Accounting Guidelines for Contingent Liabilities

The measurement requirement refers to the
company’s ability to reasonably estimate the amount of loss. Even
though a reasonable estimate is the company’s best guess, it should
not be a frivolous number. For a financial figure to be reasonably
estimated, it could be based on past experience or industry
standards (see
Figure 12.9). Before understanding contingent liabilities, one must learn about what is considered as a liability in the accounting and economic context. A liability is any financial event that poses as an obligation to a company, and the company needs to make a monetary settlement regarding it in the future.

Instead, Sierra Sports will include a note describing any details available about the lawsuit. When damages have been determined, or have been reasonably estimated, then journalizing would be appropriate. If the contingent liability is probable and inestimable, it is likely to occur but cannot be reasonably estimated. In this case, a note disclosure is required in financial statements, but a journal entry and financial recognition should not occur until a reasonable estimate is possible. According to the FASB, if there is a probable liability determination before the preparation of financial statements has occurred, there is a likelihood of occurrence, and the liability must be disclosed and recognized. This financial recognition and disclosure are recognized in the current financial statements.

  1. This process involves creating an expense account, which reduces the company’s net income and its retained earnings in the shareholders’ equity section.
  2. The $4.3 billion liability for Volkswagen related to its 2015 emissions scandal is one such contingent liability example.
  3. Contingent liabilities are classified into three types by the US GAAP based on the probability of their occurrence.
  4. In such scenarios, until a resolution is achieved, the business needs to report this as a contingent liability.

In the Statement of Financial Accounting Standards No. 5, it says that a firm must distinguish between losses that are probable, reasonably probable or remote. There are strict and sometimes vague disclosure requirements for companies claiming contingent liabilities. A loss contingency which is possible but not probable will not be recorded in the accounts as a liability and a loss. The conversion of a contingent liability into an actual liability depends on how the events unfold. In addition to fair value, the measure of ‘present obligation’ is also crucial in the accounting for contingent liabilities.

No journal entry or financial adjustment in the
financial statements will occur. Instead, Sierra Sports will
include a note describing any details available about the lawsuit. When damages have been determined, or have been reasonably
estimated, then journalizing would be appropriate. According to the FASB, if there is a probable liability
determination before the preparation of financial statements has
occurred, there is a likelihood of occurrence, and
the liability must be disclosed and recognized. This financial
recognition and disclosure are recognized in the current financial
statements.

Contingent Assets

Now 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 contingent liabilities in balance sheet 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.

Contingent assets are not recognised, but they are disclosed when it is more likely than not that an inflow of benefits will occur. However, when the inflow of benefits is virtually certain an asset is recognised in the statement of financial position, because that asset is no longer considered to be contingent. These liabilities become contingent whenever their payment contains a reasonable degree of uncertainty. Only the contingent liabilities that are the most probable can be recognized as a liability on financial statements. Other contingencies are relegated to footnotes as long as uncertainty persists. A contingent liability is an existing condition or set of circumstances involving uncertainty regarding possible business loss, according to guidelines from the Financial Accounting Standards Board (FASB).

How Do Liabilities Become Contingent Liabilities?

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. If a possibility of a loss to the company is remote, no disclosure is required per GAAP. However, the company should disclose the contingent liability information in its footnotes to the financial statements if the financial statements could otherwise be deemed misleading to financial statement users. Contingent assets are possible assets whose existence will be confirmed by the occurrence or non-occurrence of uncertain future events that are not wholly within the control of the entity.

If the potential for a negative outcome from the lawsuit is reasonably possible but not probable, the company should disclose the information in the footnotes to its financial statement. The footnote disclosure should include the nature of the lawsuit, the timing of when it expects a settlement decision, and the potential amount– either the range or the exact amount if it is identifiable. If the likelihood of a negative lawsuit outcome is remote, the company does not need to disclose anything in the footnotes. 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 contingent liability, it often becomes difficult as there is no active market for such liabilities, and the timing and amount of the payment are uncertain. As such, the fair value of contingent liabilities involves a great deal of estimation and judgement. Warranties arise from products or services sold to customers that cover certain defects (see Figure 12.8). The events are not under the control of the company, so the company cannot decide on the occurrence of the event. So the mobile manufacturer will record a contingent liability in the P&L statement and the balance sheet, an amount at which the 2,000 mobile phones were made. Another fantastic example of contingent liability would be product warranties.

What Is the Journal Entry for Contingent Liabilities?

But it will be recorded in the books only if the probability is more than 50%. Contingent liabilities are recorded on the P&L statement and the balance sheet if the probability of https://accounting-services.net/ occurrence is more than 50%. When the probability of such an event is extremely low, it is allowed to omit the entry in the books of accounts, and disclosure is also not required.

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. If the warranties are honored, the company should know how
much each screw costs, labor cost required, time commitment, and
any overhead costs incurred. This amount could be a reasonable
estimate for the parts repair cost per soccer goal. Since not all
warranties may be honored (warranty expired), the company needs to
make a reasonable determination for the amount of honored
warranties to get a more accurate figure.

About the IFRS Foundation

First, following is the necessary journal entry to record the expense in 2019. Assume that Sierra Sports is sued by one of the customers who purchased the faulty soccer goals. A settlement of responsibility in the case has been reached, but the actual damages have not been determined and cannot be reasonably estimated. This is considered probable but inestimable, because the lawsuit is very likely to occur (given a settlement is agreed upon) but the actual damages are unknown. No journal entry or financial adjustment in the financial statements will occur.

As a general rule, contingent liabilities, whether recognized or not, must be disclosed. If any of these elements cannot be calculated reliably, that fact should be stated. For example, Sierra Sports has a one-year warranty on part repairs and replacements for a soccer goal they sell. Sierra Sports notices that some of its soccer goals have rusted screws that require replacement, but they have already sold goals with this problem to customers.

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