Accounting Guidelines for Contingent Liabilities

Since the company’s inventory of supply parts (an asset) went down by $2,800, the reduction is reflected with a credit entry to repair parts inventory. First, following is the necessary journal entry to record the expense in 2019. 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. The income statement and balance sheet are typically impacted by contingent liabilities.

These liabilities must be disclosed in the footnotes of the financial statements if either of the two criteria is true. Suppose a lawsuit is filed against a company, and the plaintiff claims damages up to $250,000. It’s impossible to know whether the company should report a contingent liability of $250,000 based solely on this information. Here, the company should rely on precedent and legal counsel to ascertain the likelihood of damages. For example, Sierra Sports has a one-year warranty on part
repairs and replacements for a soccer goal they sell.

Products and services

A contingent liability should be recorded on the company’s books if the liability is probable and the amount can be reasonably estimated. If it does not meet both of these criteria, the contingent liability may still need to be recorded as a disclosure in the footnotes to the financial statements. A company should always aim to present its financial statements fairly and accurately based on the information it has available as of the balance sheet date. Instead, contingent liabilities are disclosed in the notes to the financial statements if the potential obligation is reasonably possible. However, if the contingent liability is probable and the amount can be reasonably estimated, it gets reported as a liability in the financial statements, much like an actual liability. Now assume that a lawsuit liability is possible but not probable and the dollar amount is estimated to be $2 million.

If the tax assessment is higher than anticipated, it could potentially cause a significant reduction in the firm’s net income. Possible contingency is not recorded in the books of accounts because it is very difficult to articulate the liability in monetary terms due to its limited occurrence. If a court is likely to rule in favor of the plaintiff, whether because there is strong evidence of wrongdoing or some other factor, the company should report a contingent liability equal to probable damages. This second entry recognizes an honored warranty for a soccer goal based on 10% of sales from the period. In our case, we make assumptions about Sierra Sports and build our discussion on the estimated experiences. A provision is measured at the amount that the entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time.

  • Contingent liabilities are recorded on the P&L statement and the balance sheet if the probability of occurrence is more than 50%.
  • Since there is a
    past precedent for lawsuits of this nature but no establishment of
    guilt or formal arrangement of damages or timeline, the likelihood
    of occurrence is reasonably possible.
  • Generally accepted accounting principles (GAAP) require contingent liabilities that can be estimated and are more likely to occur to be recorded in a company’s financial statements.
  • A great example of the application of prudence would be recognizing anticipated bad debts.
  • However, if there is more than a 50% chance of winning the case, according to the prudence principle, no benefits would be recorded on the books of accounts.

If the contingency is reasonably possible, it could occur but is not probable. Since this condition does not meet the requirement of likelihood, it should not be journalized or financially represented within the financial statements. Rather, it is disclosed in the notes only with any available details, financial or otherwise. Since this warranty expense allocation will probably be carried on for many years, adjustments in the estimated warranty expenses can be made to reflect actual experiences.

IFRIC 1 — Changes in Existing Decommissioning, Restoration and Similar Liabilities

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. In financial reporting, actual liabilities are recognized and recorded in the books of the company at their present amount. Since they represent true obligations due to past transactions or events, they are considered firm liabilities. These come in the form of accounts payable, notes payable, mortgages payable, and other similar items.

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Implication of Contingent Liabilities on Financial Statements

The principle of prudence is a crucial principle that states that a company must not record future anticipated gains into the books of accounts, but any expected losses must be accounted for. A contingent liability can be very challenging to articulate in monetary terms. As it depends on the probability of the occurrence of that specific circumstance, that probability can vary according to one’s judgment.

IFRIC 6 — Liabilities Arising from Participating in a Specific Market – Waste Electrical and Electronic Equipment

For example, Vacuum Inc. will debit the warranty liability account $500 and credit either cash– in the case of a full refund– or inventory– in the case of a replacement– in the amount of $500. It will end up reducing both a liability account and an asset account at that point. Pending lawsuits and product warranties are two examples of contingent liabilities. Contingent liabilities are recorded differently based on whether they are probable, reasonably possible, or remote.

IAS 12 — Accounting for uncertainties in income taxes

Companies should set aside a contingency reserve to cover unexpected liabilities. This fund can provide a financial cushion for unknown or unexpected obligations. In conclusion, the consideration of contingent liabilities is an essential part of mergers and acquisitions. Their presence can immensely affect the valuation of a business and structure the negotiation of the deal.

Finally, how a loss contingency is measured varies between the two options as well. Under US GAAP, the low end of the range would be accrued, and the range disclosed. 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. There is a probability that someone who purchased the soccer goal may bring it in to have the screws replaced. Not only does the contingent liability meet the probability requirement, it also meets the measurement requirement.

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