Contingent LiabilityDefined along with Examples

Written By:
Lisa Borga

What is a Contingent Liability?

A contingent liability is a potential loss or a liability that could arise based on the outcome of a particular event.

This is recorded if the company believes the contingency will likely occur and the company can reasonably estimate the liability.

A business may disclose the liability in the footnotes of their financial statements as long as at least one of the above conditions is met.

Explaining Contingent Liabilities

Some typical examples of contingent liabilities are product warranties and pending lawsuits.

These are contingent liabilities due to the fact that it is unknown what will happen in a lawsuit or whether or not a warranty will be used.

Contingent liabilities are recorded differently based on the predicted dollar amount of the liability and how likely it is the liability will occur.

The accounting rules were made to ensure that people reading the financial statements would be given enough information.

If an estimated liability definitely occurs, then it must be recorded whether or not the company knows the exact amount of the liability when they are recording it.

Contingent Liability Example

Suppose a customer filed a lawsuit for $100,000 against a business for selling them a defective product.

The legal department for the business believes that the customer has a considerable amount of evidence to support their case and will likely win in court.

This liability is likely to occur and can be estimated.

Therefore, the business will record an accounting entry on its balance sheet.

They will debit the legal expenses account for the amount of $100,000 and credit the accrued expenses account for the amount of $100,000.

By using an accrual account, the business can record an expense without needing to promptly pay the expense.

Then, if the business loses money as a result of the lawsuit, they can debit the accrued account and credit cash for the amount of the loss, which in this case is $100,000.

Suppose a business believes that they may lose the lawsuit but that the loss is not probable and the amount of the liability is estimated at $100,000.

In this case, the contingent liability should be disclosed by the business in the footnotes of their financial statements.

If the business decides that there is a low probability of the liability occurring, they are not required to disclose the contingent liability.

According to the Generally Accepted Accounting Principles and the International Financial Reporting Standards, companies are required to disclose contingent liabilities while adhering to the three major accounting principles of materiality, prudence, and full disclosure.

Product Warranties

Warranties are one of the more common contingent liabilities due to the fact that businesses do not know how many products will be returned while covered by a warranty.

Suppose a coffee machine manufacturer provides a two-year warranty on a coffee machine that costs $250.

If the company manufacturers 5000 machines a year and provides a warranty for each machine, the company would need to estimate how many machines they expect might be returned each year while covered by the warranty.

If the company expects 1000 machines to be returned and need to be replaced while they are still covered by the warranty, this would mean the company would need to debit the warranty expense account for $250,000 and credit the accrued warranty liability account for $250,000.

Once the year ends, the accounts would need to be adjusted to account for the warranty expense that the company actually incurred.

Recording Contingent Liabilities

Contingent liabilities are potential liabilities.

These types of liabilities could occur, but they are dependent upon the results of an uncertain future event.

Whether or not the contingent liability needs to be recorded depends on how likely it is that the contingent liability will become an actual liability, as well as whether it is possible to reasonably estimate the amount of the liability.

If the contingent liability is probable and the business can reasonably estimate the amount, they must record the liability.

Businesses are required to record their contingent liabilities according to the Generally Accepted Accounting Principles and the International Financial Reporting Standards.

The Three Categories of Contingent Liabilities

There are three categories of contingent liabilities recognized by GAAP, remote, possible, and probable.

Remote contingent liabilities are very unlikely to occur and are not required to be recorded in a company’s financial statements.

Possible contingent liabilities are less likely than probable to occur but are not yet a remote possibility.

Possible contingent liabilities need to be disclosed in the footnotes of the financial statements.

Probable contingent liabilities are likely to occur, and if they can be reasonably estimated, they must be shown on the company’s financial statements.

Common Contingent Liabilities

There are many examples of contingent liabilities, but warranties and pending lawsuits are the most common.

Companies do not know what the outcome of a lawsuit will be, which makes lawsuits a contingent liability.

Whereas warranties are contingent liabilities because a company does not know how many products will be returned while still covered by a warranty.

Key Takeaways

• A contingent liability is a possible loss or liability that could occur in the future. These liabilities could include product warranties, potential lawsuits, and pending investigations, among others.
• Companies need to record contingent liabilities in order to make sure their financial statements meet the requirements of the International Financial Reporting Standards (IFRS) or the Generally Accepted Accounting Principles (GAAP), as well as to ensure their accuracy.
• If a business believes that a contingent liability is likely to occur and that they will be able to reasonably estimate the amount, they should record the liability in their accounting records.