Contingent Liabilities

How Do Contingent Liabilities Work?

A conditional liability refers to a potential obligation incurred by a company on a future date if certain conditions are met.

Contingent liabilities are incurred on a conditional basis, where the outcome of an uncertain future event dictates whether the loss is incurred.

A contingency describes a scenario wherein the outcome is indeterminable at the present date and will remain uncertain for the time being. The outcome could be favorable to the company (or the reverse).

Publicly traded companies are obligated to recognize contingent liabilities on their balance sheets to comply with GAAP (FASB) and IFRS accounting guidelines.

Therefore, a contingent liability is the estimated loss incurred based on the outcome of a particular future event.

While these sorts of conditional financial commitments are not guaranteed, per se, the odds are likely stacked against the company.

The factor of uncertainty, where the outcome is out of the company’s control for the most part, is one of the core attributes of contingent liabilities.

On that note, a company could record a contingent liability and prepare for the worst-case scenario, only for the outcome to still be favorable.

Based on the outcome of the underlying event that is set to occur in the future, the financial obligation can be “triggered” and cause the company to be held accountable to issue a conditional payment (or fee).

What are the Categories of Contingent Liabilities?

Broadly put, there are three categories of contingent liabilities:

• Probable Contingencies → More Likely to Occur than to Not Occur
• Possible Contingencies → Possible but Cannot Be Predicted with Certainty
• Remote Contingencies → Unlikely to Occur

For probable contingencies, the potential loss must be quantified and reflected on the financial statements for the sake of transparency.

In the case of possible contingencies, commentary is necessary on the liabilities in the footnotes section of the financial filings to disclose the risk to existing and potential investors.

If the contingent loss is deemed remote—specifically, with less than a 50% probability of occurrence under IFRS—the formal disclosure and recognition on the balance sheet is not necessary.

^{Summary of Statement No. 5 — Accounting for Contingencies (Source: FASB)}

What are the Different Types of Contingent Liabilities?

To elaborate upon the prior section, the different types of contingency liabilities are described in more detail here.

1. Probable Contingency

• A probable contingency describes a scenario wherein the risk of liability occurring is greater than 50% (IFRS) or 80% (GAAP).
• In such cases, the potential loss is recognized as a probable contingent liability on the balance.
• For instance, a law firm representing a corporate client—upon reviewing the circumstances surrounding the case and determining the merits of the lawsuit to be fairly strong—is likely to provide legal counsel regarding the need to prepare for the ramifications (and monetary losses).

2. Possible Contingency

• A possible contingency arises when a liability may or may not occur, i.e. there is substantial uncertainty regarding the probability of occurrence.
• Unlike a probable contingency, the likelihood of occurrence is less than 50% in a possible contingency and the amount cannot be estimated.
• Therefore, potential contingencies are usually disclosed in the footnotes, rather than recorded on the financial statements.

3. Remote Contingency

• A remote contingency is a liability determined to have a very low probability of occurring, barring abnormal circumstances.
• Since the likelihood of remote contingencies (and incurring losses), the liability account is not recorded on the books or mentioned in the footnotes section of a financial report.

Accounting Reporting Requirements and Footnotes

Under U.S. GAAP accounting standards (FASB), the reported contingent liability amount must be “fair and reasonable” to not mislead investors or regulators.

Loss contingencies are accrued if determined to be probable and the liability can be estimated. But unlike IFRS, the bar to qualify as “probable” is set higher at a likelihood of 80%.

The deliberate decision by the management team of a company to conceal (or downplay) a significant risk engaged in a breach of their fiduciary duty to act in their “best interests”.

Once a contingent liability is identified and rightfully disclosed in the footnotes section of their financial reports, the company must make the objective determination of whether the likelihood of occurrence should be categorized as remote, possible, or probable.

The reason contingent liabilities are recorded is to adhere to the standards established by IFRS and GAAP, and for the company’s financial statements to be accurate.

The recognition of contingent liabilities on the financial statements (and footnotes) is to present investors, lenders, and others with reliable financial statements that contain accurate, conservative information.

If the contingency is deemed probable with a reasonably estimated amount, it is recorded in a financial statement. However, suppose neither of those conditions can be met—then, the contingent liability could be inserted in the footnote of a financial statement (or leftover if immaterial).

Some common examples of contingent liabilities are pending lawsuits and product warranties because each scenario is characterized by uncertainty, yet still poses a credible threat.

• Pending Legal Risks → If a company encounters an unanticipated legal matter, such as a lawsuit, an unfavorable outcome from the trial could result in the potential risk of incurring significant monetary losses from damages or fines (“suit pending”).
• Product Warranties → Companies often sell products to customers with a warranty attached stating terms of their conditional obligation to repair (or replace) faulty products. The potential costs are considered contingent liabilities and are estimated based on the historical warranty claim data collected from past transactions.

Contingent Liabilities Accounting Treatment (U.S. GAAP)

Under U.S. GAAP, contingent liabilities are recognized on the liabilities section of the balance sheet only if the following criteria are met:

• Potential Liability is Categorized as Probable
• Liability can be Reasonably Estimated in Monetary Terms

Historical data often serves as the precedent by which the percentage assumption is set, i.e. to estimate the future liability incurred for purposes of internal planning.

For example, the percentage of defective products with a warranty should be derived from past customer transaction data.

Furthermore, the matching convention dictates the timing of the recognition. In short, the expense must be recorded in the period of the corresponding sale, as opposed to the period in which the repair is made.

Contingent Liabilities Journal Entry Example (Debit and Credit)

For contingent liabilities, the accounting treatment is different from most other types of more standard liabilities.

Contingent liabilities are recorded on the balance sheet only if the conditional event is likely to occur and the liability can be reasonably estimated.

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.