Accounting

When Would Contingent Liabilities Become Provisions

Meaning of Contingent Liability : Contingent liabilities are such type of liabilities or a potential losses that may occur in some future period, depending on the outcome of a specific event.

Since, contingent liabilities are dependent on the happening of a certain event, their disclosure, accounting and reporting are also dependent on that event. But, at what point would contingent liabilities become provisions? Let us have a keen look on this key accounting issue.

Contingent liabilities need to be continually assessed to determine whether or not they have become actual liabilities. This is done by considering whether the recognition criteria for liabilities have been met.

If it becomes probable that an outflow of economic benefits will be required for an item previously dealt with as a contingent liability, a provision is recognized in the financial statements in the period in which the change in probability occurs.

This is how contingent liabilities become provisions.

How A Borrowing Cost Could Arise As Part Of The Measurement Of A Provision?

Where discounting is used, the carrying amount of a provision increases in each period to reflect the passage of time. This increase is recognized as borrowing cost. This is similar to the way finance lease liabilities are accounted for under IAS 17 Leases.

Illustration:

A customer filed a lawsuit against the company in December 2014, for costs and damages allegedly incurred as a result of the failure of an electrical product. The company is confident that it will successfully defend the case, however the company’s lawyers have advised that expected costs and damages would be about $500 000 in the event that the company is unsuccessful in defending the case.

(Paragraph 86 of IAS 37 requires disclosure of each class of contingent liabilities unless the possibility of an outflow in settlement is remote, which is not the case here. However, paragraph 86 also requires that the estimate of the financial effect be measured under paragraphs 36 – 52: that is, the amount is a ‘best estimate’ of the expenditure required to settle the obligation, rather than the amount claimed by the customer).

Examples of Contingent liabilities :

  • Pending Investigation
  • Outstanding litigations or lawsuits
  • Deposit insurance programs in banks
  • Guarantees on bank debt
  • Product warranty expenses
  • Any liability that you are supposed to pay after an event. For example, if you take a study loan from Bank One of $5,000 to fund your son’s higher studies. That amount may turn into a contingent liability if your son fails to make payments after getting his job. You have to pay this amount since you have taken the loan from the bank.

When to Record a Contingent Liability?

Contingent liabilities should be recorded in the books of accounts when it is probable that the future event will occur and the amount of the liability can be reasonably estimated. This means that a loss should be recorded (debiting expense) and a liability established (crediting liability).

An example of journal entry to record warranty expense/contingent liability is as follows:
Warranty Expense (Dr.) – $5,000
Warranty Accrual -Reserve ( Cr.) – $5,000

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