What is a contingent liability?

A contingent liability is a potential liability. This means that the contingent liability might become an actual liability and a loss, or it might not. It depends on something in the future.

If your parent guarantees your loan, your parent will have a contingent liability. Your parent will have an actual liability and a loss only if you do not make the payments on the loan. On the other hand, if you make the loan payments, your parent will not have a liability and loss.

A $100,000 lawsuit filed against your company is a contingent liability (or loss contingency). Your company will have a liability and a loss only if your company is found guilty. If your company proves that it is not guilty, the contingent liability will not become an actual liability and loss.

Another example of a contingent liability is a product warranty. If a company promised to replace a defective unit at no cost to the customer within one year of purchase, the company will have an actual liability only if units are defective. If the company is certain that no units will be returned as defective, the company will have no liability and no warranty expense.

Accountants will record a journal entry to report a liability on the balance sheet and a loss or expense on the income statement only if the loss contingency is both probable and the amount can be estimated.

If a contingent liability is possible (but not probable), no journal entry is needed. However, the accountant must disclose the contingent liability and loss in the notes to the financial statements.

If a contingent liability is remote, then the accountant will not report the liability and loss and will not disclose it.

You can learn more about contingent liabilities by reading the Financial Accounting Standards Board’s Statement of Financial Accounting Standard No. 5, “Accounting for Contingencies” at www.FASB.org/st.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.