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Explain GAAP guidelines for contingent liabilities
Contingent liabilities include different liabilities like warranty costs, injury claims, lawsuits etc. Each of the expenses are treated differently and it should satisfy a set of conditions before realizing.
General accepted accounting principles (GAAP) have some guidelines for recognition, measurement and reporting for contingent liabilities. These are explained below −
Identification
- First step in identification is to determine the odds of each contingency occurring and then, they should be classified based on probable, possible or remote.
- Reevaluate the items, if there are any changes (if increase in percentage of contingency or not).
- Write the reasonable liabilities in footnotes.
- Finally, probable liabilities are listed in financial statements with the description of it in footnotes.
Amount
- Liability amount should be estimated in reasonable and fair ways.
- Under estimation will mislead the creditors and investors.
- Sometimes underestimations may impact the bottom line of the company.
- Warranties and coupon usage can be estimated based on prior sales history and customer’s behaviour.
Journal entries
- Debit the expenses account and credit in accrued liability account (corresponding cost type).
- If payment is realised, debit the accrued liability account and credit the cash account.
- Unrecognized liabilities are not considered as contingent.
Reporting
- Disclosed contingencies alter company’s estimated earnings, if they are any misleading obscure and potential items are explained in footnotes.
- In the final version of financial statements, footnotes are used if there are any changes in contingent liabilities from initial creation.
Updated on: 08-Jul-2021
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