Contingent Liabilities: Definition & Examples

Contingent Liabilities: Definition & Examples
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  • 0:01 What Are Contingent…
  • 1:24 Product Recalls
  • 2:41 Pending Lawsuits
  • 3:42 Changes in Legislation
  • 4:02 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, you'll learn about three types of contingent liabilities: product recalls, pending lawsuits, and changes in legislation. You'll also learn how to account for these types of liabilities on the financial statements.

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.

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