Contingent liabilities are potential costs to a business that are accounted for based on the probability of that cost occurring. Generally Accepted Accounting Principles (GAAP) have specific rules pertaining to how a contingent liability is identified, measured and recorded. Companies with high amounts of possible contingent liabilities run the risk of experiencing greater recorded cash losses on future financial statements, and consequently indicate corresponding risk to investors.
The Financial Accounting Standards Board (FASB) determines what contingent liabilities are via GAAP. The precise meaning of liabilities is detailed in the FASB's Accounting Standards Codification (ASC) and Statements of Financial Accounting Concepts. GAAP requires businesses to classify contingent liabilities as either probable, reasonably possible or remote. Only the most probable contingent liability is recognized as a liability on financial statements, whereas reasonably possible contingent liabilities are only mentioned via footnotes within financial reports until their outcome is realized.
Contingent liabilities are accrued because the liability is not realized immediately per the FASB. Moreover, the future cost is first expensed and the liability account is credited. When the contingent liability is realized, the actual expense is then credited from cash and the liability account is debited by the same amount. Contingent liabilities also exclude certain unrecognized liabilities. For example, FASB Statement Number 143 states that retirement pension expenses are not contingent liabilities because the time and amount of the costs are certain, rather than probable fair value estimates.
Although probable contingent liabilities are required to be reported directly on financial statements, GAAP only require them to be recorded as unspecified expense charges. However, when contingent liabilities such as litigation allow for potentially higher losses than estimated, disclosure of such is required. The FASB Statement of Financial Accounting Standards Number 5 makes clear obscure or potentially misleading contingent liabilities should be disclosed in addition to those incurred after the creation of financial statements, but prior to their release.
The FASB requires contingent liabilities to be reasonably estimable if they are to follow GAAP. Since a contingent liability is valued fairly, even a slight underestimation can mean beating or falling short of analyst profit expectations for large corporations with billions of dollars in revenue. For example, if General Electric has $30 billion in sales and determines its contingent warranty liability to be 2 percent instead of 3 percent, then revenue increases by $300 million and its working capital ratios also improve. Similarly, probable litigation expenses can be underestimated.
The Securities and Exchange Commission has proposed converging GAAP with International Financial Reporting Standards (IFRS). This process requires examination and reconciling of accounting rules and processes. Differences between GAAP and IFRS are often highlighted or revised in light of this accounting objective. For example, in an accounting firm bulletin from McGladrey & Pullen LLP, the estimated valuation of contingent liabilities is contrasted with expected value using weighted costs. As developments in global accounting methods occur, the SEC and FASB amend standards to better account for differences in accounting.
Austin Berry has five years' experience in online, contractual and academic writing. He has been published at HomeownersInsurance.org and TaxBox.org. He holds a Master of Business Administration in finance and marketing from the University of Missouri, and a Master of Arts and Bachelor of Arts with concentrations in the philosophy of science and philosophy from George Mason University.