Definition
A contingent liability is a potential obligation that may become an actual liability depending on the outcome of a future uncertain event (for example, the result of a lawsuit or the number of product returns under warranty). It is recorded in a company’s accounting records only when the obligation is likely to occur and its amount can be reasonably estimated. Otherwise it is usually disclosed in the financial-statement footnotes or ignored if deemed remote.
Key takeaways
– Contingent liabilities reflect possible future claims on a company’s resources; they affect users’ view of future cash flows.
– Accounting frameworks (GAAP and IFRS) require recognition when an outflow is probable and measurable; otherwise, disclose or omit depending on likelihood.
– Common examples: pending litigation, product warranties, environmental cleanup obligations, and guarantees.
– Probability categories typically used: probable (must record if estimable), possible (disclose in notes), remote (no disclosure required).
How contingent liabilities work (mechanics)
1. Identify the triggering event or condition (e.g., lawsuit filed, warranty offered).
2. Assess the likelihood that the obligation will materialize.
– Probable: the event is more likely than not.
– Possible: occurrence is neither likely nor unlikely (about as likely as not).
– Remote: occurrence is very unlikely.
3. Determine whether the amount can be reasonably estimated.
4. Apply the accounting treatment:
– Probable and estimable: record a liability and a corresponding expense (accrual).
– Possible or not reasonably estimable: disclose the nature and, if possible, range of possible loss in the footnotes.
– Remote: usually no recognition or disclosure.
5. Update the assessment each reporting period; adjust recorded amounts or disclosures as new information arrives.
Recognition checklist (for accountants and managers)
– Have you identified all events or commitments that might create future obligations?
– For each item, classify the likelihood: probable / possible / remote.
– Can you reasonably estimate the amount? If yes, compute the best estimate or a range.
– If probable and estimable: prepare a journal entry to record the liability and expense.
– If possible (but not probable) or not estimable: prepare a clear footnote disclosure describing the contingency and any ranges.
– If remote: document the rationale for treating it as remote.
– Reassess and update at each reporting date; disclose any material changes.
Worked numeric example — lawsuit
Scenario: A company is sued for patent infringement. Legal counsel believes it is likely the company will lose, and the
best estimate of damages is $2.0 million; counsel gives a range of $1.5–$2.5 million. Under typical accounting guidance (US GAAP ASC 450 and IFRS IAS 37), this situation is “probable” and “estimable,” so the company should record a liability for the best estimate and disclose the nature of the contingency and the range.
Worked numeric entries (probable and estimable)
1) Initial recognition (assume company records the best estimate of $2,000,000)
– Journal entry on recognition date:
– Dr Litigation expense (or Loss from lawsuit) $2,000,000
– Cr Accrued litigation liability $2,000,000
– Balance sheet effect: liabilities ↑ $2,000,000; equity ↓ (via expense) $2,000,000.
– Income statement: records $2,000,000 expense in the period the loss becomes probable and estimable.
2) Footnote disclosure (example wording)
– “The
The “The” footnote disclosure (example wording) — complete text
– “The Company is a defendant in litigation related to [brief description of claim]. Management, with counsel, believes that loss is probable and has recorded a liability of $2,000,000 based on the best estimate of the obligation. Counsel’s estimated loss range is $1,500,000 to $2,500,000. The ultimate outcome and timing are inherently uncertain and could result in a payment within that range. Any insurance recoveries are subject to approval by the insurer and are not recognized until realization is probable. The Company
The Company currently believes that the ultimate resolution will be within the range above and that any insurance recoveries are subject to the insurer’s approval; accordingly, no insurance receivable has been recognized in the financial statements at this time. Management will continue to monitor developments and will update the recorded liability and related disclosures as additional information becomes available.
Recognition and measurement — practical rules (U.S. GAAP and IFRS)
– U.S. GAAP (ASC 450, Contingencies)
– Recognize (accrue) a liability and record an expense when a loss is both probable (likely to occur) and the amount can be reasonably estimated.
– If a loss is probable but the amount cannot be reasonably estimated, disclose the nature of the contingency and, if possible, provide an estimated range.
– If a loss is only reasonably possible (less than probable but more than remote), disclose the nature and estimate of loss or range.
– If a loss is remote, no disclosure is typically required.
– When a range of loss is reported and no amount within the range is a better estimate, recognize the minimum amount in the range (ASC 450 guidance).
– IFRS (IAS 37, Provisions, Contingent Liabilities and Contingent Assets)
– Recognize a provision (liability) when: (a) an entity has a present obligation as a result of a past event, (b) it is probable (more likely than not) that an outflow of resources will be required, and (c) a reliable estimate can be made.
– If a reliable estimate cannot be made, disclose the contingency instead.
– When a range of outcomes exists under IFRS, management should use its best estimate; when no single amount is a better estimate, the mid-point or an expected value approach may be used depending on which better reflects the obligation (IAS 37 requires judgement).
– Contingent assets (possible assets arising from past events) are not recognized; they are disclosed only when inflow of economic benefits is probable.
Worked numeric example (simple)
– Facts: Company records a best estimate loss of $2,000,000 for litigation (cited in the footnote), insurer approval is uncertain.
– Initial recording (when loss is probable and estimable):
– Dr Litigation expense (income statement) $2,000,000
– Cr Accrued litigation liability (balance sheet) $2,000,000
– Effect: Equity decreases by $2,000,000 (via expense); liabilities increase by $2,000,000.
– Subsequent settlement and insurance recovery example:
– If Company settles for $2,200,000 in cash:
– Dr Accrued litigation liability $2,000,000
– Dr Litigation expense (or other loss) $200,000
– Cr Cash $2,200,000
– If, after settlement, insurer formally accepts coverage and pays $1,500,000 (and recovery is now considered probable):
– Dr Insurance receivable $1,500,000
– Cr Litigation expense (or other income) $1,500,000
– Net economic effect: cash outflow remains $700,000 net of insurance (2,200,000 − 1,500
,000 = $700,000).
Final journal entries and net effect (complete)
– At initial recognition (probable, estimable loss of $2,000,000):
– Dr Litigation expense $2,000,000
– Cr Accrued litigation liability $2,000,000
– On cash settlement of $2,200,000:
– Dr Accrued litigation liability $2,000,000
– Dr Litigation expense (additional loss) $200,000
– Cr Cash $2,200,000
– When insurer formally accepts coverage and pays $1,500,000 (recovery now probable/collectible):
– Dr Insurance receivable $1,500,000
– Cr Litigation expense (or other income) $1,500,000
Net economic/financial statement effect after all events:
– Cash outflow: $2,200,000 paid − $1,500,000 received = $700,000 net cash outflow.
– Net expense recognized in income statement: $700,000 (original $2,200,000 expense offset by $1,500,000 insurance recovery recognized when receivable recorded).
– Balance sheet: liability eliminated (paid), insurance receivable extinguished when cash is collected; equity reflects net expense of $700,000.
Key accounting rules (practical summary)
– US GAAP (ASC 450 — Contingencies)
– Recognize (record) a contingent liability when a loss is both probable (likely to occur) and the amount can be reasonably estimated.
– If loss is reasonably possible (less