A contingency occurs when a current situation has an outcome that is unknown or uncertain and will not be resolved until a future point in time. A contingent liability can produce a future debt or negative obligation for the company. Some examples of contingent liabilities include pending litigation (legal action), warranties, customer insurance claims, and bankruptcy. Assume that Sierra Sports is sued by one of the customers whopurchased the faulty soccer goals.

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Liquidity measures evaluate a company’sability to pay assets = liabilities + equity current debts as they come due, while solvencymeasures evaluate the ability to pay debts long term. One commonliquidity measure is the current ratio, and a higher ratio ispreferred over a lower one. This ratio—current assets divided bycurrent liabilities—is lowered by an increase in currentliabilities (the denominator increases while we assume that thenumerator remains the same). When lenders arrange loans with theircorporate customers, limits are typically set on how low certainliquidity ratios (such as the current ratio) can go before the bankcan demand that the loan be repaid immediately. Another way to establish the warranty liability could be anestimation of honored warranties as a percentage of sales. In thisinstance, Sierra could estimate warranty claims at 10% of itssoccer goal sales.

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• The company should report a contingent liability equal to probable damages if a court is likely to rule in favor of the plaintiff either because there’s strong evidence of wrongdoing or some other contributing factor.
• A future sacrifice of an economic benefit is probable.The future sacrifice arises from a present obligation.The obligation results from a past event.
• For instance, if new evidence in a lawsuit makes a favorable outcome more likely, the financial statements may need to be updated in future accounting periods.
• Liquidity measures evaluate a company’s ability to pay current debts as they come due, while solvency measures evaluate the ability to pay debts long term.
• Instead, contingent liabilities are disclosed in the notes to the financial statements if the potential obligation is reasonably possible.

Contingent Liability: Understanding Its Impact on Financial Statements

To simplify our example, we concentrate strictly on the journal entries for the warranty expense recognition and the application of the warranty repair pool. If the company sells 500 goals in 2019 and 5% need to be repaired, then 25 goals will be repaired at an average cost of $200. The average cost of $200 × 25 goals gives an anticipated future repair cost of $5,000 for 2019. Assume for the sake of our example that in 2020 Sierra Sports made repairs that cost $2,800. Following are the necessary law firm chart of accounts journal entries to record the expense in 2019 and the repairs in 2020.

Four Potential Treatments for Contingent Liabilities

• If the contingencies do occur, it may stillbe uncertain when they will come to fruition, or the financialimplications.
• However, some companies may be reluctant to recognize contingent liabilities because they lower earnings and increase liabilities, potentially raising a red flag for stakeholders.
• Conversely, if the buyer assumes these liabilities, they may negotiate a lower price or require a larger percentage of the purchase price be held in escrow until potential liabilities are resolved.
• A contingent liability is a liability that may occur depending on the outcome of an uncertain future event.
• The existence of the liability is uncertain and usually, the amount is uncertain because contingent liabilities depend (or are contingent) on some future event occurring or not occurring.
• The disclosure requirements for contingent liabilities are set forth in accounting standards.

The amount of the loss can be reasonably estimated.It is probable that a future loss will occur. Establishing protocols and controls is another savvy strategy for dealing with these liabilities. Companies should put up policies to prevent or even limit the occurrence of triggering events.

Impact on Business Valuation

Usually have a lower interest rate than long-term debt.are frequently used by large corporations as a significant component of capital structure. The sale of accounts receivables to obtain short-term financing is referred to as ______ receivables. They are unsecured notes.They are often purchased by other companies as investments.They have minimum denominations of $25,000. When accounts receivable serve as collateral for a loan, we refer to the arrangement as ______ accounts receivable. Jones Company signs a $15,000, 12-month note and receives $14,250 from the bank.

• Generally, the amount of these liabilities must be estimated; the actual amount cannot be determined until the event that confirms the liability occurs.
• In summary, contingent liabilities and actual liabilities differ not only in their state of certainty but also in the way they’re treated in financial reporting.
• Working through the vagaries of contingent accounting is sometimes challenging and inexact.
• In such scenarios, until a resolution is achieved, the business needs to report this as a contingent liability.
• They could be lawsuits, warranty claims, product liabilities, environmental cleanup costs, or any unforeseen expenses that may arise in the future.

Another way to establish the warranty liability could be an estimation of honored warranties as a percentage of sales. In this instance, Sierra could estimate warranty claims at 10% of its soccer goal sales. The measurement requirement refers to the company’s ability to reasonably estimate the amount of loss. Even though a reasonable estimate is the company’s best guess, it should not be a frivolous number. For a financial figure to be reasonably estimated, it could be based on past experience or industry standards (see Figure 12.9). For example, Sierra Sports has a one-year warranty on part repairs and replacements for a soccer goal they sell.

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The measurement requirement refers to thecompany’s ability to reasonably estimate the amount of loss. Eventhough a reasonable estimate is the company’s best guess, it shouldnot be a frivolous number. For a financial figure to be reasonablyestimated, it could be based on past experience or industrystandards (see Figure 12.9). While a contingency may be positive or negative, we only focuson outcomes that may produce a liability for the company (negativeoutcome), since these might lead to adjustments in the financialstatements in certain cases. Positive contingencies do not requireor allow the same types of adjustments to the company’s financialstatements as do negative contingencies, since accounting standardsdo not permit positive contingencies to be recorded.

Implication of Contingent Liabilities on Financial Statements

This disclosure should include the nature of the contingent liability, an estimate of the potential loss, and any significant factors that may affect the final outcome. Sierra Sports may have more litigation in the future surroundingthe soccer goals. These lawsuits have not yet been filed or are inthe very early stages of the litigation process. Since there is apast precedent for lawsuits of this nature but no establishment ofguilt or formal arrangement of damages or timeline, the likelihoodof occurrence is reasonably possible. Since a contingent liability that is probable and for which the dollar amount can be estimated should be the outcome is possible, thecontingent liability is disclosed in Sierra Sports’ financialstatement notes. If the contingent liability is probable andinestimable, it is likely to occur but cannot bereasonably estimated.