Question

Research the topic of contingent liabilities and identify a specific real or theoretical contingent liability.

Compose a recommendation that covers the following:

Describes the contingent liability you have selected.

Recommends whether this contingent liability should be reported and why or why not. (Be sure to include GAAP support for your conclusion!)

If you recommend reporting of this contingent liability, justify how it would be reported

Answer 1

A contingent liability is a potential liability...it depends on a future event occurring or not occurring. For example, if a parent guarantees a daughter's first car loan, the parent has a contingent liability. If the daughter makes her car payments and pays off the loan, the parent will have no liability. If the daughter fails to make the payments, the parent will have a liability.

If a company is sued by a former employee for $500,000 for age discrimination, the company has a contingent liability. If the company is found guilty, it will have a liability. However, if the company is not found guilty, the company will not have an actual liability.

In accounting, a contingent liability and the related contingent loss are recorded with a journal entry only if the contingency is both probable and the amount can be estimated.

If a contingent liability is only possible (not probable), or if the amount cannot be estimated, a journal entry is not required. However, a disclosure is required.

Example 1: Lawsuit Expenses

CFG Limited is a California-based consulting firm, specializing in engineering products and development. Just before the end of the year the company received a notice of a legal case from one of its competitors. The case is related to a potential infringement of the competitor's patent. The inhouse legal counsel discussed the case with CFG Limited's management and based on information available concluded that the lawsuit was possible, however, there was not enough information to estimate the potential loss. This lawsuit is considered a contingent liability, which should be only described in the notes to the financial statements as the second criteria (i.e. reasonable estimate of loss amount) was not met.

Example 2: Warranty Reserves

A local manufacturer of Blue-ray players sells products nationwide. As part of customer service, the manufacturer provides a warranty to repair or replace its products one year after the sale. Using accumulated historical information, the manufacturer estimated that each sold player results, on average, in $30 of warranty expenses. During the current year, the manufacturer sold 3,000 players. As it is probable that the manufacturer inccurred warranty expenses (i.e. by selling the players that will need to be fixed later when customers return them) and the amount of warranty expense can be reasonably estimated (based on historical information), a contingent liability related to warranty expenses should be recorded in the financial statements. An example of journal entry to record this warranty expense is as follows:

Account Titles	Debit	Credit
Warranty Expense	90,000
Warranty Accrual (Reserve)		90,000

Contingent liabilities are potential costs to a business that are accounted for based on the probability of that cost occurring. Generally Accepted Accounting Principles (GAAP) have specific rules pertaining to how a contingent liability is identified, measured and recorded. Companies with high amounts of possible contingent liabilities run the risk of experiencing greater recorded cash losses on future financial statements, and consequently indicate corresponding risk to investors.

Contingent liabilities are accrued because the liability is not realized immediately per the FASB. Moreover, the future cost is first expensed and the liability account is credited. When the contingent liability is realized, the actual expense is then credited from cash and the liability account is debited by the same amount. Contingent liabilities also exclude certain unrecognized liabilities. For example, FASB Statement Number 143 states that retirement pension expenses are not contingent liabilities because the time and amount of the costs are certain, rather than probable fair value estimates.

Although probable contingent liabilities are required to be reported directly on financial statements, GAAP only require them to be recorded as unspecified expense charges. However, when contingent liabilities such as litigation allow for potentially higher losses than estimated, disclosure of such is required. The FASB Statement of Financial Accounting Standards Number 5 makes clear obscure or potentially misleading contingent liabilities should be disclosed in addition to those incurred after the creation of financial statements, but prior to their release.

The FASB requires contingent liabilities to be reasonably estimable if they are to follow GAAP. Since a contingent liability is valued fairly, even a slight underestimation can mean beating or falling short of analyst profit expectations for large corporations with billions of dollars in revenue. For example, if General Electric has $30 billion in sales and determines its contingent warranty liability to be 2 percent instead of 3 percent, then revenue increases by $300 million and its working capital ratios also improve. Similarly, probable litigation expenses can be underestimated.

The Securities and Exchange Commission has proposed converging GAAP with International Financial Reporting Standards (IFRS). This process requires examination and reconciling of accounting rules and processes. Differences between GAAP and IFRS are often highlighted or revised in light of this accounting objective. For example, in an accounting firm bulletin from McGladrey & Pullen LLP, the estimated valuation of contingent liabilities is contrasted with expected value using weighted costs. As developments in global accounting methods occur, the SEC and FASB amend standards to better account for differences in accounting.