The deposit ensures future economic benefits, either through a cash refund or settling the liability. Nonetheless, this agenda decision shouldn’t be generalised to regular legal proceedings where, facing an adverse verdict, an entity doesn’t retain any assets. In such instances, the ‘virtually certain’ threshold is applicable before a disputed asset can be recognised. As you’ve learned, not only are warranty expense and warranty liability journalized, but they are also recognized on the income statement and balance sheet. The following examples show recognition of Warranty Expense on the income statement Figure 12.10 and Warranty Liability on the balance sheet Figure 12.11 for Sierra Sports.
Everything You Need To Build Your Accounting Skills
At the end of the year, the accounts are adjusted for the actual warranty expense incurred. In the day to day business, we can encounter some transactions whose final outcome will not be known. Some of the examples of such transactions can be insurance claims, oil spills, lawsuits. All these create a liability for the company and liabilities that are created in such situations are known as contingent liabilities. To further simplify, the loss due to future events is not likely to happen but not necessarily be considered as unlikely.
- An example is litigation against the entity when it is uncertain whether the entity has committed an act of wrongdoing and when it is not probable that settlement will be needed.
- If the liability arises, it would negatively impact the company’s ability to repay debt.
- The liability won’t significantly affect the stock price if investors believe the company has strong and stable cash flows and can withstand the damage.
- There is a probability that someone who purchased the soccer goal may bring it in to have the screws replaced.
What are examples of contingent liability?
Moreover, if the likelihood of an economic benefit inflow increases to the level of probability, the entity is required to disclose the contingent asset (IAS 37.35). While a contingency may be positive or negative, we only focus on outcomes that may produce a liability for the company (negative outcome), since these might lead to adjustments in the financial statements in certain cases. Positive contingencies do not require or allow the same types of adjustments to the company’s contingent liabilities financial statements as do negative contingencies, since accounting standards do not permit positive contingencies to be recorded. Disclose the existence of a contingent liability in the notes accompanying the financial statements if the liability is reasonably possible but not probable, or if the liability is probable, but you cannot estimate the amount. “Reasonably possible” means that the chance of the event occurring is more than remote but less than likely.
Examples of Contingent liabilities
This amount could be a reasonable estimate for the parts repair cost per soccer goal. Since not all warranties may be honored (warranty expired), the company needs to make a reasonable https://www.bookstime.com/ determination for the amount of honored warranties to get a more accurate figure. The measurement requirement refers to the company’s ability to reasonably estimate the amount of loss.
- The outcome of the lawsuit has yet to be determined but could have negative future impact on the business.
- An entity must recognize a contingent liability when both (1) it is probable that a loss has been incurred and (2) the amount of the loss is reasonably estimable.
- Sierra Sports notices that some of its soccer goals have rusted screws that require replacement, but they have already sold goals with this problem to customers.
- Since there is a past precedent for lawsuits of this nature but no establishment of guilt or formal arrangement of damages or timeline, the likelihood of occurrence is reasonably possible.
- At the end of the year, the accounts are adjusted for the actual warranty expense incurred.
Standards and frameworks
In our case, we make assumptions about Sierra Sports and build our discussion on the estimated experiences. If a company is sued by a former employee for $500,000 for age discrimination, the company has a contingent liability. However, if the company is not found guilty, the company will not have any liability. The nature of contingent liability is important for deciding whether it is good or bad. Liabilities are related to the financial obligations or debts that a person or a company has to another entity. There are numerous different categories of liabilities, each with special characteristics and implications for the creditor and debtor.