Final answer:
Disclosure of a contingent liability is made in the footnotes rather than adjusting financial statements when the outcome is judged to be reasonably possible but the loss cannot be reasonably estimated, as per option 3.
Step-by-step explanation:
When disclosing a contingent liability, an adjustment to the financial statements is not made but instead is noted in the footnotes when the outcome of the event is judged to be reasonably possible, but the loss cannot be reasonably estimated. This response corresponds to option 3. When businesses face uncertain future events that could lead to a financial loss, accounting principles require reporting these potential liabilities differently based on the level of uncertainty and the ability to estimate the potential loss. In situations where the loss can be reasonably estimated but the outcome is unknown, or the outcome is known to be reasonably possible, disclosure through footnotes provides necessary information to users of the financial statements without the need to adjust the financials prematurely.
Disclosure ensures transparency and provides recognition of potential financial impacts without overstating liabilities. This conforms to the prudence concept of accounting, which encourages caution in reporting and avoiding overstatement of financial position and performance. The approach to disclosure is analogous to the principles behind how insurance works, where estimation of risk and the handling of imperfect information are crucial.