If a business is facing a potential obligation that must be fulfilled at a future date, it might have to record a liability in the present period. Contingent liability depends on the likelihood of an event occurring. In other words, it is a conditional or a potential liability that could become real if a possible subsequent event arising from previous transactions occurs; for example, legal costs, liabilities on discounted bills of exchange, the due date of which has not arrived, environmental problems, etc.
Such liability is included on the Balance sheet and Income Statement if it is reasonably probable and a reliable estimation can be made for the amount or timing of the obligation. It must meet all two criteria to be recognized. Otherwise, it is disclosed in the notes to the financial statements. Legal claims, when someone sues the company and the case is still going on, are a contingent liability because the business might owe somebody money but then it might not.
Tax assessments and warranties are other examples of contingent liabilities. If a company has a product and a warranty on it, then it might have to pay cash to get it fixed or somehow resolve the issue. The company is not sure how much it is going to be, but more than like there is going to be some liability. Employees might also go on a vacation, so at the end of the year, the business might have to record vacation pay liability.
Along with the actual costs incurred for the acquisition of property, plant, and equipment, the initial cost of an object may also include the estimated costs that may arise in connection with its liquidation at the end of its useful life. Estimated costs of dismantling, liquidation of an asset, and site restoration, obligations in respect of which arose with the acquisition of the asset or as a result of its operation during a specified period, can be considered a contingent liability.
Accounting for contingent liability is not that simple. First, you need to determine whether it is
- probable (likely)
- remote (unlikely).
Usually, you would get lawyers or other people involved to see if it is likely or not because in real life it is often hard to tell. You are probably going to stay on the side of conservatism when you are going to decide on these things.
If the liability is possible, meaning it is reasonably possible that it might happen given the situation, you are going to disclose it in the notes. If it is remote and probably not going to happen, then you are not required to make a disclosure.
If an uncertain event moves from being a possibility to being both likely to occur and measurable, then you are going to record the liability. You would record a loss, some sort of expense, or some sort of decrease in your income, and you will credit liability, showing that you owe money (probably).
If the liability is not probable or you cannot estimate the dollar amount, then you are going to disclose in the notes to the financial statements. This way, when people are looking at the financial statements can see that there are contingent liabilities. If possible, you can provide a range for the amount of the contingent liability.
On November 5th, 2020 employees filed claims against the company, seeking an $800,000 settlement to be decided on April 10th, 2021. The company feels this settlement is probable, so it would record this lawsuit as a contingent liability while the case is open and it is not acknowledged as debt.
Since the company believes there is a high likelihood it will lose this case and it knows how much approximately it might owe its employees, it should recognize this liability when the case is filed and not wait until the decision is made. To record this, it will debit an expense account, let’s call it Legal Expense, and credit a liability account – Accrued Liability.
Nov. 5, 2020
Once the case is closed, the company can record it as an actual liability if the employees won the case or remove this contingent liability from its accounting books.
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Author: Charles Lutwidge