What are contingent liabilities?

March 27, 2010

1. Nature of contingent liabilities in accounting

A contingent liability is an amount that may be due depending on future events. Because it cannot be determined whether the amount must be paid until events unfold, the company's likelihood of loss is scored as one of the following:

  • Probable. The future event or events are likely to occur.
  • Reasonably possible. The chance of occurrence of future events is between probable and remote.
  • Remote. The chance of future event or events occurring is slight.

A contingent liability should be recorded in the financial statements when (a) it is probable that a liability has been incurred and (b) the amount of the loss can be reasonably estimated.

If either (a) or (b) does not apply, then a company should put a disclosure about the liability in the footnotes (i.e. notes to the financial statements).

The above information applies to a loss contingency. Gain contingencies are not recorded until they are realized or realizable (i.e. cash has been received or cash is expected to be received).

2. Examples of contingent liabilities

Let's look at a few examples of loss contingent liabilities.

Example 1: Lawsuit Expenses

CFG Limited is a California-based consulting firm, specializing in engineering products and development. Just before the end of the year the company received a notice of a legal case from one of its competitors. The case is related to a potential infringement of the competitor's patent. The inhouse legal counsel discussed the case with CFG Limited's management and based on information available concluded that the lawsuit was possible, however, there was not enough information to estimate the potential loss. This lawsuit is considered a contingent liability, which should be only described in the notes to the financial statements as the second criteria (i.e. reasonable estimate of loss amount) was not met.

Example 2: Warranty Reserves

A local manufacturer of Blue-ray players sells products nationwide. As part of customer service, the manufacturer provides a warranty to repair or replace its products one year after the sale. Using accumulated historical information, the manufacturer estimated that each sold player results, on average, in $30 of warranty expenses. During the current year, the manufacturer sold 3,000 players. As it is probable that the manufacturer inccurred warranty expenses (i.e. by selling the players that will need to be fixed later when customers return them) and the amount of warranty expense can be reasonably estimated (based on historical information), a contingent liability related to warranty expenses should be recorded in the financial statements. An example of journal entry to record this warranty expense is as follows:

Account Titles

Debit

Credit

Warranty Expense

90,000

 

      Warranty Accrual (Reserve)

 

90,000 *

(*) $90,000 = $30 per unit x 3,000 units sold

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