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how to record a contingent liability

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how to record a contingent liability

While a contingency may be positive or negative, we only focus on outcomes that may produce a liability for the company (negative outcome), since these might lead to adjustments in the financial statements in certain cases. Positive contingencies do not require or allow the same types of adjustments to the company’s financial statements as do negative contingencies, since accounting standards do not permit positive contingencies to be recorded. 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.

Recognition of a provision

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. Two classic examples of contingent liabilities include a company warranty and a lawsuit against the company. Both represent possible losses to the company, and both depend on some uncertain future event. It does not know the exact number of vacuums that will be returned under the warranty, so the amount must be estimated. Using historical averages, it estimates that 5% of those, or 500 vacuums will be returned under warranty per year.

  • Both represent possible losses to the company, and both depend on some uncertain future event.
  • Liabilities are related to the financial obligations or debts that a person or a company has to another entity.
  • Another way to establish the warranty liability could be an estimation of honored warranties as a percentage of sales.
  • The recording of contingent liabilities prevents the understating of liabilities and expenses.
  • Remote (not likely) contingent liabilities are not to be included in any financial statement.
  • 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.

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Measurement of provisions

The type of contingent liability and the risk that goes along with it are important considerations. Similarly, knowing about contingent liability can influence a creditor’s decision to lend money to a company. The contingent liability may turn into actual liability which will harm the company’s ability to repay its debt.

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Under GAAP, a contingent liability is defined as any potential future loss that depends on a “triggering event” to turn into an actual expense. 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. The journal entry would include a debit to legal expense for $1.25 million and a credit to an accrued liability account for $1.25 million. Contingent liabilities are a type of liability that may be owed in the future as the result of a potential event.

Contingent Assets Meaning

For example, a company might be involved in a legal dispute that could result in the payment of a settlement based on a verdict reached in a court. However, at the time of the company’s financial statements, whether there will be a settlement liability and the date and amount of any settlement have yet to be determined. This is an example of a contingent liability that may or may not materialize in the future.

  • These liabilities must be disclosed in the footnotes of the financial statements if either of the two criteria is true.
  • If the liability arises, it would negatively impact the company’s ability to repay debt.
  • A contingent liability is a specific type of liability, which may occur depending on the result of an uncertain future event.
  • Per GAAP, contingent liabilities can be broken down into three categories based on the likelihood of those liabilities actually occurring.

Our example only covered the warranty expenses anticipated from the 2019 sales. Since the company has a three-year warranty, and it estimated repair costs of $5,000 for the goals sold in 2019, there is still a balance of $2,200 left from the original $5,000. If it is determined that too much is being set aside in the allowance, then future annual warranty expenses can be adjusted downward. If it is determined that not enough is being accumulated, then the warranty expense allowance can be increased. In general, it is important for companies to properly identify, measure, and disclose contingent liabilities in their financial statements to provide a fair and accurate representation of their financial position.

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