Ministry of education tashkent financial institute

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.

Now assume that a lawsuit liability is possible but not probable and the dollar amount is estimated to be $2 million. Under these circumstances, the company discloses the contingent liability in the footnotes of the financial statements. If the firm determines that the likelihood of the liability occurring is remote, the company does not need to disclose the potential liability.

Both GAAP (generally accepted accounting principles) and IFRS (international financial reporting standards) require companies to record contingent liabilities in accordance with the three accounting principles: full disclosure, materiality, and prudence.

A warranty is another common contingent liability because the number of products returned under a warranty is unknown. Assume, for example, that a bike manufacturer offers a three-year warranty on bicycle seats, which cost $50 each. If the firm manufactures 1,000 bicycle seats in a year and offers a warranty per seat, the firm needs to estimate the number of seats that may be returned under warranty each year. If, for example, the company forecasts that 200 seats must be replaced under warranty for $50, the firm posts a debit (increase) to warranty expense for $10,000 and a credit (increase) to accrued warranty liability for $10,000. At the end of the year, the accounts are adjusted for the actual warranty expense incurred.