Question

What are the requirements for determining the financial reporting of a contingent liability? Why would a company want to keep its contingent liability as low as possible? How could a company manipulate contingent liability to its advantage?

Answer 1

CONTINGENT LIABILITY:

A contingent liability is a potential liability that may occur depending on the outcome of an uncertain future event. A contingent liability is recorded in the accounting records if the contingency is probable and the amount of the liability can be reasonably estimated. If both conditions are not met, the liability may be disclosed in a footnote on the financial statements or not reported at all.

WHEN TO RECOGNIZE A CONTINGENT LIABILITY:

Contingent liability is one of the most subjective, contentious and fluid concepts in contemporary accounting.

There are two distinct hurdles when determining if a contingent liability should be recognized:

1. The timing of the possible liability
2. The degree of confidence an external obligation will be realized

This is why the FASB created three categories of contingency: probable, reasonably probable and remote. Only those classified as probable can be officially recognized.

Examples of Contingent Liability:

• The outcome of a lawsuit
• A government investigation
• The threat of expropriation

REQUIREMENTS FOR DETERMINING REPORTING OF CONTINGENT LIABILITY:

Contingent liabilities need to pass two thresholds before they can be reported in financial statements. First, it must be possible to estimate the value of the contingent liability. If the value can be estimated, the liability must have a greater than 50 percent chance of being realized. Qualifying contingent liabilities are recorded as an expense on the income statement and a liability on the balance sheet.

If the contingent loss is remote, meaning it has a less than 50 percent chance of occurring, the liability should not be reflected on the balance sheet. Any contingent liabilities that are questionable before their value can be determined should be disclosed in the footnotes to the financial statements.

WAYS TO MANIPULATE CONTINGENT LIABILITY TO ITS ADVANTAGE:

Liabilities represent a company's financial obligations, so managers are sometimes tempted to downplay them. Professional accounting association notes that companies sometimes manipulate information about contingent liabilities, such as lawsuits and environmental hazards.

GAAP only requires management to recognize a contingent liability on the balance sheet if the event is probable and the amount can be estimated. By labeling the event as possible, but not probable, the company can leave the dollar amount out of the liabilities section.