Contingent Liabilities: Definition & Examples

What are Contingent Liabilities?

Contingent liabilities are a type of liability that may be owed in the future as the result of a potential event. They are, therefore, contingent, on something happening. A contingency is defined by Generally Accepted Accounting Principles (GAAP) as an existing condition, situation, or set of circumstances involving uncertainty as to a possible gain or loss to a business that will be resolved when a future event occurs or fails to occur. A contingent liability would involve a potential loss to the business. 

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.

Types of Contingent Liabilities 

There contingent liabilities according to Generally Accepted Accounting Principles (GAAP). The three levels of contingent liabilities are: probable, reasonably possible, and remote.

• ‍Probable: A probable contingency is defined as a future event that is likely to occur– generally defined as a 75% or greater chance of occurring. 

• Reasonably Possible: A reasonably possible contingency is defined as a future event that is more than remote but less than likely to occur– generally defined as a 50-75% chance of occurring. 
• Remote: A remote contingency is defined as a future event that is unlikely to occur.

How are Contingent Liabilities Recorded?

Contingent liabilities are recorded differently based on whether they are probable, reasonably possible, or remote. Here are the ways to record various contingent liabilities. 

Probable

If information as of the balance sheet date indicates a future loss for the company is probable and the amount is reasonably estimable, the company should record an accrual for the liability. The liability would be considered a short-term liability if the expected settlement date is within one year of the balance sheet date. If it is beyond the one year point, the liability would be considered a long-term liability. The amount that the company should accrue is either the most accurate estimate within a range or– if no amount within the potential range is more likely than the others– the minimum amount of the range.

Reasonably Possible

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. 

Remote

If a possibility of a loss to the company is remote, no disclosure is required per GAAP. 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. 

Why are Contingent Liabilities Recorded?

Contingent liabilities are recorded to ensure the financial statements fully reflect the true position of the company at the time of the balance sheet date. Because a contingent liability has the ability to negatively impact a company’s net assets and future profitability, it should be disclosed to financial statement users if it is likely to occur. External financial statement users may be interested in a company’s ability to pay its ongoing debt obligations or pay out dividends to stockholders. Internal financial statement users may need to know about the contingent liability to make strategic decisions about the direction of the company in the future. 

Companies should disclose all of the qualitative and quantitative information necessary for its financial statement users to understand the:

• Nature of the contingent liability 
• The magnitude of the contingent liability
• The potential timing of the contingent liability

Examples of Contingent Liabilities

Pending lawsuits and product warranties are two examples of contingent liabilities.

Pending lawsuit

Assume ABC Company is being sued by a competitor. ABC Company’s legal team believes the chance of a negative outcome for ABC is probable. They estimate the potential legal settlement to be between $1 million and $2 million– with the most likely settlement amount being $1.25 million. In this case, the company should record a contingent liability on the books in the amount of $1.25 million. 

The journal entry would include a debit to legal expense for $1.25 million and a credit to an accrued liability account for $1.25 million. 

The legal expense would appear on the current years’ income statement. The accrued liability would appear on the company’s balance sheet. If the expected settlement date is within the upcoming year, the liability would be classified under the short-term liability section of the balance sheet. 

Assume, on the other hand, ABC Company’s settlement amount was likely to be between $1 million and $2 million– but no specific amount within that range is more likely than any other. In that case, the company should record the minimum of the range as its contingent liability. It would record a journal entry to debit legal expense for $1 million and credit an accrued liability account for $1 million. 

If the potential for a negative outcome from the lawsuit is reasonably possible but not probable, the company should disclose the information in the footnotes to its financial statement. The footnote disclosure should include the nature of the lawsuit, the timing of when it expects a settlement decision, and the potential amount– either the range or the exact amount if it is identifiable. If the likelihood of a negative lawsuit outcome is remote, the company does not need to disclose anything in the footnotes.

Product Warranty

The matching principle of accounting states that expenses should be recorded in the same period as their related revenues. In the case of warranties, a contingent liability is required because it represents an amount that is not fully earned by a company at the time of sale. The expense of the potential warranties must offset the revenue in the period of sale. 

Assume Vacuum Inc. offers a one year warranty on its vacuums. The vacuums cost $500. It does not know the exact number of vacuums that will be returned under the warranty, so the amount must be estimated. Vacuum Inc. manufactures 10,000 vacuums per year. Using historical averages, it estimates that 5% of those, or 500 vacuums will be returned under warranty per year. Vacuum Inc. should record a debit to warranty expense for $250,000 and a credit to a warranty liability account for $250,000. 

Where:

• $250,000 = 500 x $500

And:

• $250,000 = contingent liability
• 500 = vacuums returned under warranty per year
• $500 = cost of each vacuum

The warranty liability account will be reduced when the warranties are paid out to the customers. For example, Vacuum Inc. will debit the warranty liability account $500 and credit either cash– in the case of a full refund– or inventory– in the case of a replacement– in the amount of $500. It will end up reducing both a liability account and an asset account at that point. 

Additional Resources

If you found this article useful, consider checking out our Financial Accounting Essentials where you'll learn how to build a balance sheet, income statement, and cash flow statement from scratch based on a set of transactions. You'll also learn to find, read, and analyze the financial statements of real companies such as Microsoft and PepsiCo. Students who have taken this course have gone on to work at Barclays, Bloomberg, Goldman Sachs, EY, and many other prestigious companies. Get started now!

Other Articles You May Find Helpful

• Current Liabilities
• Current Assets
• Current Ratio
• Accrued Expenses
• Quick Ratio