Contingent Liability

By CAROLINE BANTON

 Reviewed By MARGARET JAMES 

 Updated May 24, 2020

What Is a Contingent Liability?

A contingent liability is a liability that may occur depending on the outcome of an
uncertain future event. A contingent liability is recorded if the contingency is likely
and the amount of the liability can be reasonably estimated. The liability may be
disclosed in a footnote on the financial statements unless both conditions are not
met.

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Contingent Liability

Understanding Contingent Liabilities

Pending lawsuits and product warranties are common contingent liability
examples because their outcomes are uncertain. The accounting rules for
reporting a contingent liability differ depending on the estimated dollar amount of
the liability and the likelihood of the event occurring. The accounting rules ensure
that financial statement readers receive sufficient information.

 
An estimated liability is certain to occur; so, an amount is always entered into the
accounts even if the precise amount is not known at the time of data entry.

Example of a Contingent Liability

Assume that a company is facing a lawsuit from a rival firm for patent
infringement. The company's legal department thinks that the rival firm has a
strong case, and the business estimates a $2 million loss if the firm loses the
case. Because the liability is both probable and easy to estimate, the firm posts
an accounting entry on the balance sheet to debit (increase) legal expenses for
$2 million and to credit (increase) accrued expense for $2 million.

The accrual account permits the firm to immediately post an expense without the
need for an immediate cash payment. If the lawsuit results in a loss, a debit is
applied to the accrued account (deduction) and cash is credited (reduced) by $2
million.