As renowned investor Warren Buffet has stated, “Accounting is the language of business.” Thus, it is critical for business leaders to get the “language” right. That includes properly and accurately recording, reporting, and acting on an organization’s financial statements, including a focus on assets and liabilities, including contingent liabilities. 

What is the Accounting Equation 

The accounting equation is simply that a company’s assets are equal to the sum of its liabilities (including contingent liabilities) plus shareholders’ equity. Assets include cash and cash equivalents, accounts receivable, inventory, and company property, machinery, and equipment. Liabilities include a company’s long and short-term debts including rent, utilities, wages, taxes, dividends payable, and contingent liabilities. Shareholders’ equity represents what a company would have left if it paid off all its liabilities and liquidated all its assets. 

What Are Contingent Liabilities 

Contingent liabilities are any potential liabilities that may arise depending on the happening and outcome of a future event that may be beyond the company’s control. 

There are three categories of contingent liabilities recognized and directed to be reported according to generally accepted accounting principles (GAAP). First are those that are probable and can be reasonably estimated. These must be recorded on financial statements. Second are those that are as likely to occur as not. These are only required to be disclosed in the footnotes to the financial statements. Third are those that are extremely unlikely to occur. They do not need to be included in the financial statements.  

Here are the types of contingent liabilities: 

  • Lawsuit. If a company expects that it may lose a lawsuit, it can record a contingent expense. If it believes it will not lose a lawsuit, no contingent liability will be recorded. This also applies if there are pending investigations or pending cases. 
  • Warranty. If a company sells products with an accompanying warranty, it must estimate a contingent liability to make good on the warranties. 
  • Bank guarantee. If one company guarantees a loan on behalf of another and has a reasonable chance to default on that guarantee, a contingent liability must be recorded. 
  • Government policy changes. If a change in government policies is reasonably expected that could change product cost structure or tax rates, a contingent liability must be recorded. 
  • Change in the foreign exchange rate. Significant changes in the foreign exchange rate that may affect raw materials’ cost may need to be recorded if the impact is negative. 
  • Liquidate damage costs. If there is potential damage of contract breach, a contingent liability may be recorded. 

GAAP operates on the three principles of full disclosure. First, all relevant and significant facts regarding a company’s financial performance should be included in the company’s financial statements. Second, all material facts should be disclosed. Material items are any items that if left out would change any economic decisions by any users of the company’s financial statements. Third is the principle of prudence, meaning that assets and income are not overstated, and liabilities and expenses are not understated.

What Can Happen if Contingent Liabilities Are Not Reported or Reported Properly 

Improperly or inaccurately recorded contingent liabilities can impact and distort a company’s financial statements, giving reviewers an incorrect impression of a company’s financial condition. Incorrect information can lead to incorrect decisions made by investors, suppliers, creditors, and lenders. 

Benefits of Professional Accounting Assistance 

Here are 6 benefits of securing professional accounting assistance: 

  1. Get all assets, income, expenses, and liabilities (including contingent liabilities) recorded accurately and properly to avoid stakeholder confusion and incorrect decisions, and to avoid legal penalties. 
  2. Comply with all tax laws and maximize tax benefits. 
  3. Save time and worry for business owners so they can give more focus to essential business operating functions. 
  4. Provide accurate information to help solidify business plans and clarify business decisions. 
  5. Help minimize business risks. 
  6. Help ensure the security of financial information.

Seek Professional Accounting Assistance 

Contact Nolan Accounting Center, based in Greenfield, WI. We build strong relationships and support strategies for success. We provide accounting, tax preparation, bookkeeping, and payroll services to small business owners in Southeast Wisconsin including Milwaukee, Greenfield, New Berlin, Muskego, West Allis & Waukesha.