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.
Two classic examples of contingent liabilities include a company warranty and a lawsuit against the company. Both represent possible losses to the company, yet both depend on some uncertain future event.
Suppose a lawsuit is filed against a company, and the plaintiff claims damages up to $250,000. It's impossible to know whether the company should report a contingent liability of $250,000 based solely on this information.
Here, the company should rely on precedent and legal counsel to ascertain the likelihood of damages. If a court is likely to rule in favor of the plaintiff, whether because there is strong evidence of wrongdoing or some other factor, the company should report a contingent liability equal to probable damages. This is true even if the company has liability insurance.
If the lawsuit is frivolous, there may be no need for disclosure. Any case with an ambiguous chance of success should be noted in the financial statements but need not be listed as a liability on the balance sheet.
Companies operating in the United States rely on the guidelines established in the generally accepted accounting principles (GAAP). Under GAAP, a contingent liability is defined as any potential future loss that depends on a "triggering event" to turn into an actual expense.
It's important that shareholders and lenders be warned about possible losses; an otherwise sound investment might look foolish after an undisclosed contingent liability is realized.
There are three GAAP-specified categories of contingent liabilities: probable, possible and remote. Probable contingencies are likely to occur and can be reasonably estimated. Possible contingencies do not have a more-likely-than-not chance of being realized, but are not necessarily considered unlikely either. Remote contingencies aren't likely to occur and aren't reasonably possible.
Working through the vagaries of contingent accounting is sometimes challenging and inexact. Company management should consult experts or research prior accounting cases before making determinations. In the event of an audit, the company must be able to explain and defend its contingent accounting decisions.
Any probable contingency needs to be reflected in the financial statements – no exceptions. Remote contingencies should never be included. Contingencies that are neither probable, nor remote should be disclosed in the footnotes of the financial statements.