Contingent Liabilities - Online Tutor, Practice Problems & Exam Prep

Contingencies in accounting involve uncertain events that may lead to gains or losses. Contingent gains are not recorded until realized, reflecting a conservative approach. Conversely, contingent liabilities may be accrued if the likelihood of loss is probable and the amount can be estimated. If the loss is reasonably possible, it is disclosed in footnotes. The key terms include "probable," "reasonably possible," and "remote," guiding the treatment of these liabilities. Understanding these criteria is essential for accurate financial reporting and investor transparency.

Contingent Liabilities and Gains

Now let's talk about contingencies which are based on events that may or may not happen. Let's see how we deal with this from an accounting standpoint. So, contingencies relate to situations that are uncertain. And this could relate to contingent gains and contingent losses. However, let's start here with contingent gains because this is the chance that we might make some money in the future. Hey, we have a chance that we're going to make some money. Well, we like to be conservative when we do our accounting. We don't want to say, "Hey, there's a chance we're going to make some money, let's take that revenue right now." No, we can't do that. What we do with gains is we wait until they actually happen. With the contingent gain, if there's some uncertain event, let's say maybe we're in the middle of a lawsuit and we think we're going to win the lawsuit and get some money. Well, we can't right now say I think we're going to win so let's take the gain right now. We don't do that. Contingent gains are never recorded, okay? And I want to talk about that quickly because it's easy to remember. We're conservative when we do accounting so we never record a contingent gain until it actually happens and it's realized and then we're going to take that gain at that point, okay? So it's an uncertain result that might result in a gain, well we don't deal with that. We don't make any sort of journal entry for that.

However, contingent liabilities, if there's a chance that we're going to lose some money, well there are situations where we're going to accrue a liability. We're actually going to have a liability on our balance sheet for the chance that we're going to lose some money in the future because we're conservative. We don't want to be so proactive about taking gains, but we're proactive about losses that might occur because that's very important to an investor, right? An investor, if they see that 'hey, there's a chance we're going to lose a lawsuit and lose a bunch of money', well, that's important information that they might want to know about, okay? So uncertainties that result in a loss could result in a contingent liability. However, they're not always going to be a liability. There could be situations where instead of just accruing a liability, we might disclose in the footnotes, which is after we show all our balance sheet, income statement, retained earnings, statement of cash flows, there are pages and pages in the financial statements of footnotes where we describe in words a bunch of information that could be relevant to the investors, okay? So in the footnotes there might be a note, hey, we're in the middle of a lawsuit and there's a chance that we might lose some money. However, the chance wasn't big enough to accrue a liability. And there could be other situations where the chance of this happening is so small that we're not going to record anything about it, okay?

So let's talk about the criteria because this is very definite criteria and these problems end up being really easy because they have to use very specific vocabulary in the problems when they give it to you, whether you're going to record a liability or a disclosure or do nothing at all. So we have 2 criteria here. The first one is the likelihood of payment. So the likelihood that you're going to have to pay out some money, the most common is with a lawsuit and you're going to end up losing the lawsuit and having to pay some money out. So what's the likelihood of payment? Well we've got 3 different categories. We've got probable. It's probable that we're going to pay out money and that's when it's likely to occur, right? It's probable, it's likely to occur. Then there's reasonably possible and that's somewhere in the middle between probable and remote. Where remote is that the chance is slight. It's a remote chance, right? So we have these very definitive words and you're going to see when you have problems about contingent liabilities, they're going to use this very specific vocabulary. Probable, reasonably possible and remote, okay? So that's the likelihood of payment, but then there's also the ability to estimate the amount of the payment, okay? So we might know that we're going to pay out some money, but we might not be sure how much that money is yet, right? Maybe the lawsuit there's a chance we'll end up paying out a $1,000,000 but it could actually only be like $200,000 or some different amount of money. Well, that's why we have this estimating quality as well. So we're either going to know the amount that we're going to have to pay out or reasonably estimate that amount or we're not going to be able to estimate it at all, right? So those are the 2 categories. If we know or could reasonably estimate or if we can't estimate at all, okay? So let's see what happens with these two criteria in the different categories. So the most the time that we accrue liability, there's only one time we accrue a liability. And that's when the payment is probable, so there's a high chance that we're going to pay out like lose this lawsuit and we're going to have to pay out some money, so if it's probable and we can reasonably estimate or we know the amount, we're going to accrue a liability. Okay? So if we know it's probable that we're going to have to pay out $1,000,000 in this lawsuit, well we're going to have a liability. We're going to take legal expense for a $1,000,000 and we're going to have a liability on our balance sheet for that $1,000,000 that we're accruing. Now not only do we accrue a liability, but we disclose it in the footnotes. We give a little more information. We're going to have this liability, this contingent liability and then we're going to say in the footnotes a little more information about it. Now this is pretty easy. This is why these problems are so easy because this is the only situation where we accrue liability is when it's probable and at least reasonably possible to estimate the amount. If we can't reasonably estimate but we know we're going to have some payout, well we're going to disclose it in the footnotes, okay? We still disclose it in the footnotes when it's probable, but we can't reasonably estimate the amount, okay? Now when it's reasonably possible, so this is somewhere in the middle between probable and remote that we're going to lose the lawsuit or something, we're not entirely sure yet. Well, we disclose in the footnotes and that's in both cases, if we can estimate or not estimate, it's just a disclosure. So we disclose in the footnotes and that's in both cases. So it doesn't matter if we can estimate it or not, we're gonna give the the users of the financial statements the information that we do know, okay? And then if the payment is remote, so maybe it's a lawsuit that just started and there's gonna be a long legal battle and we don't really know what's gonna happen. Well, we don't have to say anything. We don't do anything in that case, Okay? So the big thing here is to be able to basically memorize these terms and just the main thing to remember is if it's probable and reasonably possible that we're gonna be able that this is gonna happen, well, that's when we accrue a liability. Okay? So this is the only case where we accrue a liability is in this box up here. Otherwise, it's disclosures and when you think, hey, it's remote, it's a remote chance it's going to happen. Well, it's why would we accrue something that we don't actually expect to happen. Okay? That's why we do nothing in that case. Alright? So let's do a quick practice problem about contingent liabilities and you'll see how discreet they are with this vocabulary that they use it explicitly. Alright? Let's go ahead and pause here and then we'll do a practice problem.

