Thursday, 1 November 2012

The unique thing about Contingent Liabilities

            A contingent liability an accrued liability. As with an accrued liability,which is a non cash liability,  no cash is taken from anybody to create a contingent liability. Instead we fear we may have to pay for something, soon, and thus create a liability by recording an expense.

Let us examine some examples.

         A typical example is the accounting of warranty. When we sell a product, we have to give warranty. Since we cannot charge warranty fees from the customers, we charge it indirectly while the product is sold. The entry is

  cash                                            1000000
  est warranty exp (3yrs)                200000
  est warranty liability                                          200000

  sales                                                                  1000000

Here the product is sold for 1200000, and the estimated warranty expense 200000 is recorded and a consequent liability is capitalized in the balance sheet. As we know, when an expense is made, the retained earning is reduced by the same amount. So 200000 is reduced from the capital to create a liability of the same amount. Now when the warranty is claimed by the customer for say 50000, that expense which is paid in cash, reduces the liability.

  est warranty liability                     50000
 cash                                                                     50000

If this is the only amount claimed during the entire warranty period of 3 years, we remove the unclaimed liability by adding it back to the retained earnings (capital) through a revenue entry

 est warranty liability                     150000
 warranty revenue                                                1500000         

Another example is that of a probable and estimable lawsuit settlement. We create a contigent liability called lawsuit settlement liability.

  lawsuit settlement exp               xxxxx
  lawsuit settlement liability                                xxxxx

When the settlement actually happens

  lawsuit liability                            xxxxx
  cash                                                                   xxxxx

for eg:

  cash                                  1000000
  est warranty exp                200000
  est warranty liability                              200000
  sales                                                       1000000

  est warranty liability         4000
  cash                                                            4000 (when claimed)


The uniqueness of contingent liabilities is that they don't have an opposite called contingent asset. Yes, there are certain short lived asset additions made which goes into gain section in the income statement like the following entry

Investment-Securities.                             xxx
Gain on appreciation of securities.                             xxx
This is done  when an investment in security is declared as a dividend; the security in question is revalued to its fair market value. But the nature of Investment-Securities is short term. This account gets removed from the balance sheet once the said dividend is paid.

 We do not create a revenue by dreaming that we will gain/win an income, creating a contingent asset.

For example

 Lawsuit receivable        100000000
Lawsuit win revenue                             100000000    

As you can see this is as absurd as it seems.                                 

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