose this contingent liability in their books of accounts.

Contingent Liabilities: Definition & Examples

Bob starts by speaking with the executives and reviewing the balance sheet. Bob specifically focuses on the liabilities section of the balance sheet. The company agrees to guarantee that the supplier’s bank loan will be repaid. As a result of the company’s guarantee, the bank makes the loan to the supplier. If the supplier makes the loan payments needed to pay off the loan, the company will have no liability.

It can also help Ashlynn Coffee Products determine if it needs to readjust or fix its products and inventory. If it faces a few lawsuits every year for different products, the company may save money by investing more time and resources into making more sustainable and beneficial goods.

Product Recalls

Burt’s Headphones discovers the warranty may cost them an added $80,000. However, they believe if that cost occurs, the warranty is still beneficial, so they decide to list it as a contingent liability. If the liability is probable and the amount can be reasonably estimated, companies should record contingent liabilities in the accounts.

As a result of several bunny ears catching fire, the executives were seriously thinking about recalling the bunny ears and giving everyone their money back. Show bioTammy teaches business courses at the post-secondary and secondary level and has a master’s of business administration in finance. Sophisticated analyses include techniques like options pricing methodology, expected loss estimation, and risk simulations of the impacts of changed macroeconomic conditions. The Company and its subsidiaries are also involved in various other litigation arising in the ordinary course of business.

“Reasonably possible” means that the chance of the event occurring is more than remote but less than likely. Disclose the existence of a contingent liability in the notes accompanying the financial statements if the liability is reasonably possible but not probable, or if the liability is probable, but you cannot estimate the amount. When discussing your liabilities, it’s important to include not just what you owe, but also other obligations that have a possibility of occurring, known as contingent liabilities. Some examples of contingent liabilities include product recalls, pending lawsuits, and changes in legislation.

Top 8 Most Common Examples Of Contingent Liability

However, since most contingent liabilities may not occur and the amount often cannot be reasonably estimated, the accountant usually does not record them in the accounts. Instead, firms typically disclose these contingent liabilities in notes to their 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. Record a contingent liability when it is probable that a loss will occur, and you can reasonably estimate the amount of the loss. Prudence is the accounting principle which says a company must accurately list its expenses and liabilities on financial statements and not overstate potential revenue or success.

What about contingent assets/gains, like a company’s claim against another for patent infringement? Such amounts are almost never recognized before settlement payments are actually received. As a general guideline, the impact of contingent liabilities on cash flow should be incorporated in a financial model if the probability of the contingent liability turning into an actual liability is greater than 50%. In some cases, an analyst might show two scenarios in a financial model, one which incorporates the cash flow impact of contingent liabilities and another which does not.

Timing Of Events

One of his job responsibilities will be reviewing company financial statements to make sure the calculations are accurate and all important information has been disclosed. A contingent liability is included in a financial statement if the liability is likely to occur and its amount can be accurately estimated. The accounting of contingent liabilities is a very subjective topic and requires sound professional judgment. Contingent liabilities can be a tricky concept for a company’s management, as well as for investors.

• The exact status of a contingent liability is important when determining which liabilities to present in the balance sheet or in the attached disclosures.
• Similarly, the knowledge of a contingent liability can influence the decision of creditors considering lending capital to a company.
• According to FASB Statement No. 5, if the liability is probable and the amount can be reasonably estimated, companies should record contingent liabilities in the accounts.
• Judicious use of a wide variety of techniques for the valuation of liabilities and risk weighting may be required in large companies with multiple lines of business.
• Examples of contingent liabilities include product warranties and guarantees, pending or threatened litigation, and the guarantee of others’ indebtedness.

A contingent liability that is expected to be settled in the near future is more likely to impact a company’s share price than one that is not expected to be settled for several years. Often, the longer the span of time it takes for a contingent liability to be settled, the less likely that it will become an actual liability. Since a contingent liability can potentially reduce a company’s assets and negatively impact a company’s future net profitability and cash flow, knowledge of a contingent liability can influence the decision of an investor.