Sumsang designs and sells smartphones for personal and commercial use. During the current year, the product engineers notified management of a flaw in the design that could cause the latest model to spontaneously combust. After a further investigation, it was noted that a product recall was probable, with an estimated cost to the company of $2,500,000. What influence might this information have on the current year financial statements?

• A. The company should accrue a liability for the entire $2,500,000
• B. The company should accrue a liability for an amount less than $2,500,000
• C. The company should disclose information about this contingency in the notes to the financial statement
• D. The company does not need to accrue a liability or disclose in the footnotes until the actual payments occur
• E. Both (a) and (c)
• F. Both (b) an (c)

Here’s what students ask on this topic:

What are contingent liabilities and how are they recorded in financial statements?

Contingent liabilities are potential obligations that may arise from past events, depending on the outcome of future events. They are recorded in financial statements based on the likelihood of the event occurring and the ability to estimate the amount. If the liability is probable and the amount can be reasonably estimated, it is accrued and recorded on the balance sheet. If the liability is reasonably possible but not probable, it is disclosed in the footnotes. If the likelihood is remote, no action is taken. This approach ensures transparency and provides investors with relevant information.

What is the difference between contingent gains and contingent liabilities?

Contingent gains and contingent liabilities both involve uncertain future events, but they are treated differently in accounting. Contingent gains are potential future inflows of economic benefits, such as winning a lawsuit. They are not recorded until they are realized, reflecting a conservative approach. On the other hand, contingent liabilities are potential future outflows, such as losing a lawsuit. If the liability is probable and can be estimated, it is accrued and recorded. If it is reasonably possible, it is disclosed in the footnotes. This ensures that potential losses are communicated to investors, while potential gains are only recognized when certain.

When should a contingent liability be disclosed in the footnotes of financial statements?

A contingent liability should be disclosed in the footnotes of financial statements if the likelihood of the event occurring is reasonably possible or probable but the amount cannot be reasonably estimated. Disclosure in the footnotes provides additional information to investors and other users of the financial statements about potential risks and uncertainties. This helps maintain transparency and allows stakeholders to make informed decisions based on the potential impact of these uncertainties on the company's financial position.

How do the terms 'probable,' 'reasonably possible,' and 'remote' affect the treatment of contingent liabilities?

The terms 'probable,' 'reasonably possible,' and 'remote' are used to assess the likelihood of a contingent liability occurring and determine its treatment in financial statements. If an event is 'probable' and the amount can be reasonably estimated, the liability is accrued and recorded. If it is 'reasonably possible,' it is disclosed in the footnotes, regardless of whether the amount can be estimated. If the likelihood is 'remote,' no action is taken. These terms help ensure that potential liabilities are appropriately communicated to stakeholders, maintaining transparency and accuracy in financial reporting.

Why are contingent gains not recorded until they are realized?

Contingent gains are not recorded until they are realized to maintain a conservative approach in accounting. This principle ensures that financial statements do not overstate the company's financial position by recognizing potential gains that may never materialize. By waiting until the gain is certain, the financial statements provide a more accurate and reliable representation of the company's financial health. This approach helps prevent misleading information and ensures that investors and other stakeholders can make informed decisions based on actual, rather than potential, financial outcomes.