Contingent liabilities are liabilities whose outcome is contingent on the outcome of an uncertain event. These duties will very certainly become liabilities in the future.
Before contingent liabilities can be reported in financial statements, they must meet two criteria. First, the value of the contingent liability must be estimable.
If the value is estimable, the liability must have a greater than 50% likelihood of being realised. Qualifying contingent liabilities are recognised on the income statement as an expense and on the balance sheet as a liability.
The obligation should not be represented on the balance sheet if the contingent loss is remote, which means it has less than a 50% chance of occurring. Any contingent liabilities that are in doubt before their value can be assessed should be stated in the financial statements’ footnotes.
A company warranty and a lawsuit against the firm are two classic instances of contingent liabilities. Both indicate potential losses for the company and are dependent on some unforeseeable future event.
Contingent liabilities are recorded as journal entries even if they have not yet been realised. It necessitates crediting the accrued liability account and debiting an expense account. When the obligation is met, the liabilities account on the balance sheet is debited and the cash account is credited. In addition, an item is made in the income statement’s corresponding expense.
Companies in the United States rely on the guidelines set out in generally accepted accounting principles (GAAP). A contingent liability is defined as any potential future loss that is dependent on a “triggering event” to become an actual expense under GAAP. It is critical to advise shareholders and lenders about potential losses—an otherwise sensible investment may appear dumb after an undisclosed contingent obligation is realised.
There are three types of contingent liabilities defined by GAAP: probable, feasible, and remote. Probable contingencies are likely to occur and may be assessed realistically. Possible contingencies do not have a greater-than-no possibility of being realised, but they are also not necessarily regarded as implausible. Remote contingencies are unlikely to occur and are only theoretically plausible.
Complicated contingent accounting calculations can be complicated and inaccurate. Management should consult experts or study past accounting problems before making choices. If audited, the company must explain and justify its contingent accounting decisions.
There are no exceptions: any possible contingency must be included in the financial accounts. There should never be any remote contingencies considered. Possible contingencies—those that are neither probable nor remote—should be included in the financial statements’ footnotes.
What Are the GAAP Accounting Rules for Contingent Liabilities?
According to GAAP, probable contingent liabilities are those that can be calculated and are likely to materialise. Contingent liabilities that are probable but not estimable should be noted in the footnotes. Remote (unlikely) contingent liabilities are not to be reported.
The Bottom Line
Contingent liabilities are expected to be realised if certain events occur. Probable and estimable liabilities are those that are likely to occur. Contingent liabilities must be recognised in a company’s financial statements if they can be estimated and are more likely to materialise. To get information on what is a debit note and a credit note, click here!
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