The average cost of $200 × 25goals gives an anticipated future repair cost of $5,000 for 2019.Assume for the sake of our example that in 2020 Sierra Sports maderepairs that cost $2,800. Following are the necessary journalentries to record the expense in 2019 and the repairs in 2020. Theresources used in the warranty repair work could have includedseveral options, such as parts and labor, but to keep it simple weallocated all of the expenses to repair parts inventory. Since thecompany’s inventory of supply parts (an asset) went down by $2,800,the reduction is reflected with a credit entry to repair partsinventory. A contingency occurs when a current situationhas an outcome that is unknown or uncertain and will not beresolved until a future point in time.
In addition, the term ‘contingent liability’ is used for liabilities that do not meet the recognition criteria. Sierra Sports may have more litigation in the future surrounding the soccer goals. These lawsuits have not yet been filed or are in the very early stages of the litigation process. Since contingent liabilities example there is a past precedent for lawsuits of this nature but no establishment of guilt or formal arrangement of damages or timeline, the likelihood of occurrence is reasonably possible. Since the outcome is possible, the contingent liability is disclosed in Sierra Sports’ financial statement notes.
Related IFRS Standards
Care is needed to avoid duplicating adjustments for risk and uncertainty with consequent overstatement of a provision. Where it is more likely that no present obligation exists at the end of the reporting period, the entity discloses a contingent liability, unless the possibility of an outflow of resources embodying economic benefits is remote (see paragraph 86). A noteworthy agenda decision revolves around the accounting treatment of a deposit made to tax authorities. In the scenario discussed by the IFRS Interpretations Committee, an entity, confident about winning a dispute with tax authorities, pays the disputed amount as a deposit to avert penalties if it loses.
- This does not meet the likelihood requirement, and the possibility of actualization is minimal.
- In some cases, the entity will not be liable for the costs in question if the third party fails to pay.
- This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
- One common liquidity measure is the current ratio, and a higher ratio is preferred over a lower one.
- If the contingent liability is consideredremote, it is unlikely to occur and may or may notbe estimable.
- A “medium probability” contingency is one that satisfies either, but not both, of the parameters of a high probability contingency.
The nature of contingent liability is important for deciding whether it is good or bad. Another fantastic example of contingent liability would be product warranties. Let’s say a mobile phone manufacturer produces many mobiles and sells them with a brand warranty of 1 year.
IAS 12 — Accounting for uncertainties in income taxes
For example, Sierra Sports has a one-year warranty on part repairs and replacements for a soccer goal they sell. Sierra Sports notices that some of its soccer goals have rusted screws that require replacement, but they have already sold goals with this problem to customers. There is a probability that someone who purchased the soccer goal may bring it in to have the screws replaced. Not only does the contingent liability meet the probability requirement, it also meets the measurement requirement. Contingent liabilities are also important for potential lenders to a company, who will take these liabilities into account when deciding on their lending terms.
Contingent assets usually arise from unplanned or other unexpected events that give rise to the possibility of an inflow of economic benefits to the entity. An example is a claim that an entity is pursuing through legal processes, where the outcome is uncertain. Since this warranty expense allocation will probably be carriedon for many years, adjustments in the estimated warranty expensescan be made to reflect actual experiences. Also, sales for 2020,2021, 2022, and all subsequent years will need to reflect the sametypes of journal entries for their sales. In essence, as long asSierra Sports sells the goals or other equipment and provides awarranty, it will need to account for the warranty expenses in amanner similar to the one we demonstrated. The measurement requirement refers to thecompany’s ability to reasonably estimate the amount of loss.