A contingent liability is a liability or a potential loss that may occur in the future depending on the outcome of a specific event.
A contingent liability is recorded if the contingency is likely and the amount of the liability can be reasonably estimated.
If the amount can be estimated, the company sets aside that amount separately to be paid out when the liability arises. Contingent liability as a term does not apply only to companies, but to individuals as well.
Suppose a company might be in the middle of a lawsuit and your lawyer thinks that the other party has a strong case which could potentially lead to damages worth Rs 500000.
In that case, the company would book that amount as contingent liability on its balance sheet.
On the other hand, if the lawyer or the legal department thinks that the other party does not have a very strong case in hand. They would advise the firm not to make any provision of a contingent liability.
When the probability of a contingent liability is low then is no disclosure is required in the books of accounts.
Accounting Rules for Contingent Liability
- A contingent liability should not itself be recognized in the statement of financial position.
- A contingent liability should be disclosed only under notes to financial statements unless the possibilities of a transfer of economic benefits are remote.
Example of contigent liabilities
contingent liabilities example
- Guarantees and counter guarantees are given by a company..
- Product warranty.
- Shareholders guarantee.
- Letter of credit issued.
- Potential adverse judgment (cases regarding any financial dispute).
When to Recognize a Contingent Liability?
Under this scenario, contingent Liability is recorded only when it is probable that the loss will occur, and you can reasonably estimate the amount of loss. Here, “Probable” means that the future event is likely to occur.
Therefore, it is also important to describe the liability in the footnotes that accompany the financial statements.
Here, contingent liabilities are recognized only when the liability is reasonably possible to estimate and not probable.
Here, “Reasonably possible” means that the chance for occurrence of an event is more than remote but less than likely.
To further simplify, the loss due to future events is not likely to happen but not necessarily be considered as unlikely. It could be a situation where the liability is probable, but the amount couldn’t be estimated.
Under this situation, the preparers of financial statements should disclose the existence of contingent Liability in the notes accompanying such financial statements
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.
Journal entry for contingent liability
Taking the example lawsuit filed on X company where company violating rules. customer file a lawsuit of Rs. 3000000 and in final judgment company pay Rs 1000000 to its customer.
The lawsuit was considered as a contingent liability in the
Prepare journal entries for the year ending 2021, assuming
it is probable that X company will be liable to pay an amount of Rs 2000000
Prepare journal entries for the year ending 2021, assuming it is not probable that X company will be liable to pay any amount.
Considering no other pending lawsuits prepare journal entries for the year ending 2021, where X Company lost the lawsuit and has to pay Rs 1000000.
#1 – The Amount is Estimated, and the likelihood of Occurrence is High
Contingent Liabilities Example 1
Lawsuit loss A/c dr
To law suit liability
#2 – The Probability of Occurrence is Very Less or Nil
Journal entries will not be passed. The loss is not accrued because it is not probable that liability will arise soon.
Full disclosure should be made in the footnotes of the financial statements because liability might not arise shortly, but there is a possibility of its occurrence in later years.
#3 – Payment of Lost Lawsuit
Lawsuit liability dr
To cash A/c