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.