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.

1. Judicious use of a wide variety of techniques for the valuation of liabilities and risk weighting may be required in large companies with multiple lines of business.
2. Examples of contingent liabilities are the outcome of a lawsuit, a government investigation, or the threat of expropriation.
3. A contingent liability can produce a future debt or negative obligation for the company.
4. The recognition of contingent liabilities on the financial statements (and footnotes) is to present investors, lenders, and others with reliable financial statements that contain accurate, conservative information.
5. In the case of possible contingencies, commentary is necessary on the liabilities in the footnotes section of the financial filings to disclose the risk to existing and potential investors.
6. Such contingency is neither recorded on the financial statements nor disclosed to the investors by the management.

Instead, only disclose the existence of the contingent liability, unless the possibility of payment is remote. There are three possible scenarios for contingent liabilities, all of which involve different accounting transactions. According to the FASB, if there is a probable liability determination before the preparation of financial statements has occurred, there is a likelihood of occurrence, and the liability must be disclosed and recognized.

Measurement of provisions

A “medium probability” contingency is one that satisfies either, but not both, of the parameters of a high probability contingency. These liabilities must be disclosed in the footnotes of the financial statements if either of the two criteria is true. The determination of whether a contingency is probable is based on the judgment of auditors and management in both situations. This means a contingent situation such as a lawsuit might be accrued under IFRS but not accrued under US GAAP. Finally, how a loss contingency is measured varies between the two options as well.

Possible Contingency

Contingent liabilities are recorded on the P&L statement and the balance sheet if the probability of occurrence is more than 50%. A possible contingency is when the event might or might not happen, but the chances are less than that of a probable contingency, i.e., less than 50%. This liability is not required to be recorded in the books of accounts, but a disclosure might be preferred. IAS 37 defines and specifies the accounting for and disclosure of provisions, contingent liabilities, and contingent assets. A contingent liability that is expected to be settled in the near future is more likely to impact a company’s share price than one that is not expected to be settled for several years. Often, the longer the span of time it takes for a contingent liability to be settled, the less likely that it will become an actual liability.

How Contingent Liabilities Work

Some industries have such a large number of transactions and a vast data bank of past warranty claims that they have an easier time estimating potential warranty claims, while other companies have a harder time estimating future contingent liabilities claims. In our case, we make assumptions about Sierra Sports and build our discussion on the estimated experiences. Warranties arise from products or services sold to customers that cover certain defects (see Figure 12.8).

The journal entry for a contingent liability—as illustrated below—is a credit entry to the contingent warranty liability account and a debit entry to the warranty expense account. Some common examples of contingent liabilities are pending lawsuits and product warranties because each scenario is characterized by uncertainty, yet still poses a credible threat. If the contingency is deemed probable with a reasonably estimated amount, it is recorded in a financial statement. However, suppose neither of those conditions can be met—then, the contingent liability could be inserted in the footnote of a financial statement (or leftover if immaterial). A warranty is considered contingent because the number of products that will be returned under a warranty is unknown. A warranty is another common contingent liability because the number of products returned under a warranty is unknown.

Do not record or disclose the contingent liability if the probability of its occurrence is remote. Even though they are only estimates, due to their high probability, contingent liabilities classified as probable are considered real. This is why they need to be reported via accounting procedures, and why they are regarded as “real” liabilities. 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. A probable contingent liability that can be reasonably estimated is entered into the accounts even if the precise amount cannot be known.