According to the Financial Accounting Standards Board, or FASB, a contingent liability is any existing condition or set of circumstances that involves uncertainty regarding possible business loss. Per the FASB Statement of Accounting Standards No. 5, a firm must distinguish between losses that are probable, reasonably probable or remote. There are strict and sometimes vague disclosure requirements for companies claiming contingent liabilities.
Contingent liabilities are sometimes referred to as "loss contingencies" in the FASB literature. The concept of a contingent liability is centered around the two primary aspects of an accounting liability: they are present responsibilities and obligations to other entities. These liabilities gain contingency whenever their payment contains a reasonable degree of uncertainty. Only the contingent liabilities that are the most probable can be recognized as a liability on financial statements. Other contingencies are relegated to footnotes as long as uncertainty persists.
Contingent liability is one of the most subjective, contentious and fluid concepts in contemporary accounting. There are two distinct hurdles when determining if a contingent liability should be recognized: the timing of the possible liability and degree of confidence an external obligation will be realized. This is why the FASB created three categories of contingency: probable, reasonably probable and remote. Only those classified as probable can be officially recognized.
It does not make any sense to immediately realize a contingent liability; immediate realization signifies the financial obligation has occurred with certainty. Instead, the FASB requires contingent liabilities be accrued. Future costs are expensed first, and then a liability account is credited based on the nature of the liability. In the event the liability is realized, the actual expense is credited from cash and the original liability account is similarly debited.
If a contingent liability is deemed probable, it must be directly reported in the financial statements. Nevertheless, generally accepted accounting principles, or GAAP, only require contingencies be recorded as unspecified expenses. Any details are contained within disclosures in the footnotes. FASB Statement of Accounting Standards No. 5 requires any obscure, confusing or misleading contingent liabilities be disclosed until the offending quality is no longer present.
Estimation of contingent liabilities is another vague application of accounting standards. Under GAAP, the listed amount must be "fair and reasonable" to avoid misleading investors, lenders or regulators. Specific note is made of estimating the costs of litigation or any liabilities resulting from legal action. Lawsuits, especially with huge companies, can be an enormous liability and significantly impact the bottom line. Companies that underestimate the impact of legal fees or fines are found noncompliant with GAAP.
Common Examples of Contingent Liabilities
Possible contingent liabilities include loss from damage to property or employees; most companies carry many types of insurance, so these liabilities are normally expressed in terms of insurance costs. Banks that issue standby letters of credit or similar obligations carry contingent liabilities. All creditors, not just banks, carry contingent liabilities equal to the amount of receivables on their books. Warranties and lawsuits are commonplace in the business environment. Both are considered contingent liabilities.