Accounting: The Language of Business (Part 67)

A static hero is a public liability. Progress grows out of motion.

Richard E. Byrd

 Current Liabilities (Part B)

by

Charles Lamson

Contingent Liabilities

Some past transactions will result in liabilities if certain events occur in the future. These potential obligations are called contingent liabilities. For example, Ford Motor Company would have a contingent liability for the estimated costs associated with warranty work on new car sales. The obligation is contingent upon a future event, namely, a customer requiring warranty work on a vehicle. The obligation is the result of a past transaction, which is the original sale of the vehicle.

If a contingent liability is probable and the amount of the liability can be reasonably estimated, it should be recorded in the accounts. Ford Motor Company's vehicle warranty costs are an example of a recordable contingent liability. The warranty costs are probable because it is known that warranty repairs will be required on some vehicles. In addition, the costs can be estimated from past warranty experience.

To illustrate, assume that during June a company sells a product for $60,000 on which there is a 36-month warranty for repairing defects. Past experience indicates that the average cost to repair defects is 5% of the sales price over the warranty period. The entry to record the estimated product warranty expense for June is as follows:

This transaction matches revenues and expenses properly by recording warranty costs in the same period in which the sale is recorded. When the defective product is repaired, the repair costs are recorded by debiting Product Warranty Payable and crediting Cash, Supplies, or other appropriate accounts. Thus, if a customer required a $200 part replacement on August 16, the entry would be:

If a contingent liability Is probable but cannot be reasonably estimated or is only possible, then the future of the contingent liability should be disclosed in the footnotes to the financial statements. Professional judgment is required in distinguishing between contingent liabilities that are probable versus those that are only possible.

The accounting treatment of contingent liabilities is summarized in Exhibit 1. 

EXHIBIT 1 Accounting Treatment of Contingent Liabilities

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 438-439*

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