Question

How can a contingent liability be recognized in a liability and how is it related to accounting theory?

Answer 1

Contingent liabilities are liabilities that may occur, depending on the outcome of a future event. Therefore, contingent liabilities are potential liabilities. A contingent liability is only recorded if the liability is probable and the amount of the resulting liability can be reasonably estimated.

Pending lawsuits and product warranties are common contingent liability examples because their outcomes are uncertain. The accounting rules for reporting a contingent liability differ depending on the estimated dollar amount of the liability and the likelihood of the event occurring. The accounting rules ensure that financial statement readers receive sufficient information.

Considering that we follow a conservative approach to accounting, we must follow the practice of the disclosure. So a contingent liability, like contingent assets, will be disclosed in the final statements of a company as a footnote. i.e. notes to accounts. This will happen if

• There must be a possible present obligation from a past event
• The outflow of economic resources to settle the obligations is not probable (only possible)
• Such a possibility of an outflow of resources is not remote
• The amount of obligation can be reasonably measured