Notes

Contingent liabilities are circumstances where a company may owe obligations to other parties. Explore three common types of contingent liabilities: product recalls, pending lawsuits, and changes in legislation.
What Are Contingent Liabilities?
Bob just landed his dream job as an auditor for the largest accounting firm in the United States. One of his job responsibilities will be reviewing company financial statements to make sure the calculations are accurate and all important information has been disclosed.

The accounting firm sent Bob to audit the financial statements of Ocean World Amusement Park. Bob starts by speaking with the executives and reviewing the balance sheet. Bob specifically focuses on the liabilities section of the balance sheet. Liabilities are obligations owed by the amusement park.

In his conversation with the executives, they told Bob there may be a product recall on rabbit ears they manufactured this year. In addition to the recall, a lawsuit is pending against the company and legislation may change regarding healthcare for employees.

Bob tells the executives that these situations are considered contingent liabilities. Contingent liabilities are possible obligations the company may owe. Based on their probabilities of occurring, they may need to be estimated and added to the financial statements.

For the remainder of this lesson, we'll explore three types of contingent liabilities: product recall, lawsuits, and changes in legislation. You'll also learn where this information should be reported on the balance sheet.

Product Recalls
As Bob continues to explain contingent liabilities to the executives, he reviews the balance sheet to see where they are reported. Bob asks the executives, 'Where are these situations you just mentioned on the balance sheet?' The executives tell Bob since they have not occurred, they did not list them.

Bob tells the executives that if the contingencies have a high probability of occurring, they must list them as a footnote on the balance sheet to provide more of an accurate picture of possible future obligations. The executives look confused. Bob says, 'Let's take the product recall as an example, but first tell me what happened.'

The executives explain to Bob that they manufactured and sold battery-operated bunny ears for kids to purchase and wear at the park. As the kids wore the bunny ears and the day got hotter, the bunny ears overheated and caught fire. Some of the kids' hair was singed, but no serious injuries occurred. As a result of several bunny ears catching fire, the executives were seriously thinking about recalling the bunny ears and giving everyone their money back.

Bob explained to them that if they anticipated recalling the bunny ears, they would need to estimate how many refunds they would give and note that dollar amount on the balance sheet. He then asked about the pending lawsuit.

Pending Lawsuits
After Bob clarified how the amusement park needs to account for the possible product recall, he asked them about the pending lawsuit. The executives explained to Bob that the amusement park was being sued by some of the parents whose kids' hair got singed by the bunny ears catching on fire.

Bob asked them to bring in their attorney to discuss the probability of the amusement park losing the lawsuit. The attorney walked in the room and told Bob that they were more than likely going to lose the lawsuit and would need to pay the parents millions of dollars.

Bob told the executives, since there was such a high probability of loss, they would need to include this information on the balance sheet also as a footnote. Now, for the change in legislation, Bob asks, 'What is that about?'

Changes in Legislation
The executives explained to Bob that federal law may mandate that all employers provide health insurance to their employees. The executives all agreed health insurance was important and wanted each and every employee to be covered; however, the costs to the company would be astronomical.

Bob asks his typical question again, 'Is there a possibility this legislation will pass?' 'Do you think employers will be required to provide health insurance coverage to all employees?' The executives all agreed; they believed the legislation would pass. Bob said, 'Well then, you must estimate the costs and include it as a footnote on the balance sheet.'

Lesson Summary
Liabilities are obligations a company owes. Contingent liabilities are obligations a company may possibly owe. As resounded above, Bob told the executives if there's a high probability the liability will occur, then it needs to be recorded and footnoted on the balance sheet to provide an accurate picture of their future liabilities.

In this lesson, we discussed three types of contingent liabilities: product recalls, pending lawsuits, and changes in legislation. Liabilities with a high probability of occurring need to be accurately estimated and added as a note on the balance sheet.

Lesson at a Glance
When discussing your liabilities, it's important to include not just what you owe, but also other obligations that have a possibility of occurring, known as contingent liabilities. This will give a more accurate account on your balance sheet. Some examples of contingent liabilities include product recalls, pending lawsuits, and changes in legislation.

Product recalls can lead to lawsuits, both of which are contingent liabilities.
contingent liability
Learning Outcomes
After reviewing this lesson, you should be able to complete these tasks:

Describe the difference between a liability and a contingent liability
Provide examples of contingent liabilities