Contingent Liability Journal Entry
Overview
Contingent liability is a potential obligation that may or may not become an actual liability in the future. It is a liability of uncertain timing and amount. In this case, the company needs to account for contingent liability by making proper journal entry if the potential future cost is probable (i.e. likely to occur) and its amount can be reasonably estimated.
On the other hand, if the potential future cost is only possible (i.e. could occur) or the amount cannot be reasonably estimated, the company should not make the journal entry; but it needs to disclose the event in the financial statements. In another case, if the future cost is remote (i.e. unlikely to occur), the company doesn’t need to make journal entry nor disclose contingent liability at all.
If the company doesn’t make journal entry for contingent liability when the liability is probable and the amount can be reasonably estimated, both total liabilities and expenses will be understated in the balance sheet and the income statement respectively.
Contingent liability journal entry
The company can make contingent liability journal entry by debiting the expense account and crediting the contingent liability account.
| Account | Debit | Credit |
|---|---|---|
| Expense | 000 | |
| Contingent liability | 000 |
This journal entry is to show that when there is a probability of future cost which can be reasonably estimated, the company needs to recognize and record it as an expense immediately. Likewise, the contingent liability is a payable account, in which the company will expect the outflow of resources containing economic benefits (e.g. cash out).
Example
For example, the company ABC Ltd. has an outstanding lawsuit which is likely that it will lose with the amount that can be reasonably estimated to be $25,000.
In this case, the company ABC Ltd. needs to recognize the expense and contingent liability immediately by making the journal entry as below:
| Account | Debit | Credit |
|---|---|---|
| Loss from lawsuit | 25,000 | |
| Lawsuit payable | 25,000 |
In this journal entry, lawsuit payable account is a contingent liability, in which it is probable that a $25,000 loss will occur. This leads to the result of an increase of liability (credit) by $25,000 in the balance sheet.
Other the other hand, loss from lawsuit account is an expense that the company needs to recognize (debit) in the current accounting period as it is a result of the past event (i.e. lawsuit). If the contingent liability journal entry above is not recorded, the ABC’s total liabilities and expenses will be both understated by $25,000.
