A contingent liability exists when an organization incurs a liability that is dependent on the occurrence of a future event, but the likelihood of that event is uncertain. To qualify as contingent, the liability must occur during the reported statement period and have a determinable amount. Additionally, the likelihood of that event’s occurrence must be probable, reasonably possible, or remote. The most common forms of contingent liabilities are product warranties or guarantees. Companies generally offer guarantees or warranties with the introduction of new products to boost sales. Contingent liabilities are accrued because product warranties or guarantees are related to future costs based on current sales.
Things You'll Need
- Income statement
- Accounting software
Locate total sales for the new product on the Income Statement or Profit and Loss Statement for a specific period. Companies either list sales in one lump sum or per product. If the sales per product are not listed separately, this information can be found by reviewing a detailed Income Statement or Profit and Loss Statement.
Record the journal entry for total sales. Accounting for product warranties and guarantees requires a debit to Cash or Accounts Receivable for total sales in the period the product is sold and a credit to Sales Receivable. For example, if a company generates $1.5 million in sales for the new product, the entry is:
Debit - Cash $1,500,000 Credit - Sales revenue $1,500,000
Calculate warranty expense. Warranty expenses are generally based on the company’s previous sales experience. For example, if warranty expenses for similar products were equal to 3 percent of sales in the past, the company will assume the new product's warranty expense is based on 3 percent of the sales.
Record the journal entry for the warranty expense. A debit to Warranty Expense and a credit to the Estimated Warranty Liability is required. If total sales are $1.5 million and the estimated warranty expenses are 3 percent of sales, the entry is:
Debit - Warranty expense (3% x $1.5 million) $45,000 Credit - Estimated warranty liability $45,000
Reduce estimated warranty liability by customers' claims. When customers make claims for product warranties or guarantees, an entry debiting Estimated Warranty Liability and crediting Cash reduces the liability previously recorded. For example, if customers claim $25,000 in year 1, the company will record the following at the end of the year to reduce the liability balance:
Debit - Estimated warranty liability $25,000 Credit - Cash, wages payable, parts and supplies, etc $25,000