Since the outcome of contingent liabilities cannot be known for certain, the probability of the occurrence of the contingent event is estimated and, if it is greater than 50%, then a liability and a corresponding expense are recorded. The recording of contingent liabilities prevents the understating of liabilities and expenses. IAS 37 defines and also specifies the accounting for and disclosure of the provisions, of all the contingent liabilities, and all the contingent assets. A provision here is described as a liability of uncertain timing or amount. A contingent liability is dependent on the outcome of an uncertain future event.

• Contingent liabilities are shown as liabilities on the balance sheet and as expenses on the income statement.
• The events are not under the control of the company, so the company cannot decide on the occurrence of the event.
• Two classic examples of contingent liabilities include a company warranty and a lawsuit against the company.
• An example is litigation against the entity when it is uncertain whether the entity has committed an act of wrongdoing and when it is not probable that settlement will be needed.
• In this journal entry, lawsuit payable account is a contingent liability, in which it is probable that a $25,000 loss will occur.

It prevents the company from ignoring the possibility of contingent liabilities. It follows the conservative nature of the financial statement, the liabilities will be recorded even if it is not certain yet. What about business decision risks, like deciding to reduce insurance coverage because of the high cost of the insurance premiums? GAAP is not very clear on this subject; such disclosures are not required, but are not discouraged.

Using Knowledge of a Contingent Liability in Investing

The accounting of contingent liabilities In the U.S., accountants adhere to the rules and standards defined by the Generally Accepted Accounting Principles, commonly referred to as GAAP. Although contingent liabilities are necessarily estimates, they only exist where it is probable that how to record a contingent liability some amount of payment will be made. This is why they need to be reported via accounting procedures, and why they are regarded as “real” liabilities. Similarly, the knowledge of a contingent liability can influence the decision of creditors considering lending capital to a company.

Contingent liabilities are also important for potential lenders to a company, who will take these liabilities into account when deciding on their lending terms. Business leaders should also be aware of contingent liabilities, because they should be considered when making strategic decisions about a company’s future. According to the full disclosure principle, all significant, relevant facts related to the financial performance and fundamentals of a company should be disclosed https://www.bookstime.com/ in the financial statements. Both GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) require companies to record contingent liabilities, due to their connection with three important accounting principles. Examples of contingent liabilities are the outcome of a lawsuit, a government investigation, and the threat of expropriation. Do not record or disclose a contingent liability if the probability of its occurrence is remote.

What Is the Journal Entry for Contingent Liabilities?

Product warranties will be recorded at the time of the products’ sales by debiting Warranty Expense and crediting to Warranty Liability for the estimated amount. A loss contingency that is remote will not be recorded and it will not have to be disclosed in the notes to the financial statements. An example is a nuisance lawsuit where there is no similar case that was ever successful. However, sometimes companies put in a disclosure of such liabilities anyway.