ACCA Financial Reporting (F7) Practice Exam

How is a contingent liability treated?

1. It is fully recognized in the financial statements

2. It is disclosed in the notes but not recognized in the financial statements

3. It can be ignored if insignificant

4. It is recorded as an expense

The correct answer is: It is disclosed in the notes but not recognized in the financial statements

A contingent liability is a potential obligation that may arise depending on the outcome of a future event, such as a lawsuit or a guarantee. The accounting treatment for contingent liabilities is specified by International Financial Reporting Standards (IFRS). In accounting, if a contingent liability has a likelihood of occurrence that is probable and can be estimated reliably, it would typically be recognized as a liability in the financial statements. However, if the likelihood is only possible or cannot be reliably measured, the liability is not recorded in the financial statements. Instead, these potential liabilities must be disclosed in the notes to the financial statements. This ensures that users of the financial statements are informed about possible obligations that may impact the entity's financial position in the future. Thus, for contingent liabilities, the correct treatment involves disclosing the nature and potential impact in the notes rather than recognizing them directly in the financial statements unless certain conditions are met. This allows stakeholders to be aware of risks without overstating the financial position of the entity.