Overview of Contingent Liabilities
A contingent liability is a potential liability arising from a past event or transaction, and its outcome is dependent on a future event or decision, such as the settlement of a pending lawsuit. There are different types of contingent liabilities. Answering the following questions helps to identify the contingent liability and how it should be recorded: To whom is the amount owed? How much is owed? When is the amount due?
A contingent liability has not yet occurred, and there is a range of probability as to whether the liability will occur. The range includes three basic types: probable, possible, and remote. The probability of occurrence must be identified to determine how to record an entry for the contingent liability, in accordance with the generally accepted accounting principles (GAAP). For example, Jay Company is the defendant in a lawsuit. With overwhelming evidence, the company will likely be found at fault, so an award is a probable liability. If, on the other hand, the lawsuit is frivolous, and it is highly unlikely the company will be found at fault, the liability would be considered remote. Some other sources of contingent liabilities, besides lawsuits, are disagreements with government authorities, such as the IRS or state tax authority, and warranty contract claims.
Determining Type of Contingent Liability
Of the three types of contingent liabilities—probable, possible, or remote—a probable liability is one for which the probability of the liability becoming actual is more likely than not, and it can be estimated. An example of a probable liability is a lawsuit for which the likelihood of losing a case could change over the course of time. Legal counsel to a company might provide a reliable opinion about when a financial cost to the company will occur in regard to the outcome.
An important factor in determining probable liability is the ability to make a reasonable estimate of the liability. Corporate taxes, prizes, rebates, and warranty liabilities are some examples of liabilities that can be reasonably estimated. In these cases an accrual entry is made to record the probable liability. An additional notation could also be included in the notes to the financial statements. Such probable liabilities are later recognized as expenses when incurred.
For example, Jay Company manufactures household appliances, and the appliances come with a 5-year manufacturer's warranty for parts and labor. Because the warranty extends 5 years into the future, the dollar amount of this probable liability is estimated, based on prior trends and past history of claims.
A second type of contingent liability is categorized as a possible liability. Some contingent liabilities are possible but not probable. A possible liability is different from a probable one because the possibility for the liability is less certain. The liability is not likely but could come to exist. The possible liability is not recorded on the balance sheet. Instead, it is disclosed and described in the notes to the financial statements.For example, Jay Company sells refrigerators with claims of being energy-efficient. Customers complain that this is not true and sue the company. This action could possibly result in a liability for Jay Company, depending on the court decision and the amount of award. So, the liability is dependent on or contingent upon a future event. There is uncertainty about the outcome. There is uncertainty about the amount of penalties. There is also uncertainty regarding the timing of payment for penalties. This possible liability should not be recorded on the balance sheet but should be disclosed in the notes to the financial statements.