Contingent Liabilities

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Blog Author :

WallStreetMojo Team

Edited by :

Ashish Kumar Srivastav

Reviewed by :

Dheeraj Vaidya, CFA, FRM

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Contingent Liabilities Meaning

Contingent Liabilities refer to the possible liability of the firm which may occur on some future date based on a contingent event that is beyond the company's control. It is recorded by the company on its balance sheet only if it becomes evident that contingency is possible in the company and the amount of such liability can be estimated reasonably.

Contingent Liabilities

Thus, its existence is confirmed along with the happening of the particular event. Various lawsuits, warranties on goods and services, loan guarantees or disputed taxation-related matters come under this type of liability because the company is not certain about the outcome of any of these events. But they directly or indirectly affect the financial condition of the company.

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Contingent Liability Explained

In simple words, Contingent Liability is defined as future obligations or liabilities that may or may not arise due to uncertain events or situations. These liabilities are also recorded in the accounting books if the amount of the liability can be estimated.

Contingent liabilities in balance sheet or footnotes are usually related ti product warranties or pending lawsuits that do not have any obvious and guaranteed results in the future. The company will record the liability in the books of accounts only if it is sure of its occurrence. This is done to ensure that it is within the rules of the generally accepted accounting principles (GAAP), or follows the International Financial Reporting Standards (IFRS).

It is difficult to estimate the exact amount of such liabilities as they depend on the type of case and various other external factors. But the company should always try to ensure that the users of the financial statement, namely the management, shareholders, investors, lenders, etc get a clear view of the position of such liability. Therefore, the best possible level of information should be revealed for better understanding.

This liability affects the income-earning capacity and valuation of assets in various ways. Therefore, contingent liabilities disclosure and representation of an estimated amount is significant. They directly or indirectly affect the cash flows of the business, which in turn have an impact on investors ‘return and liability towards creditors. Thus, it is implied that this liability amount should be taken into consideration while making strategic decision regarding investments and future plans.

Types

Some of the types of contingent liabilities accounting are given below

#1 - Potential Lawsuits

Potential lawsuits arise when an individual gives the guarantee on the other person's behalf; when the actual person or individual fails to pay that the person who provided the guarantee must pay the money.

#2 - Product Warranty

When a product is manufactured and ready to sell then some companies give a product warranty, i.e., a minimum guarantee for a certain period, and when the product fails to perform within the warranty period, then the product has to be replaced or repaired by the company which is a liability to the company.

Let us see the example where a person has purchased a motorcycle from a showroom and has a two-year warranty for the engine and the motorcycle. If the engine fails to work within six months of the purchase, the company has to replace the engine. Hence, this is a contingent liability to the company.

#3 - Pending Investigations

If any pending investigation or a court case by law found that the individual or the company is a defaulter, then they were supposed to bear the penalty as prescribed by the court of law.

Example

These contingent liabilities accounting will be like if a person X obtains a loan from the Bank and Y is signed as a guarantee for that loan, and the bank will release the funds based on that guarantee; if the person X fails to repay the loan, then the guarantee Y has to pay it, this, in turn, is referred to as contingent liability. They are generally not recognized as financial assets or liabilities on the balance sheet before the conditions are met.

Contingent Liabilities

Disclosure

Contingent liabilities disclosure requirements are a crucial aspect in order to ensure transparency and accountability. The stakeholders should be aware of all potential risks that the company may face in future and which may impact its financial health. The following are the typical disclosure requirements that any company should follow in case of such liability. Let us study the same in detail.

  • Probable - Record this type of liability on the balance sheet when there is a probability that the event or loss may occur and when we can reasonably estimate the amount of the loss that happened to a specific range. This may give rise to contingent liabilities in balance sheet.
  • Reasonably Possible - Reveal the existence of this liability when in the financial statements if the obligation or the liability is reasonably possible but not probable.
  • Remote - There is no need to record or reveal this contingent liability if the chances of its occurrence are remote.

Contingent Liability Vs Provisions

Both the above are two types of financial obligations that any company may have to face during its operational process. However, there are some differences between them, as follows:

  • The most important difference is that the contingent liabilities in financial statements is a liability that may or may not arise, because it completely depends on the outcome of a future event. But the latter is a liability that is sure to arise after a certain point of time, due to which the business has to create provision or keep aside some fund to meet it without affecting the planned budget.
  • The former is not directly entered in the financial statements, but they are definitely mentioned in the footnotes of the financial statements or in supplementary information. This is important in order to inform the stakeholders about their existence. But for the latter, they are directly recorded in the books of accounts and displayed in financial statements.
  • The value of the contingent liabilities in financial statements, can only be estimated based on past experiences and proper study of the case. But the value of the latter can be mostly accurately calculated based on which funds are kept aside for future purpose.

Thus, the above are some important differences between the two concepts.