12 3 Define and Apply Accounting Treatment for Contingent Liabilities Principles of Accounting, Volume 1: Financial Accounting
As you’ve learned, not only are warranty expense and warranty liability journalized, but they are also recognized on the income statement and balance sheet. The following examples show recognition of Warranty Expense on the income statement (Figure) and Warranty Liability on the balance sheet (Figure) for Sierra Sports. The measurement requirement refers to the company’s ability to reasonably estimate the amount of loss. Even though a reasonable estimate is the company’s best guess, it should not be a frivolous number. For a financial figure to be reasonably estimated, it could be based on past experience or industry standards (see (Figure)).
Although contingent liabilities are necessarily estimates, they only exist where it is probable that some amount of payment will be made. This is why they need to be reported via accounting procedures, and why they are regarded as “real” liabilities. 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. 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.
This ratio—current assets divided by current liabilities—is lowered by an increase in current liabilities (the denominator increases while we assume that the numerator remains the same). When lenders arrange loans with their corporate customers, limits are typically set on how low certain liquidity ratios (such as the current ratio) can go before the bank can demand that the loan be repaid immediately. Contingent Liabilities are the possible future liabilities that may or may not happen due to the independent event not under company control.
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When the company’s future cash flow can measure reliably, it means the item meets the definition of assets. It is the assets, so it needs to record on the balance sheet as normal assets. The warranty liability account will be reduced when the warranties are paid out to the customers. For example, Vacuum Inc. will debit the warranty liability account $500 and credit either cash– in the case of a full refund– or inventory– in the case of a replacement– in the amount of $500. It will end up reducing both a liability account and an asset account at that point.
Under GAAP, the listed amount must be “fair and reasonable” to avoid misleading investors, lenders, or regulators. Estimating the costs of litigation or any liabilities resulting from legal action should be carefully noted. A loss contingency that is remote will not be recorded and it will not have to be disclosed in the notes to the financial statements. An example is a nuisance lawsuit where there is no similar case that was ever successful. Companies operating in the United States rely on the guidelines established in the generally accepted accounting principles (GAAP). Under GAAP, a contingent liability is defined as any potential future loss that depends on a “triggering event” to turn into an actual expense.
- A contingent liability that is expected to be settled in the near future is more likely to impact a company’s share price than one that is not expected to be settled for several years.
- In essence, as long as
Sierra Sports sells the goals or other equipment and provides a
warranty, it will need to account for the warranty expenses in a
manner similar to the one we demonstrated. - Google, a subsidiary of
Alphabet Inc., has expanded from
a search engine to a global brand with a variety of product and
service offerings. - Also, sales for 2020,
2021, 2022, and all subsequent years will need to reflect the same
types of journal entries for their sales.
Our example only covered the warranty expenses anticipated from the 2019 sales. Since the company has a three-year warranty, and it estimated repair costs of $5,000 for the goals sold in 2019, there is still a balance of $2,200 left from the original $5,000. If it is determined that too much is being set aside in the allowance, then future annual warranty expenses can be adjusted downward. If it is determined that not enough is being accumulated, then the warranty expense allowance can be increased. If the warranties are honored, the company should know how much each screw costs, labor cost required, time commitment, and any overhead costs incurred.
IAS 37 Provisions, Contingent Liabilities and Contingent Assets
We know that the customers are going to bring back the MacBook and claim a warranty due to various issues. Based on the historical data, 5% of the product will be broken within 12 months and claim the warranty. Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory. These materials were downloaded from PwC’s Viewpoint (viewpoint.pwc.com) under license.
The income statement and balance sheet are typically impacted by contingent liabilities. Assume that Sierra Sports is sued by one of the customers who
purchased the faulty soccer goals. A settlement of responsibility
in the case has been reached, but the actual damages have not been
determined and cannot be reasonably estimated. This is considered
probable but inestimable, because the lawsuit is very likely to
occur (given a settlement is agreed upon) but the actual damages
are unknown.
Where Are Contingent Liabilities Shown on the Financial Statement?
Contingent assets are assets that are likely to materialize if certain events arise. These assets are only recorded in financial statements’ footnotes as their value cannot be reasonably estimated. Insurance can be an excellent shield against the contingent liabilities in balance sheet financial risks of contingent liabilities. By transferring risk to an insurance company, firms can manage their potential losses. The cost of insurance premiums is often far less than the possible financial impact of the unrestrained liability.
About the IFRS Foundation
It’s crucial to understand the significant connection between contingent liabilities and sustainability in a corporate landscape. This link is premised on the concept that a company’s social and environmental responsibilities manifest real potential liabilities. The legal implications of contingent liabilities necessitate having legal expertise onboard. Legal counsel can aid in negotiation of contracts to limit the responsibility of the company for contingent liabilities.
IAS 37 — Changes in decommissioning, restoration, and similar liabilities
Let’s say a mobile phone manufacturer produces many mobiles and sells them with a brand warranty of 1 year. For example, when a company is fighting a legal battle and the opposite party has a stronger case, and the probability of losing is above 50%, it must be recorded in the books of accounts. Warranties arise from products or services sold to customers
that cover https://accounting-services.net/ certain defects (see
Figure 12.8). It is unclear if a customer will need to use a
warranty, and when, but this is a possibility for each product or
service sold that includes a warranty. The same idea applies to
insurance claims (car, life, and fire, for example), and
bankruptcy. There is an uncertainty that a claim will transpire, or
bankruptcy will occur.
A contingent liability is thus a type of financial event that might or might not evolve into an obligation in the future for the company. As per the definition provided by General Accepted Accounting Standards (GAAP), a contingent liability is any potential future expense that depends on a “triggering event” to convert it into an actual loss. The balance sheet provides a snapshot of a company’s financial condition — its assets, liabilities, and equity at a particular time.
These come in the form of accounts payable, notes payable, mortgages payable, and other similar items. The financial impact may not be immediate but nonetheless the company must account for it on their balance sheet as a contingent liability. An example of determining a warranty liability based on a percentage of sales follows. The sales price per soccer goal is $1,200, and Sierra Sports believes 10% of sales will result in honored warranties. The company would record this warranty liability of $120 ($1,200 × 10%) to Warranty Liability and Warranty Expense accounts.
