12 3: Define and Apply Accounting Treatment for Contingent Liabilities Business LibreTexts

Therefore, contingent liabilities—as implied by the name—are conditional on the occurrence of a specified outcome. The company sets an accounting entry to debit (increase) legal expenses for $5 million and credit (raise) accrued expenses for $5 million on the balance sheet because the liability is probable and simple to estimate. Such contingency is neither recorded on the financial statements nor disclosed to the investors by the management.

Contrarily, a contingent liability represents a potential obligation that may or may not arise, based on future events. Thus, provisions are recognized as liabilities and affect the financial statements by reducing net income and equity, whereas contingent liabilities are disclosed in the notes to the financial statements unless their occurrence is remote. The key principle established by the Standard is that a provision should be recognised only when contingent liabilities example there is a liability i.e. a present obligation resulting from past events. The Standard thus aims to ensure that only genuine obligations are dealt with in the financial statements – planned future expenditure, even where authorised by the board of directors or equivalent governing body, is excluded from recognition. Therefore, they are assessed continually to determine whether an outflow of resources embodying economic benefits has become probable.

GAAP Compliance

The journal entry for a contingent liability—as illustrated below—is a credit entry to the contingent warranty liability account and a debit entry to the warranty expense account. A contingent liability is a potential obligation that depends on the occurrence or non-occurrence of one or more events in the future. If the event occurs, the company may be required to make a payment; if it does not occur, the company will not be required to make a payment.

• These lawsuits have not yet been filed or are in the very early stages of the litigation process.
• Future events that may affect the amount required to settle an obligation shall be reflected in the amount of a provision where there is sufficient objective evidence that they will occur.
• If a company is sued by a former employee for $500,000 for age discrimination, the company has a contingent liability.
• If an entity applies this Standard for periods beginning before 1 July 1999, it shall disclose that fact.
• In the statement of comprehensive income, the expense relating to a provision may be presented net of the amount recognised for a reimbursement.
• Let’s understand why it is important for a business to provide for contingent liabilities with an example.

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. It can be recorded only if estimation is possible; otherwise, disclosure is necessary. According to the full disclosure principle, all significant, relevant facts related to the financial performance and fundamentals of a company should be disclosed in the financial statements. This Standard becomes operative for annual financial statements covering periods beginning on or after 1 July 1999. If an entity applies this Standard for periods beginning before 1 July 1999, it shall disclose that fact. Evidence that an entity has started to implement a restructuring plan would be provided, for example, by dismantling plant or selling assets or by the public announcement of the main features of the plan.

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

Generally, a ‘remote’ likelihood ranges between 5% and 10%, though IAS 37 doesn’t explicitly specify this. IAS 37.86 details the disclosure requirements, emphasising that any contingent liability with an outflow possibility exceeding ‘remote’ should be disclosed. Contingent liabilities are significant because they represent potential future obligations that could have a material impact on a company’s financial health and stability. Investors and creditors need to be aware of these possible liabilities when assessing a company’s risk level and making informed decisions. For the company itself, understanding and managing contingent liabilities is crucial for financial planning and risk management. By identifying and estimating potential liabilities, a company can take proactive steps to mitigate negative financial impacts, such as setting aside reserves or obtaining insurance coverage.