Contingent Liability

Contingent liability is a potential liability that may occur, depending on the outcome of an uncertain future event. A contingent liability is recorded in the accounting records if the contingency is likely and the amount of the liability can be reasonably estimated. The liability may be disclosed in a footnote on the financial statements or not reported at all if both conditions are not met.

Pending lawsuits and product warranties are common examples of contingent liabilities because their outcomes are uncertain. The accounting rules for reporting a contingent liability differ depending on the estimated dollar amount of the liability and the likelihood of the event occurring. The accounting rules ensure that financial statement readers receive sufficient information.

[Important: An estimated liability is certain to occur, so an amount is always entered into the accounts even if the precise amount is not known at the time of data entry.]

Assume that a company is facing a lawsuit from a rival firm for patent infringement. The company's legal department thinks that the rival firm has a strong case, and the business estimates a $2 million loss if the firm loses the case. Because the liability is both probable and easy to estimate, the firm posts an accounting entry on the balance sheet to debit (increase) legal expenses for $2 million and to credit (increase) accrued expense for $2 million.

The accrual account permits the firm to immediately post an expense without the need for an immediate cash payment. If the lawsuit results in a loss, a debit is applied to the accrued account (deduction) and cash is credited (reduced) by $2 million.

Assume that a lawsuit liability is possible but not probable, and the dollar amount is estimated to be $2 million. Under these circumstances, the company discloses the contingent liability in the footnotes of the financial statements. If the firm determines that the likelihood of the liability occurring is remote, the company does not need to disclose the potential liability.

• A contingent liability is a potential liability that may occur in the future, such as pending lawsuits or honoring product warranties.
• 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.
• Contingent liabilities are recorded to ensure that the financial statements are accurate and meet GAAP or IFRS requirements.

A warranty is another common contingent liability because the number of products returned under a warranty is unknown. Assume, for example, that a bike manufacturer offers a three-year warranty on bicycle seats, which cost $50 each. If the firm manufactures 1,000 bicycle seats in a year and offers a warranty per seat, the firm needs to estimate the number of seats that may be returned under warranty each year.

If, for example, the company forecasts that 200 seats must be replaced under warranty at a cost of $50, the firm posts a debit (increase) to warranty expense for $10,000 and a credit (increase) to accrued warranty liability for $10,000. At the end of the year, the accounts are adjusted for the actual warranty expense incurred.

[Fast Fact: Both GAAP (generally accepted accounting principles) and IFRS (international financial reporting standards) require companies to record contingent liabilities in accordance with the three accounting principles: full disclosure, materiality, and prudence.]