By Daryl Luna
Reading time: 2 min
Contingent liabilities reflect monetary amounts that your business might owe if a specific “triggering” event happens. Although contingent liabilities should be reported, some companies struggle knowing when those contingent liabilities should be included in their financial statements. Here are the basics under Generally Accepted Accounting Principles (GAAP).
What are Contingent Liabilities?
Owning and operating a business always deals with some uncertainty. For example, your organization may become involved in a legal dispute, which could result in financial payments and penalties of varying degrees. However, payments like these do not follow clear timetables. Despite the need to file financial statements, it is not unusual for the date and amount of any settlement to be unclear. This is an example of a contingent liability that may or may not impact your business sometime in the future.
Companies may also be faced with liabilities when dealing with a pending government investigation or product deficiencies that trigger warranty liability. Determining when that liability becomes an expense depends on a specific triggering event.
It is important to note that a contingent liability is a noncash transaction, and recording liabilities correctly is essential because it has no initial impact on cash flow. However, the creation of a contingent liability is critical because it notifies stakeholders of a potential liability that could impact your business in the future.
When Should You Report a Contingent Liability?
A contingent liability can be categorized as:
- Reasonably possible, or
Remote losses often don’t require disclosure in your financial statements shared with stakeholders. If a loss is reasonably possible, it is vital to add a note to financial statements. The same approach to these contingent liabilities applies when the loss is probable, but it is still impossible to estimate the impact with any degree of certainty.
However, if a loss becomes probable and can be reasonably estimated, it then becomes important for your company to report the liability in financial statements and a loss on the income statement. If the amount fluctuates and it is possible to make a reasonable estimate, that amount should be updated in the financial statements accordingly. Don’t forget that the contingent liability remains on the balance sheet until your company pays it off.
Can We Help with the Gray Areas?
Determining whether liability is remote, reasonably possible, or probable and estimating losses can be tricky and often fall into the gray areas of financial reporting. External auditors are always on the lookout for contingencies that should be disclosed. Additionally, auditors are tasked with evaluating if existing loss estimates are still reasonable. Companies must be ready to provide supporting documentation to auditors. Adjusting your financial statements to reflect any changes in the circumstances surrounding your contingent liabilities is easier when working with external auditors, and JLK Rosenberger can help with that process. For additional information, please call us at 949-860-9890 or click here to contact us. We look forward to speaking with you soon.