what is important to know about contingent liability 
contingent liabilities adversely impact a company s assets and net profitability as a result knowledge of both contingencies and commitments is extremely important to users of financial statements because they represent the encumbrance of potentially material amounts of resources during future periods and thus affect the future cash flows available to creditors and investors contingent liabilities are also important for potential lenders to a company who will take these liabilities into account when deciding on their lending terms business leaders should also be aware of contingent liabilities because they should be considered when making strategic decisions about a company s future example of a contingent liabilityassume that a company is facing a lawsuit from a rival firm for patent infringement the company s legal department thinks that the rival firm has a strong case and the business estimates a 2 million loss if the firm loses the case because the liability is both probable and easy to estimate the firm posts an accounting entry on the balance sheet to debit increase legal expenses for 2 million and to credit increase accrued expense for 2 million the accrual account permits the firm to immediately post an expense without the need for an immediate cash payment if the lawsuit results in a loss a debit is applied to the accrued account deduction and cash is credited reduced by 2 million now assume that a lawsuit liability is possible but not probable and the dollar amount is estimated to be 2 million under these circumstances the company discloses the contingent liability in the footnotes of the financial statements if the firm determines that the likelihood of the liability occurring is remote the company does not need to disclose the potential liability a warranty is another common contingent liability because the number of products returned under a warranty is unknown assume for example that a bike manufacturer offers a three year warranty on bicycle seats which cost 50 each if the firm manufactures 1 000 bicycle seats in a year and offers a warranty per seat the firm needs to estimate the number of seats that may be returned under warranty each year if for example the company forecasts that 200 seats must be replaced under warranty for 50 the firm posts a debit increase to warranty expense for 10 000 and a credit increase to accrued warranty liability for 10 000 at the end of the year the accounts are adjusted for the actual warranty expense incurred 