A contingent liability is an obligation of business related to an uncertain future event. The business must record it in its financial statements if the amount can be reliably estimated and it is probable that amount will be paid by business as a result of the occurrence of an uncertain future event.
Define contingent liabilities
By definition, a contingent liability is a possible obligation depending on whether some uncertain future event occurs, or a present obligation but payment is not probable or the amount cannot be measured reliably.
FASB contingent liabilities
The above ruling is given by FASB/ IAS 37/ IFRS. They have described the contingent liabilities as obligations are either probable or possible. In case of probable, if the amount is reliably measurable, the liability should be recorded on the reporting date. If either the payment is not reliably measurable or the occurrence of an event is possible or remote, only disclosure to financial statements is required.
GAAP contingent liabilities
GAAP understanding of contingent liability is also the same as of IFRS. As per GAAP, there are three levels of assessing the cost payable associated with an uncertain future event, i.e.; high, moderate and low probability. High probability is described that a liability will be recorded as both of the criteria that payment is a probable and reliable measurement of cost is met. Under the moderate approach, the disclosure is required when either of the above criteria does not meet. And finally, under low probability approach, no liability is recorded or disclosure is required if neither the payment is probable nor the estimation is reliable.
Contingent liabilities current or noncurrent
A contingent liability can be recorded both as a current or noncurrent liability. If it is probable that a reasonably estimated payment will be made in less than one year, it is a current liability. If the probable payment will take more than on years, then it is a noncurrent liability.
Examples of contingent liabilities
Common examples are litigation suit resulting in a probable payment by the losing party, warranties of repairs or returns or customer refunds.
Recording contingent liabilities
Consider a company has been sued for copyrights infringement and the legal department of the company has confirmed that it is highly probable that the company will lose the case in next two hearings. A reliable estimate of the settlement amount is decided as $5 Million. The rules are explained above for both IFRS and GAAP approaches and for recording contingent liability the following journal entry is passed.
At the time of recording Liability
Legal Expense Account ------------------------- (DEBIT) $5,000,000
Accrued Liability Account--------------------------- (CREDIT) $5,000,000
At the time of Payment of Liability
Accrued Liability Account---------------------- (DEBIT) $5,000,000
Cash Account--------------------------------------- (CREDIT) $5,000,000
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