A contingent liability is an expense your company may or may not have to pay. The expense or liability is contingent on something that hasn’t happened yet but that might happen. In many cases, the situation is out of your control.

If you use accrual based accounting, you should include these expenses in your financial records. As a reminder, accrual based accounting is where you record income and expenses when you seal the deal. You don’t wait until you actually receive or spend the cash like you do with cash-based accounting.

With contingent liabilities, you basically have to guess whether or not something is going to happen. You also have to estimate how much the expense is going to be. To record contingent liabilities, you should debit the relevant expense account and note a credit in your accounts payable. This creates the liability on your books and recognizes the expense in the current period.

A common example of a contingent liability is a warranty. If you sell a product with a warranty, you might have additional expenses in the future if your customers take you up on your offer to fix or replace the product. You don’t know upfront whether or not your clients are going to use the warranty, but to be on the safe side, you should estimate these expenses and include them in your records.

Another common situation for contingent liabilities involves lawsuits or legal proceedings. The final result of a proceeding is not known during the case, but you still need to estimate the financial impact on your business. To do that, you should note likely settlements or payouts in your records.

Including contingent liabilities in your financial records creates a more accurate picture of your company’s finances. Individuals outside of your company, such as lenders, find your records more accurate and relevant. Plus, when you record contingent liabilities, you can also make better decisions because you have a better picture of what’s likely to happen.