GAAP Guidelines for Contingent Liabilities

Because of subjective accounting rules, investors should make their own determination of a company's contingent liabilities.

Oct 25, 2015 at 11:47PM

A contingent liability is a potential cost a company may or may not incur in the future. A contingent liability could be a guarantee on a debt to another entity, a lawsuit, a government probe, or even a product warranty. Any of these circumstances could cost a company money, but the amount of that cost is unknown. It could be zero, or it could be billions.

Understanding the accounting treatment of contingent liabilities can help investors fully vet the risks of a potential investment.

The accounting of contingent liabilities
In the U.S., accountants adhere to the rules and standards defined by the Generally Accepted Accounting Principles, commonly referred to as GAAP.

Per GAAP, contingent liabilities can be broken down into three categories based on the likelihood of those liabilities actually occurring. A "high probability" contingency is a liability that is both probable of actually occurring and one where the costs can be reasonably estimated. For high probability contingent liabilities, the company must disclose the estimated amount of the potential loss and also describe the contingency in the footnotes of its financial statements.

A "medium probability" contingency is one that falls short of either but not both of the parameters of a high probability liability. These liabilities must be disclosed in the footnotes of the financial statements if either of two criteria are true. First, if the contingency is probable but the company cannot estimate the loss, or second, if the contingency the contingency is reasonably possible, although not necessarily probable.

Last, GAAP qualifies other contingent liabilities as "low probability." The likelihood of these contingent liabilities actually triggering a cost is very low, and therefore accountants are not required to report them in the financial statements.

What this means for investors
The accounting rules regarding contingent liabilities are, as you can see above, very subjective. If a loss from one of these liabilities is imminent, then the company will disclose the liability, but otherwise there is a lot of wiggle room for companies to disclose at their discretion.

Sometimes a contingent liability can arise suddenly, catching both management and investors by surprise. The billions in liabilities for BP related to the Deep Horizon oil spill and Volkswagen's massive liabilities from its 2015 emissions scandal are two such scenarios.

However, in other cases, management can hide certain known contingent liabilities from investors until the very last minute. A lawsuit, for example, doesn't necessarily need to be disclosed as a contingent liability if the company believes the suit is frivolous and will be dismissed. It's only later when a settlement or trial is imminent that this contingency would qualify as a medium or high probability occurrence.

Understanding this, investors should watch a company's contingent liabilities with a skeptical eye. Most companies will be forthcoming and present their affairs fairly and with transparency. But there will be bad actors who intentionally mislead investors within the rules of GAAP's contingent liability treatment. In those cases, investors will be glad to have relied on other sources like news reports, press releases, and independent assessments of legal proceedings to make their own determination of a company's contingent liabilities.

The $15,978 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. In fact, one MarketWatch reporter argues that if more Americans knew about this, the government would have to shell out an extra $10 billion annually. For example: one easy, 17-minute trick could pay you as much as $15,978 more... each year! Once you learn how to take advantage of all these loopholes, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how you can take advantage of these strategies.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in the Foolsaurus. Pop on over there to learn more about our Wiki and how you can be involved in helping the world invest, better! If you see any issues with this page, please email us at knowledgecenter@fool.com. Thanks -- and Fool on!

the_motley_fool has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers