How should a contingent liability that is reasonably possible be reported in the financial statements?

• A. It should be disclosed in the notes to the financial statements.
• B. It should be recognized as an expense in the income statement.
• C. It should be recognized as a liability on the balance sheet.
• D. It should not be reported or disclosed.

Answer: (A)

Verified step by step guidance

1. Understand the concept of contingent liabilities: A contingent liability is a potential obligation that may arise depending on the outcome of a future event. It is classified based on the likelihood of occurrence: probable, reasonably possible, or remote.
2. Review the accounting treatment for contingent liabilities: If the likelihood is probable and the amount can be reasonably estimated, it is recognized as a liability on the balance sheet. If the likelihood is reasonably possible, it is disclosed in the notes to the financial statements. If the likelihood is remote, it is neither recognized nor disclosed.
3. Analyze the scenario in the problem: The contingent liability is described as 'reasonably possible,' which means it does not meet the criteria for recognition as a liability on the balance sheet or as an expense in the income statement.
4. Determine the appropriate reporting method: Since the likelihood is reasonably possible, the correct treatment is to disclose the contingent liability in the notes to the financial statements. This provides transparency to users of the financial statements without overstating liabilities.
5. Conclude the reporting requirement: The contingent liability should be disclosed in the notes to the financial statements, as this aligns with the accounting standards and ensures proper communication of potential obligations to stakeholders.