Contingent liabilities are amounts your company owes only in the case of a future event occurring. Their impact on the financial statements depends on the likelihood of the contingency being satisfied and the amount of the transaction. For example, a pending lawsuit could result in a large damage payout in the future. According to generally accepted accounting principles, you must include known contingent liabilities in the financial statements or the company's financial position will be misrepresented.
The disclosure requirement for contingencies depends on whether the liability is deemed to be material to the company's financial statements. The auditors will determine the materiality threshold before looking at any individual liabilities. If a liability does not exceed this limit, it is not believed to have a significant impact. The appropriate amount depends on the rest of the company's financial information. If the amount of a liability cannot be reasonably estimated, the auditor must treat it as if it was material and list it in the footnotes.
The likelihood of each contingent event must also be estimated to determine its effect on the company's financial statements. Disclosing every possible contingency can distort outsider analysis if there is no realistic possibility of these events happening. GAAP recognizes three levels of probability: Remote, reasonably possible and probable. Only possible and probable contingencies must be disclosed in the footnotes.
If the contingency is probable, the company must also include it on the general ledger. For example, a pending lawsuit would be recorded as a debit to legal expenses and a credit to accrued liabilities. You must be able to estimate the amount to make a journal entry. If you cannot, simply make a note of the contingency in the footnotes and mention that the amount is not known. The auditors will review the company's accrued liability ledger and verify that all journal entries have sufficient documentation.
The auditors are required to look for undisclosed contingent liabilities, so it is in the company's best interest to mention all of these at the beginning of the engagement. To confirm the company's claims, the auditors will review Internal Revenue Service reports to find any open tax liabilities, search for discussions of possible lawsuits in the minutes of past board of directors' meetings and analyze the company's legal expense ledger. Invoices and supporting documentation from attorneys may provide information relating to a pending legal action.
Events after the preparation of the financial statements and before the auditors finish their report can also create a contingent liability. Auditors typically discover this information through interviews with managers, review of board of directors meetings after the balance sheet date or comparing interim financial statements to the period under audit. Significant differences between the two balance sheets may indicate a material contingency that should be disclosed.