Reporting Requirements of Contingent Liabilities and GAAP Compliance

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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. Definition of Contingent Liability
A contingent liability is a potential liability that may or may not become an actual liability. Whether the contingent liability becomes an actual liability depends on a future event occurring or not occurring.

  • Contingent liabilities also include obligations that are not recognised because their amount cannot be measured reliably or because settlement is not probable.
  • A contingent liability is a potential liability that may occur in the future, such as pending lawsuits or honoring product warranties.
  • Pending lawsuits and product warranties are two examples of contingent liabilities.
  • A provision is a liability which can only be measured using a significant degree of estimation.
  • This case illustrates how their practices might lead to future liabilities, dependent on contingent events like law enforcement or legal proceedings.
  • Our goal is to deliver the most understandable and comprehensive explanations of financial topics using simple writing complemented by helpful graphics and animation videos.

A contingent liability should be recorded on the company’s books if the liability is probable and the amount can be reasonably estimated. If it does not meet both of these criteria, the contingent liability may still need to be recorded as a disclosure in the footnotes to the financial statements. 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.

Why are Contingent Liabilities Recorded?

A great example of the application of prudence would be recognizing anticipated bad debts. Prudence can be helpful if certain liabilities might occur but aren’t certain; here contingent liabilities. A liability is something owed by someone—it sets up an obligation or a debt. Provisions are a sum of money that is set aside in order to cover a probable expense that will happen in future. In this case, the obligation is already present, but the amount for such an obligation cannot be determined exactly.

The present obligation and fair value form two significant part of the measurement and recognition criteria for contingent liabilities. When a contingent liability becomes a present obligation, it is recorded in the balance sheet as a provision. This recognition can increase a company’s liabilities, decrease its net assets and potentially reduce its net profit in the current period. Contingent liabilities refer to potential obligations that may arise depending on the outcome of a future event. The matching principle of accounting states that expenses should be recorded in the same period as their related revenues.

Why is a Contingent Liability Recorded?

A contingent liability threatens to reduce the company’s assets and net profitability and, thus, comes with the potential to negatively impact the financial performance and health of a company. Therefore, such circumstances or situations must be disclosed in a company’s financial statements, per the full disclosure principle. A contingent liability is recorded in what is a capital campaign the accounting records if the contingency is probable and the related amount can be estimated with a reasonable level of accuracy. Other examples include guarantees on debts, liquidated damages, outstanding lawsuits, and government probes. For example, a customer files a lawsuit against a business, claiming that its product broke, causing $500,000 of damage.

Product Warranty

The most common example of a remote contingency would be a frivolous lawsuit. If the lawyer and the company decide that the lawsuit is frivolous, there won’t be any need to provide a disclosure to the public. The principle of materiality states that all items with some monetary value must be accounted into the books of accounts. Items can be considered to have a monetary value if their inclusion or exclusion has an impact on the business. Similarly, the knowledge of a contingent liability can influence the decision of creditors considering lending capital to a company. The contingent liability may arise and negatively impact the ability of the company to repay its debt.

Ask Any Financial Question

Initially, when the customer had reported it to, the company refused to accept the claim and therefore, the customer has filed a legal claim against them. Generally, indemnities are appropriate for matters which fall outside the responsibility of the customer or buyer. If you are the party providing the indemnity, you should carefully consider how you will fund the compensation in the event it is called on. So GAAP has a lower threshold for disclosure, while IFRS has a lower threshold for recognizing provisions. Estimates are reassessed each reporting period as new information becomes available.

Common examples include pending lawsuits, product warranties, and guarantees on loans. Under the generally accepted accounting principles (GAAP), contingent liabilities are recorded as actual liabilities only if the potential liability is probable and its amount can be reasonably estimated. 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. GAAP accounting rules require probable contingent liabilities—ones that can be estimated and are likely to occur—to be recorded in financial statements.

A contingent liability must be recorded on official financial statements for the startup to comply with

Generally Accepted Accounting Principles (GAAP)

. If a loss from a contingent liability is reasonably possible but not probable, it should be recorded as a disclosure in the footnotes to the financial statements. The company should record the nature of the contingent liability and give an estimate or range of estimates for the potential loss. If an estimate cannot be made, that should also be noted in the disclosure.