The accountant knows that if Rey Co reports a profit of $13m, directors will not get any more of a bonus than if they reported $10m. Finance Strategists has an advertising relationship with some of the companies included on this website. We may earn a commission when you click on a link or make a purchase through the links on our site. All of our content is based on objective analysis, and the opinions are our own. CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path.

1. A contingent liability is defined under GAAP as any potential future loss that depends on a “triggering event” to become an actual expense.
2. Qualifying contingent liabilities are recorded as an expense on the income statement and as a liability on the balance sheet.
3. This rule has two parts, first the type of obligation, and second, the requirement for it to arise from a past event (ie something must already have happened to create the obligation).
4. Although cash may be needed in the future, no event (delivery of the truck) has yet created a present obligation.
5. If no amount within the range is a better estimate, the minimum amount within the range should be accrued, even though the minimum amount may not represent the ultimate settlement amount.
6. 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.

Following are the necessary journal entries to record the expense in 2019 and the repairs in 2020. The resources used in the warranty repair work could have included several options, such as parts and labor, but to keep it simple we allocated contingent liability journal entry all of the expenses to repair parts inventory. 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.

Then in the next year, the chief accountant could reverse this provision, by debiting the liability and crediting the statement of profit or loss. This is effectively an attempt to move $3m profit from the current year into the next financial year. Contingent liabilities that are not probable and/or whose amount cannot be reasonably estimated are not accrued on the company’s books.

IFRS Sustainability Standards are developed to enhance investor-company dialogue so that investors receive decision-useful, globally comparable sustainability-related disclosures that meet their information needs. Contingent liability is one of the most subjective, contentious and fluid concepts in contemporary accounting. (b) Past event The obligation needs to have arisen from a past event, rather than simply something which may or may not arise in the future. At the start of the year, Rey Co sets a profit target of $10m for the year ended 31 December 20X8. The chief accountant of Rey Co has reviewed the profit to date and realises they are likely to achieve profits of $13m.

Liquidity and solvency are measures of a company’s ability to pay debts as they come due. Liquidity measures evaluate a company’s ability to pay current debts as they come due, while solvency measures evaluate the ability to pay debts long term. One common liquidity measure is the current ratio, and a higher ratio is preferred over a lower one.

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EXAMPLE An employee was injured at work in 20X8 due to faulty equipment and is suing Rey Co. Rey Co’s lawyers have advised that it is probable that the entity will be found liable. Rey Co would have to provide for the best estimate of any damages payable to the employee.

First, it must be possible to estimate the value of the contingent liability. The liability must have more than a 50% chance of being realized if the value can be estimated. Qualifying contingent liabilities are recorded as an expense on the income statement and as a liability on the balance sheet.

How are Contingent Liabilities Recorded?

However, it has come to light that Rey Co may have a counter claim against the manufacturer of the machinery. The legal advisors believe that there is an 80% chance that the counter claim against the manufacturer is likely to succeed and believe that Rey Co would win $8m. It can be seen here that Rey Co could only recognise an asset from a potential inflow if the realisation of income is virtually certain.

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However, the company should disclose the contingent liability information in its footnotes to the financial statements if the financial statements could otherwise be deemed misleading to financial statement users. Our example only covered the warranty expenses anticipated from the 2019 sales. Since the company has a three-year warranty, and it estimated repair costs of $5,000 for the goals sold in 2019, there is still a balance of $2,200 left from the original $5,000. However, its actual experiences could be more, the same, or less than $2,200. If it is determined that too much is being set aside in the allowance, then future annual warranty expenses can be adjusted downward.

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. A loss contingency that is remote will not be recorded and it will not have to be disclosed in the notes to the financial statements. An example is a nuisance lawsuit where there is no similar case that was ever successful.

A contingent liability is a potential liability that may occur in the future, such as pending lawsuits or honoring product warranties. If the liability is likely to occur and the amount can be reasonably estimated, the liability should be recorded in the accounting records of a firm. Assume that a company is facing a lawsuit from a rival firm for patent infringement.