Contingent Liability Example

Generally, the amount of these liabilities must be estimated; the actual amount cannot be determined until the event that confirms the liability occurs. Furthermore, in many cases, the actual payee of the liability is not known until the future event occurs. Contingent liabilities are obligations a company may possibly owe. As resounded above, Bob told the executives if there’s a high probability the liability will occur, then it needs to be recorded and footnoted on the balance sheet to provide an accurate picture of their future liabilities. Bob just landed his dream job as an auditor for the largest accounting firm in the United States.

In that case, ABC ltd record, the contingent liability in his books of accounts. When you record a liability in the accounting records, this does not mean that you are also setting aside funds to pay for the liability when it must eventually be paid – recording a contingent liability has no impact on cash flow. Since it presently is not possible to determine the outcome of these matters, no provision has been made in the financial statements for their ultimate resolution. Customers of Ashlynn Coffee Products recently filed a lawsuit claiming the company’s newest coffee pot is too hot and can burn the user’s hands. Customers are suing Ashlynn Coffee Products for $300,000 in damages.

It is also necessary for future events to occur to determine whether or not the obligation is true or not. Contingent liability exposure or the amount estimable may or may not be recognizable.

Acquired contingencies are recorded based on an estimate of actual value. 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.

• Contingent liabilities are potential liabilities that may or may not occur depending on future events.
• The accounting rules for the treatment of a contingent liability are quite liberal – there is no need to record a liability unless the risk of loss is quite high.
• Blowout Preventer’s lawyers have determined that it is probable that they will lose the case and have to pay the sum amount.
• Accrued ExpensesAn accrued expense is the expenses which is incurred by the company over one accounting period but not paid in the same accounting period.
• Since the outcome of contingent liabilities cannot be known for certain, the probability of the occurrence of the contingent event is estimated and, if it is greater than 50%, then a liability and a corresponding expense are recorded.

Judicious use of a wide variety of techniques for the valuation of liabilities and risk weighting may be required in large companies with multiple lines of business. According to the full disclosure principle, all significant, relevant facts related to the financial performance and fundamentals of a company should be disclosed in the financial statements. If in the above example company has a reason to believe that the customer will not win this case and the company has all the evidence then, in that case, this will be reported in notes of accounts of financial statements. Examples of contingent liabilities are the outcome of a lawsuit, a government investigation, or the threat of expropriation. A warranty can also be considered a contingent liability, since there is uncertainty about the exact number of units that will be returned by customers for repair or replacement.

Why Is Contingent Liability Recorded?

As Bob continues to explain contingent liabilities to the executives, he reviews the balance sheet to see where they are reported. Bob asks the executives, ‘Where are these situations you just mentioned on the balance sheet? ‘ The executives tell Bob since they have not occurred, they did not list them. In his conversation with the executives, they told Bob there may be a product recall on rabbit ears they manufactured this year. In addition to the recall, a lawsuit is pending against the company and legislation may change regarding healthcare for employees. If a company is sued by a former employee for $500,000 for age discrimination, the company has a contingent liability.

However, a note to the financial statements may be needed to explain that a material adverse event arising subsequent to year end has occurred. Remote risks need not be disclosed; they are viewed as needless clutter. What about business decision risks, like deciding to reduce insurance coverage because of the high cost of the insurance premiums? GAAP is not very clear on this subject; such disclosures are not required, but are not discouraged.

Various legal actions and governmental proceedings are pending against Sears, Roebuck, and Co. and its subsidiaries, many involving ordinary routine litigation incidental to the business engaged in. Other matters contain allegations which are non-routine and involve compensatory, punitive, or anti-trust treble damage claims in very large amounts, as well as other types of relief. The consequences of these matters are not presently determinable but, in the opinion of management, the ultimate liability resulting, if any, will not have a material effect on the shareholders’ equity in the company.

Modeling contingent liabilities can be a tricky concept due to the level of subjectivity involved. The opinions of analysts are divided in relation to modeling contingent liabilities. The cost of debt is the return that a company provides to its debtholders and creditors.