What is a contingent liability?

A contingent liability is a potential liability...it depends on a future event occurring or not occurring.

Contingent liabilities are liabilities that may be incurred by an entity depending on the outcome of an uncertain future event such as a court case.

A potential obligation that may be incurred depending on the outcome of a future event. A contingent liability is one where the outcome of an existing situation is uncertain, and this uncertainty will be resolved by a future event. A contingent liability is recorded in the books of accounts only if the contingency is probable and the amount of the liability can be estimated.

When to Recognize a Contingent Liability

There are three scenarios for contingent liabilities, all involving different accounting treatments. They are:

• High probability. Record a contingent liability when it is probable that the loss will occur, and you can reasonably estimate the amount of the loss. If you can only estimate a range of possible amounts, then record that amount in the range that appears to be a better estimate than any other amount; if no amount is better, then record the lowest amount in the range. “Probable” means that the future event is likely to occur. You should also describe the liability in the footnotes that accompany the financial statements.
• Medium probability. Disclose the existence of the 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.
• Low probability. Do not record or disclose the contingent liability if the probability of its occurrence is remote.

GAAP requires that you report contingent liabilities as unspecified expenses on the income statement. You must disclose all contingencies that could significantly alter the company's estimated earnings. Explain any obscure or potentially misleading items in the footnotes. You should also use the footnotes to discuss any contingent liabilities incurred between the initial creation of the financial statements and publication of the final version.

Example - For example, a company may be facing a lawsuit from a rival firm for patent infringement. If the company's legal department thinks that the rival firm has a strong case, and the company estimates that the damages payable if the rival firm wins the case are $2 million, it would book a contingent liability of this amount on its balance sheet. If, on the other hand, the company's legal department is of the opinion that the lawsuit is frivolous and very unlikely to be won by the rival company, no contingent liability would be necessary.

Journal Entry

Example of a Contingent Liability

For example, ABC Company files a lawsuit against Unlucky Company for $500,000. Unlucky’s attorney feels that the suit is without merit, so Unlucky merely discloses the existence of the lawsuit in the notes accompanying its financial statements. Several months later, Unlucky’s attorney recommends that the company should settle out of court for $75,000; at this point, the liability is both probable and can be estimated, so Unlucky records a $75,000 liability. A possible entry for this transaction might be:

	Debit	Credit
Legal expense	75,000
Accrued liabilities		75,000

When Unlucky later pays ABC company in the out-of-court settlement, the final entry is:

	Debit	Credit
Accrued liabilities	75,000
Cash		75,000