All you need to know about Contingent Liability


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Contingent liabilities are liabilities that may be incurred by an entity depending on the outcome of an uncertain future event such as the outcome of a pending lawsuit. A contingent liability is a potential depends on a future event occurring or not occurring. Because it cannot be determined whether the amount must be paid until events unfold, the company's likelihood of loss is scored as one of the following:

  1. Probable - The future event or events are likely to occur.
  2. Reasonably possible - The chance of occurrence of future events is between probable and remote.
  3. Remote - The chance of future event or events occurring is slight

A contingent liability should be recorded in the financial statements only when -

  1. It is probable that a liability has been incurred and
  2. The amount of the loss can be reasonably estimated

Record a contingent liability when it is probable that a loss will occur, and you can reasonably estimate the amount of the loss. If you can only estimate a range of possible amounts, then record that amount in the range that appears to be a better estimate than any other amount; if no amount is better, then record the lowest amount in the range. “Probable” means that the future event is likely to occur. You should also describe the liability in the footnotes that accompany the financial statements.

Only Disclosure: Disclose the existence of a contingent liability in the notes accompanying the financial statements if the liability is reasonably possible but not probable, or if the liability is probable, but you cannot estimate the amount. “Reasonably possible” means that the chance of the event occurring is more than remote but less than likely.

No treatment: Do not record or disclose a contingent liability if the probability of its occurrence is remote.

Examples of Contingent Liability:

  1. Lawsuits
  2. Claims against the company
  3. Legal liability
  4. Disputed Tax Liabilities
  5. Financial guarantees given
  6. The threat of expropriation
  7. A government investigation
  8. Warranty offered by company

Case Examples:

Lawsuit Expenses:

ABC Limited is a consulting firm, specializing in engineering products and development. Just before the end of the year the company received a notice of a legal case from one of its competitors. The case is related to a potential infringement of the competitor's patent. The in house legal counsel discussed the case with ABC Limited's management and based on information available concluded that the lawsuit was possible, however, there was not enough information to estimate the potential loss. This lawsuit is considered a contingent liability, which should be only described in the notes to the financial statements as the second criteria (i.e. reasonable estimate of loss amount) was not met.

Warranty Reserves:

A local manufacturer of Mobile Phones sells products nationwide. As part of customer service, the manufacturer provides a warranty to repair or replace its products one year after the sale. Using accumulated historical information, the manufacturer estimated that each sold phone results, on average, in Rs. 1000 of warranty expenses. During the current year, the manufacturer sold 1,000 phones. As it is probable that the manufacturer incurred warranty expenses (i.e. by selling the phones that will need to be fixed later when customers return them) and the amount of warranty expense can be reasonably estimated (based on historical information), a contingent liability related to warranty expenses should be recorded in the financial statements.

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