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Contingent Liabilities Meaning, Examples, and Accounting Entries

todayJuly 29, 2022

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As a general rule, contingent liabilities, whether recognized or not, must be disclosed. If any of these elements cannot be calculated reliably, that fact should be stated. A type of contingent liability, warranty obligations, are present when a company guarantees that their product would work for a certain period or meet certain standards. These obligations can become actual liability if the product fails to meet the warranty conditions.

  • Any probable contingency needs to be reflected in the financial statements – no exceptions.
  • These obligations result from previous transactions or occurrences, and they are contingent on future events and indeterminate in nature.
  • In our case, we make assumptions about Sierra Sports and build our discussion on the estimated experiences.
  • Contingent assets are possible assets whose existence will be confirmed by the occurrence or non-occurrence of uncertain future events that are not wholly within the control of the entity.
  • Legal counsel can aid in negotiation of contracts to limit the responsibility of the company for contingent liabilities.

The contingent liability may arise and negatively impact the ability of the company to repay its debt. According to the full disclosure principle, all significant, relevant facts related to the financial performance and fundamentals of a company should be disclosed in the financial statements. Contingent liabilities are shown as liabilities on the balance sheet and as expenses on the income statement. Each business transaction is recorded using the double-entry accounting method, with a credit entry to one account and a debit entry to another. Contingent liabilities, although not yet realized, are recorded as journal entries. Warranties arise from products or services sold to customers
that cover certain defects (see
Figure 12.8).

What Is the Journal Entry for Contingent Liabilities?

It’s crucial to understand the significant connection between contingent liabilities and sustainability in a corporate landscape. This link is premised on the concept that a company’s social and environmental responsibilities manifest real potential liabilities. The legal implications of contingent liabilities necessitate having legal expertise onboard.

  • This is considered probable but inestimable, because the lawsuit is very likely to occur (given a settlement is agreed upon) but the actual damages are unknown.
  • The accrual account permits the firm to immediately post an expense without the need for an immediate cash payment.
  • Sierra Sports may have more litigation in the future surrounding the soccer goals.

Past experience for the goals that the company has sold is that 5% of them will need to be repaired under their three-year warranty program, and the cost of the average repair is $200. To simplify our example, we concentrate strictly on the journal entries for the warranty expense recognition and the application of the warranty repair pool. If the company sells 500 goals in 2019 and 5% need to be repaired, then 25 goals will be repaired at an average cost of $200. The average cost of $200 × 25 goals gives an anticipated future repair cost of $5,000 for 2019.

What is the debit entry?

This second entry recognizes an honored warranty for a soccer
goal based on 10% of sales from the period. An entity may choose how to classify business interruption insurance recoveries in the statement of operations, as long as that classification is not contrary to existing generally accepted accounting principles (GAAP). Just as with environmental matters, a company’s social actions can also lead to contingent liabilities. This is more prevalent with companies that have extensive corporate social responsibility (CSR) initiatives.

Difference Between Types of Liabilities

The sales price per soccer goal is $1,200, and Sierra Sports believes 10% of sales will result in honored warranties. The company would record this warranty liability of $120 ($1,200 × 10%) to Warranty Liability and Warranty Expense accounts. If the contingent loss is remote, meaning it has less than a 50% chance of occurring, the liability should not be reflected on the balance sheet.

Contingent liabilities

If the contingent liability is considered
remote, it is unlikely to occur and may or may not
be estimable. This does not meet the likelihood requirement, and
the possibility of actualization is minimal. In this situation, no
journal entry or note disclosure in financial statements is

Contingent Assets

Their intention is to overstate assets to window-dressing financial statements. 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. Insurance can be an excellent shield against the financial risks of contingent liabilities.

One major difference between the two is that the latter is an amount you already owe someone, whereas the former is contingent upon the event occurring. The accrual account enables the company to record expenses without requiring an immediate cash payment. If the case is unsuccessful, $5 million in cash is credited (reduced), and the accruing account is debited. 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.

Written by: Lucia

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