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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). 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.
Key Takeaways
- Contingent liabilities are potential obligations that depend on uncertain future events. They must be classified as probable, reasonably probable, or remote, according to FASB guidelines.
- Only contingent liabilities deemed probable and with estimable amounts are recognized on a company’s financial statements. Others are disclosed in footnotes until the uncertainty is resolved.
- Companies accrue contingent liabilities by first recording estimated future costs as expenses. If the liability materializes, they adjust it against actual cash spent.
- Important details about contingent liabilities are included in financial statement footnotes, especially when they are obscure or potentially misleading, to ensure transparency and compliance with GAAP.
- Contingent liabilities often include potential losses from lawsuits, warranties, and certain credit obligations, which can greatly impact a company’s financial position.
Understanding the Transition to Contingent Liabilities
Contingent liabilities are sometimes referred to as “loss contingencies” by the Financial Accounting Standards Board (FASB). The concept of a contingent liability is centered around the two primary aspects of an accounting liability: that they are present responsibilities and obligations to other entities.
These liabilities become contingent whenever their payment contains a reasonable degree of uncertainty. Only the contingent liabilities that are most probable can be recognized as a liability on financial statements. Other contingencies are relegated to footnotes as long as uncertainty persists.
Evaluating the Recognition of Contingent Liabilities
Contingent liability is one of the most subjective, contentious and fluid concepts in contemporary accounting.
There are two distinct hurdles when determining if a contingent liability should be recognized:
- The timing of the possible liability
- The degree of confidence that an external obligation will be realized
This is why the FASB created three categories of contingency: probable, reasonably probable and remote. Only those classified as probable can be officially recognized.
Accrual Accounting for Contingent Liabilities
It does not make any sense to immediately realize a contingent liability – immediate realization signifies the financial obligation has occurred with certainty. Instead, the FASB requires contingent liabilities to be accrued.
Future costs are expensed first, and then a liability account is credited based on the nature of the liability. In the event the liability is realized, the actual expense is credited from cash and the original liability account is similarly debited.
Footnote Disclosures for Contingent Liabilities
If a contingent liability is deemed probable, it must be directly reported in the financial statements. Nevertheless, generally accepted accounting principles, or GAAP, only require contingencies to be recorded as unspecified expenses.
Any details are contained within disclosures in the footnotes. FASB Statement of Financial Accounting Standards No. 5 requires any obscure, confusing or misleading contingent liabilities to be disclosed until the offending quality is no longer present.
Estimating the Financial Impact of Contingent Liabilities
Estimation of contingent liabilities is another vague application of accounting standards. Under GAAP, the listed amount must be “fair and reasonable” to avoid misleading investors, lenders, or regulators. Estimating the costs of litigation or any liabilities resulting from legal action should be carefully noted.
Lawsuits, especially with huge companies, can be an enormous liability and significantly impact the bottom line. Companies that underestimate the impact of legal fees or fines will be non-compliant with GAAP.
What Are Some Common Examples?
Possible contingent liabilities include loss from damage to property or employees. Most companies carry many types of insurance, so these liabilities are normally expressed in terms of insurance costs.
Banks that issue standby letters of credit or similar obligations carry contingent liabilities. All creditors, not just banks, carry contingent liabilities equal to the amount of receivables on their books.
Warranties and lawsuits are commonplace in the business environment. Both are considered contingent liabilities.
