Contingent Liability
A potential obligation arising from a past event whose outcome depends on a future uncertain event, such as a pending lawsuit.
What is Contingent Liability?
A contingent liability is a potential financial obligation that depends on the outcome of an uncertain future event, most commonly a lawsuit, warranty claim, or regulatory investigation. Under GAAP (ASC 450), a contingent liability must be recorded on the balance sheet when two conditions are met: the loss is probable, and the amount can be reasonably estimated. If the loss is only possible but not probable, it must be disclosed in the footnotes without being recorded. If remote, no disclosure is required. The accounting treatment can materially affect a company's reported liabilities, net income, and earnings quality.
Example
A pharmaceutical company faces a patent infringement lawsuit with a potential judgment of $500 million. Its legal counsel determines that an unfavorable outcome is probable and estimates the loss at $120 million. The company records a $120 million contingent liability on its balance sheet and recognizes a corresponding loss in its income statement for the period. The remaining possible exposure above $120 million is disclosed in the footnotes.
Source: FASB — ASC 450: Contingencies