Businesses generally report liabilities on their balance sheets for obligations to transfer assets or provide services in the future for past transactions or events. Common examples include trade payables, loans and accrued expenses. However, the rules for reporting contingent obligations, such as pending lawsuits or product warranties, are less clear. Some must be reported on the business’s balance sheet, like any other liability. Others may require only footnote disclosures — or no reporting at all. Proper treatment requires management to make judgment calls based on the facts and circumstances. Here’s an overview of how to properly report these items under U.S. Generally Accepted Accounting Principles (GAAP).
Factors to Consider
Contingent obligations exist when a current circumstance may cause a loss in the future depending on other events that have yet to happen — and may never actually happen. Most contingent liabilities are governed by Accounting Standards Codification (ASC) Topic 450, Contingencies. This guidance requires companies to recognize liabilities for contingencies when two conditions are met:
1. The contingent event is probable, and
2. The amount can be reasonably estimated.
If these criteria aren’t met but the event is reasonably possible, you must disclose the nature of the contingency and the potential amount (or range of amounts). If the likelihood is remote, no disclosure is generally needed unless required under another ASC topic. However, if a remote contingency is significant enough to potentially mislead financial statement users, the business may voluntarily disclose it.
Identify Potential Contingencies
Contingent liabilities arise in various business situations. For instance, a business may need to estimate a contingent liability for pending litigation if the outcome is probable and the loss can be reasonably estimated. In such cases, the business must recognize a liability on the balance sheet and record an expense in the income statement. If the loss is reasonably possible but not probable, the business must disclose the nature of the litigation and the potential loss or range of losses, if it can be reasonably estimated. Here’s an example of how a disclosure for a pending lawsuit might look:
As of December 31, 2026, the company was involved in a lawsuit related to a contract dispute. The plaintiff is seeking approximately $500,000 in damages. Management believes an unfavorable outcome is reasonably possible but cannot estimate the amount of any potential loss. Accordingly, no liability has been recorded.
When disclosing contingencies related to pending litigation, it’s important to avoid revealing confidential legal strategies. If the outcome is remote, no accrual or disclosure is generally required.
Other common types of contingent liabilities include:
Product warranties. If the business can reasonably estimate the cost of warranty claims based on historical data, it should generally record a warranty liability. Otherwise, it should disclose potential warranty obligations.
Environmental claims. Some businesses may face environmental obligations, particularly in the manufacturing, energy and mining sectors. If cleanup is probable and reasonably estimable, the business records a liability. If the obligation is uncertain, the business should disclose it, describing the nature and extent of the potential liability.
Tax disputes are handled differently, however. If a business is involved in a dispute with the IRS or state tax agency, it should consider the applicable accounting rules for uncertain tax positions (Topic 740). Likewise, guarantees of third-party obligations — when a business agrees to repay another company’s debt if that company fails to make its payments — are reported under the applicable rules for guarantees (Topic 460).
Under GAAP, companies are generally prohibited from recognizing gain contingencies in financial statements until they’re realized or realizable. These may involve potential benefits, such as the favorable outcome of a lawsuit or a tax rebate.
Be Transparent
Transparency is essential in financial reporting. However, some companies may be reluctant to recognize contingent liabilities because they lower earnings and increase liabilities, potentially raising a red flag for stakeholders.
To help ensure transparency when reporting contingencies, companies must maintain thorough records of all contingencies. Proper documentation may include contracts, legal filings, and communications with attorneys and regulatory bodies. Legal and financial advisors can provide insights into the likelihood of contingencies and help estimate potential losses.
As new information becomes available, management may need to reassess contingencies. For instance, if new evidence in a lawsuit makes a favorable outcome more likely, the financial statements may need to be updated in future accounting periods.
Seek Outside Guidance
Accurate, timely reporting of contingencies helps business owners and other stakeholders manage potential risks and make informed financial decisions. Regularly reviewing potential contingencies can help you identify obligations that may need to be recognized or disclosed before they become financial surprises. Contact Hood & Strong to help you evaluate contingencies, determine the appropriate accounting treatment, and disclose relevant information clearly and concisely.
