What Is a Contingency in Accounting?

A contingency in accounting refers to an uncertain future event or condition that, if it occurs, will have a direct financial impact on a company’s financial statements. Accountants assess these uncertainties to ensure the financial picture presented to stakeholders is accurate.

Classifying Contingencies

Contingencies are categorized into two main types: contingent liabilities and contingent assets. Contingent liabilities represent potential obligations dependent on a future event, such as pending lawsuits, product warranties, or environmental cleanup costs. These signify a potential outflow of economic benefits. Conversely, contingent assets are potential economic benefits whose realization depends on a future event. Examples include potential insurance recoveries or pending patent infringement claims where a company anticipates a favorable outcome. These represent a potential inflow of economic benefits.

Accounting for Contingencies

Accounting treatment for contingencies differs significantly between liabilities and assets, largely due to accounting conservatism. For contingent liabilities, specific criteria determine whether they are recognized on the balance sheet or disclosed in the financial statement notes. Under U.S. Generally Accepted Accounting Principles (GAAP), a contingent liability is accrued and recognized if two conditions are met: it is probable that a liability has been incurred, and the amount of the loss can be reasonably estimated. This guidance is found in ASC 450-20.

“Probable” means the future event is likely to occur, generally a likelihood of 75% or more. If a probable loss falls within a range, the minimum amount is typically accrued. If the loss is “reasonably possible” (more than remote but less than probable, generally 25% to 75%), it is not accrued but must be disclosed in the financial statement notes. A “remote” likelihood (less than 25%) usually requires no recognition or disclosure. Contingent assets are treated more conservatively and are generally not recognized on the balance sheet. Instead, they are typically only disclosed in the financial statement notes if their realization is considered probable or reasonably possible.

Real-World Examples

Consider a company facing a lawsuit where legal counsel believes a loss is probable and can reasonably estimate the settlement between $5 million and $10 million. The company would accrue a $5 million contingent liability on its balance sheet and record a corresponding expense. A manufacturing company offering a two-year warranty estimates future repair costs based on historical data. These estimated costs are accrued as a contingent liability. Similarly, probable and estimable environmental cleanup costs would lead to an accrual.

For contingent assets, consider a company that has filed an insurance claim for property damage, expecting to receive $2 million. While recovery is probable, it is not yet legally certain until the claim is approved and paid. The company would not record the $2 million as an asset; instead, it would disclose the nature and amount of the pending insurance claim in the notes to its financial statements. A disputed tax refund claim, where a company believes it will win but the outcome is uncertain, would be treated similarly with disclosure rather than recognition.