Under these circumstances, the company discloses the contingent liability in the footnotes of the financial statements. If the firm determines that the likelihood of the liability occurring is remote, the company does not need to disclose the potential liability. 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 asset is no longer contingent, since cash has been received, so the award is recognized in the income statement and balance sheet. A contingent liability is not recognised in the statement of financial position. A contingent asset is a potential economic benefit that is dependent on some future event(s) largely out of a company’s control. Company A Ltd. has filed a lawsuit against Company B Ltd. for infringing a patent case. If there is a good chance that Company A Ltd. will win the case, it has a contingent asset in this matter. This potential asset will generally be disclosed in the financial statement, but will not be recorded as an asset until the case is over and settled.

However, there are some cases where relevant and important information is not present in some of the statements and that is due to some of these accounting principles and concepts. Here in the notes about contingent assets, we are going to figure out some of the details that students need to know about in the chapter. GAAP accounting rules require probable contingent liabilities—ones that can be estimated and are likely to occur—to be recorded in financial statements. Contingent liabilities that are likely to occur but cannot be estimated should be included in a financial statement’s footnotes.

  • As the double entry for a provision is to debit an expense and credit the liability, this would potentially reduce profit to $10m.
  • If the liability is likely to occur and the amount can be reasonably estimated, the liability should be recorded in the accounting records of a firm.
  • Some examples of the incidents would include insurance claims, litigations, and pending disputes.
  • A probable outflow simply means that it is more likely than not that the entity will have to pay money.
  • A warranty is another common contingent liability because the number of products returned under a warranty is unknown.
  • Rey Co’s lawyers have advised that it is probable that the entity will be found liable.

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 less than a 50% 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. Contingent assets are possible assets whose existence will be confirmed by the occurrence or non-occurrence of uncertain future events that are not wholly within the control of the entity. Contingent assets are not recognized, but they are disclosed when it is more likely than not that an inflow of benefits will occur. However, when the inflow of benefits is virtually certain an asset is recognized in the statement of financial position because that asset is no longer considered to be contingent.

Contingent Asset

A provision here is described as a liability of uncertain timing or amount. A contingent liability threatens to reduce the company’s assets and net profitability and, thus, comes with the potential to negatively impact the financial performance and health of a company. Therefore, such circumstances or situations must be disclosed in a company’s financial statements, per the full disclosure principle. Now assume that a lawsuit liability is possible but not probable and the dollar amount is estimated to be $2 million.

Generally, a ‘remote’ likelihood ranges between 5% and 10%, though IAS 37 doesn’t explicitly specify this. IAS 37.86 details the disclosure requirements, emphasising that any contingent liability with an outflow possibility exceeding ‘remote’ should be disclosed. Contingent assets are ruled under the conservatism principle, which is an accounting practice that states that uncertain events and outcomes should be reported in a manner that results in the lowest potential profit. In other words, companies are discouraged from inflating expectations and are generally advised to utilize the lowest estimated asset valuation. A contingent liability is not recognized in the statement of financial position. However, unless the possibility of an outflow of economic resources is remote, a contingent liability is disclosed in the notes.

  • An item is considered material if the knowledge of it could change the economic decision of users of the company’s financial statements.
  • Alternatively, they might occur due to uncertainty relating to the outcome of an event in which an asset may be created.
  • Now, the former can’t recognize this as a contingent asset even if it is sure to win and the amount can be estimated.
  • If the crops are good, the value will increase; it will decrease if they’re not good.
  • The accounting rules for recording this contingent liability vary depending on the estimated dollar which amounts to the liability and is the likelihood of the event that is occurring.

But sometimes there may be a case where important and relevant information is left out of such statements due to these accounting concepts. Contingent assets should not be recognized but should be disclosed in those cases where an inflow of economic benefits is probable. When the realization of income is virtually certain, the related asset is not a contingent asset, and its recognition is appropriate.

What is a contingent asset?

EXAMPLE – best estimate
Rey Co has received legal advice that the most likely outcome of the court case from the employee is that they will lose the case and have to pay $10m. They believe there is a 10% chance of having to pay $12m, and a 10% chance of paying nothing. A provision is a liability of uncertain timing or amount, meaning that there is some question over either how much will be paid or when this will be paid. Before the introduction of IAS 37, these uncertainties may have been exploited by companies trying to ‘smooth profits’ in order to achieve the results that their various stakeholders wanted.

What Is a Contingent Liability?

This is where IAS 37 is used to ensure that companies report only those provisions that meet certain criteria. After understanding the meaning of contingent assets, we are going to learn about the IAS 37 Provisions Contingent Liabilities And Contingent Assets. IAS stands for International Accounting Standard and according to that, there is a specific outline of the treatment provided to contingent liabilities and contingent assets too. In a similar way Accounting Standard 29 was made by ICAI to deal with such treatment details.

Recognition of a provision

Thus, recognition of the contingent liability comes before recognition of the contingent asset. Any probable contingency needs to be reflected in the financial statements—no exceptions. Possible contingencies—those that are neither probable nor remote—should be disclosed in the footnotes of the financial statements. The Company can make contingent liability journal entries by debiting the expense account and crediting the contingent liability account. This journal entry is to show that when there is a probability of future cost which can be reasonably estimated, the company needs to recognize and record it as an expense immediately. A contingent liability is recorded as an ‘expense’ in the Profit & Loss Account and then on the liabilities side of the financial statement, that is the Balance sheet.

Contingent assets are those assets which may or may not become a reality for a business depending on the outcome of a future event. The existence of this kind of asset is completely dependent on the occurrence of a probable event in future. A noteworthy agenda decision revolves 9 things you didn’t know were tax deductions around the accounting treatment of a deposit made to tax authorities. In the scenario discussed by the IFRS Interpretations Committee, an entity, confident about winning a dispute with tax authorities, pays the disputed amount as a deposit to avert penalties if it loses.

A contingent liability is simply a disclosure note shown in the notes to the accounts. Instead, a description of the event should be given to the users with an estimate of the potential financial effect. In addition to this, the expected timing of when the event should be resolved should also be included. It is imperative that the contingent assets are completely monitored in a close manner. Once, this has been made certain that there will be a rise of economic benefits, these contingent assets can easily be included in all the different financial statements which are made.

For U.S. GAAP, there generally needs to be a 70% likelihood that the gain occurs. IFRS, on the other hand, is slightly more lenient and generally permits companies to make reference to potential gains if there is at least a 50% likelihood that they will occur. A contingent liability is dependent on the outcome of an uncertain future event. A contingent liability is recorded in the records of accounting if the contingency is estimated in probability.

Remote (not likely) contingent liabilities are not to be included in any financial statement. Contingent liabilities adversely impact a company’s assets and net profitability. Two classic examples of contingent liabilities include a company warranty and a lawsuit against the company. Both represent possible losses to the company, and both depend on some uncertain future event.

EXAMPLE
At 31 December 20X8, the legal advisors of Rey Co now believe that the $10m payment from the court case would be payable in one year. It can be seen here that Rey Co could only recognise an asset from a potential inflow if the realisation of income is virtually certain. (a) Type of obligation
The obligation could be a legal one, arising from a court case or some kind of contractual arrangement. Most candidates are able to spot this in exams, identifying the presence of a potential obligation of this type.