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. Pending lawsuits and product warranties are two examples of contingent liabilities. For probable contingencies, the potential loss must be quantified and reflected on the financial statements for the sake of transparency. Contingent liabilities are incurred on a conditional basis, where the outcome of an uncertain future event dictates whether the loss is incurred. At the end of the year, the accounts are adjusted for the actual warranty expense incurred. A warranty is another common contingent liability because the number of products returned under a warranty is unknown.
- Each business transaction is recorded using the double-entry accounting method, with a credit entry to one account and a debit entry to another.
- A footnote to the balance sheet may describe the nature and extent of the contingent liabilities.
- In short, the expense must be recorded in the period of the corresponding sale, as opposed to the period in which the repair is made.
- Contingent liabilities are those that are likely to be realized if specific events occur.
- These come in the form of accounts payable, notes payable, mortgages payable, and other similar items.
- Contingent liabilities are incurred on a conditional basis, where the outcome of an uncertain future event dictates whether the loss is incurred.
Their presence can immensely affect the valuation of a business and structure the negotiation of the deal. This examination helps in determining the fair value of the target company and deciding contingent liabilities example whether or not the acquisition is financially viable. If these potential liabilities are significant, they might lead to a steep drop in the perceived value of the company being acquired.
How can companies mitigate the risks associated with contingent liabilities?
Contingent liabilities affect the valuation of a business during a merger or acquisition due to the uncertainty they represent. This is because the actual cost of a contingent liability can be far higher than its initially recognized value, or it may not occur at all. In contingent liability, it often becomes difficult as there is no active market for such liabilities, and the timing and amount of the payment are uncertain. As such, the fair value of contingent liabilities involves a great deal of estimation and judgement. Therefore, it is also important to describe the liability in the footnotes that accompany the financial statements.
The deliberate decision by the management team of a company to conceal (or downplay) a significant risk engaged in a breach of their fiduciary duty to act in their “best interests”. To elaborate upon the prior section, the different types of contingency liabilities are described in more detail here. While these sorts of conditional financial commitments are not guaranteed, per se, the odds are likely stacked against the company. Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom.
Accounting Rules for Contingent Liability
It requires the company to either replace, repair or refund the failed product, depending on the stipulations of the warranty. In this scenario, the contingent liability is not recorded or disclosed if the probability of its occurrence is remote. Here, ‘remote’ means the contingencies aren’t likely to occur and aren’t reasonably possible. To further simplify, the loss due to future events is not likely to happen but not necessarily be considered as unlikely.