When is a contingent liability recorded?
options:
1) When the amount can be reasonably estimated.
2) When the future events are probable to occur and the amount can be reasonably estimated.
3) When the future events are probable to occur.
4) When the future events will possibly occur and the amount can be reasonably estimated.
The correct answer and explanation is:
The correct answer is Option 2: When the future events are probable to occur and the amount can be reasonably estimated.
A contingent liability refers to a potential obligation that may arise depending on the outcome of a future event. The accounting treatment of a contingent liability follows certain guidelines set by accounting standards like GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards).
According to these guidelines, a contingent liability should only be recorded in the financial statements under two conditions:
- The future event is probable, meaning it is more likely than not that the event will occur.
- The amount of the liability can be reasonably estimated. If the amount of the potential liability cannot be reasonably estimated, it cannot be recorded, although it might be disclosed in the notes to the financial statements.
For example, consider a company that is involved in a lawsuit. If the company’s legal team believes that it is probable the company will lose the case, and they can reasonably estimate the amount of damages, then the contingent liability should be recorded in the financial statements. However, if the outcome is not probable, but only possible, the company would not record the liability but might still disclose it.
It is important to note that contingent liabilities are not recognized on the balance sheet unless both of these conditions are met. In cases where the probability is remote or the amount cannot be estimated, the contingent liability is not recorded but might still require disclosure depending on its nature and potential impact on the financial position of the company. This ensures that users of the financial statements are informed about significant risks, even if they are not yet recognized as liabilities.