You probably know your company’s liabilities, aka debts your business owes. But how often do you think about liabilities that you may or may not have, depending on the outcome of a future event?
These potential financial obligations are known as contingent liabilities. Examples of contingent liabilities include lawsuits, product warranties, and pending audits.
Understand your contingent liabilities for better financial planning, increased transparency, and generally accepted accounting practices (GAAP) compliance. Read on for the scoop.
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- What is a contingent liability?
- Do you need to record a contingent liability in your books?
- Why do contingent liabilities matter?
- Examples of contingent liabilities
- A quick guide to recording contingent liabilities
What is a contingent liability?
Liabilities are existing debts that your business owes to another business, organization, vendor, employee, or government agency. Contingent liabilities are liabilities you may incur, depending on a future event’s outcome, like a pending lawsuit.
There are three categories of contingent liabilities:
- Probable contingent liabilities: Likely to occur, and you can reasonably estimate the amount. Include these liabilities in your financial statements for GAAP compliance.
- Possible contingent liabilities: As likely to occur as not. Include these liabilities as a footnote in your financial statements.
- Remote contingent liabilities: Very unlikely to occur (less than 50% change). You do not need to include these liabilities in your financial statements.
Depending on the category, your contingent liabilities might affect your company’s profitability. Know your contingent liabilities and their category to make informed decisions. And, you may need to inform investors, lenders, and creditors of your contingent liabilities so they get a full picture of your company’s health.
Do you need to record a contingent liability in your books?
Again, there are three categories of contingent liabilities: 1) Probable, 2) Possible, and 3) Remote. Depending on its category, you may need to record a contingent liability in your books and financial statements to comply with generally accepted accounting principles.
You must follow GAAP’s rules, standards, and procedures if you own a publicly traded business or plan to go public someday. You might also want to follow GAAP even if your business is private to help you understand your financial health and spot inconsistencies.
Generally accepted accounting practices require that you disclose contingent liabilities in your financial statements if the liability meets two requirements:
- A contingent liability is probably likely
- You can reasonably estimate the amount of loss
Contingent liabilities must be recorded if they’re probably or possible. Include probable contingent liabilities in your financial statements. Include possible contingent liabilities in financial statement footnotes.
Why do contingent liabilities matter?
Disclose your contingent liabilities for compliance, informed decision-making, risk management, and transparency.
Here’s a closer look at why contingent liabilities matter:
- GAAP compliance: Record your contingent liabilities to comply with generally accepted accounting principles.
- Decision-making: A budget is a company’s roadmap for spending. Include all your likely liabilities—including probable contingent liabilities—in your budget for accurate financial planning and resource allocation.
- Full financial picture: Lenders, investors, creditors, and other stakeholders need to know the ins and outs of your business to decide lending terms, credit limits, etc.
Examples of contingent liabilities
There are several examples of contingent liabilities, including:
- Lawsuits
- Product warranties
- Guarantees
- Pending audits
- Disputed tax liabilities
1. Lawsuits as a contingent liability
A lawsuit from a customer, an employee, or a competitor is one of the most common examples of contingent liabilities.
Depending on the lawsuit outcome, your business may or may not need to pay to settle the liability. Generally, you can estimate the amount of the contingent liability.
2. Product warranties as a contingent liability
Do you offer a product warranty on any of your goods? Product warranties are contingent liabilities because you may need to repair or replace the product.
Let’s say you offer a two-year warranty on all TVs that you sell. You should account for the potential costs of these repairs and replacements.
3. Guarantees as a contingent liability
Have you ever guaranteed the debt of another entity? You must fulfill the debt obligation if the primary debtor defaults. As a result, guarantees are contingent liabilities.
4. Pending audits as a contingent liability
If you get audited by the IRS or another regulatory body, you may owe penalties or fines depending on the audit findings.
Pending audits are contingent liabilities because you may or may not incur a debt.
5. Disputed tax liabilities as a contingent liability
A disputed tax liability is another example of a contingent liability. For example, you might contest a tax assessment. Whether you need to pay the assessment depends on the future outcome of the dispute.
A quick guide to recording contingent liabilities
So, what are your responsibilities when it comes to contingent liabilities? Here’s a quick list of steps you can take to determine whether you need to include contingent liabilities in your statements.
You should:
- Identify the contingent liability (e.g., lawsuit, product warranty, etc.)
- Determine the likelihood of occurrence (probable, possible, or remote)
- Estimate the liability (how much will it cost to settle the liability?)
- Record in your financial statements as a liability (if applicable)
We get it—recordkeeping and generating financial statements is tricky and time-consuming. Track your expenses, income, and money with Patriot’s online accounting software. You can generate financial statements in just a few clicks to share with your accountant and other stakeholders.
This is not intended as legal advice; for more information, please click here.