- Pages: 5
- Word count: 1027
- Category: College Example Economics
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A potential liability dependent upon some future event occurring or not occurring. For example, a company is named as a defendant in a $1 million lawsuit. Does that mean the company automatically has a liability of $1 million? What if the lawsuit has no merit and can easily be defended? If it is probable that the company will lose and the amount can be estimated, a journal entry is prepared to debit Loss from Lawsuit and to credit Lawsuit Payable. If it is possible but not probable that the company will lose, the journal entry is not made but instead there will be a footnote disclosure. If the lawsuit is remote (a nuisance suit without any merit), there is no need for a journal entry and no need to disclose the lawsuit. Accountants usually consider product warranties to be a contingent liability that is both probable and can be estimated and is therefore recorded with a journal entry. What is the difference between a contingent liability and an estimated liability? A contingent liability is a potential liability (and a potential loss).
It is dependent upon a future event occurring or not occurring. For instance, if someone files a lawsuit against Jay Corp, Jay Corp will have a contingent liability. The lawsuit liability is dependent upon Jay Corp losing the lawsuit. (Some lawsuits are nuisance suits and will not cause a loss and liability.) When a contingent liability and loss are probable and the amount can be estimated, an estimated amount will be recorded as a liability. Some liabilities are not contingent liabilities but are estimated liabilities. For example, the electricity consumed, property taxes, worker compensation insurance premiums, repairs, etc. are absolutely owed because the services or goods were delivered. There is nothing contingent about these. However, the precise amounts may not be known at the time that the financial statements are prepared. Therefore, these liabilities had to be recorded by using estimated amounts. I suspect that many of the accrual-type adjusting entries involve estimated liabilities. What is a contingent asset?
A contingent asset is a potential asset associated with a contingent gain. Unlike contingent liabilities and contingent losses, contingent assets and contingent gains are not recorded in accounts, even when they are probable and the amount can be estimated. An example of a contingent gain and contingent asset might be a lawsuit filed by Company A against Company B for infringement of Company A’s patent. If it is probable that Company A will win the lawsuit and receive an estimated amount of money, it has a contingent asset and a contingent gain. However, it will not report the asset and gain until the lawsuit is settled. (At most Company A will prepare a very carefully worded disclosure stating that it possibly could win the case.) On the other hand, Company B will need to make an entry in its accounts if the loss contingency is probable and the amount can be estimated. If one of those are missing, Company B will have to disclose the loss contingency in the notes to its financial statements. What is a contingent liability?
A contingent liability is a potential liability. This means that the contingent liability might become an actual liability and a loss, or it might not. It depends on something in the future. If your parent guarantees your loan, your parent will have a contingent liability. Your parent will have an actual liability and a loss only if you do not make the payments on the loan. On the other hand, if you make the loan payments, your parent will not have a liability and loss. A $100,000 lawsuit filed against your company is a contingent liability (or loss contingency). Your company will have a liability and a loss only if your company is found guilty. If your company proves that it is not guilty, the contingent liability will not become an actual liability and loss.
Another example of a contingent liability is a product warranty. If a company promised to replace a defective unit at no cost to the customer within one year of purchase, the company will have an actual liability only if units are defective. If the company is certain that no units will be returned as defective, the company will have no liability and no warranty expense. Accountants will record a journal entry to report a liability on the balance sheet and a loss or expense on the income statement only if the loss contingency is both probable and the amount can be estimated. If a contingent liability is possible (but not probable), no journal entry is needed. However, the accountant must disclose the contingent liability and loss in the notes to the financial statements. If a contingent liability is remote, then the accountant will not report the liability and loss and will not disclose it. Where is a contingent liability recorded?
A contingent liability that is both probable and the amount can be estimated is recorded as 1) an expense or loss on the income statement, and 2) a liability on the balance sheet. As a result, a contingent liability is also referred to as a loss contingency. Warranties are cited as a contingent liability that meets both of the required conditions (probable and the amount can be estimated). Warranties will be recorded at the time of a product’s sale with a debit to Warranty Expense and a credit to Warranty Liability. A loss contingency which is possible but not probable, or the amount cannot be estimated, will not be recorded in the accounts. Rather, it will be disclosed in the notes to the financial statements. A loss contingency that is remote will not be recorded and will not have to be disclosed in the notes to the financial statements. contingent gain
A potential gain that is not recognized by accountants in the financial statements until it actually occurs. For example, Company P is suing Company D over a patent infringement. Company P has a contingent gain. Because of conservatism, accountants usually do not report or disclose contingent gains (but will report or disclose contingent losses).