Contingent Liabilities: Definition, Types and Example

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Tally Solutions | Jan-12-2020

Definition of Contingent Liabilities

Why do you Provision for Contingent Liability?

When to Recognize a Contingent Liability?

Accounting rules for Contingent Liability

Contingent Liability Examples

Definition of Contingent Liabilities

A contingent liability is a possible obligation that may arise in future depending on occurrence or non- occurrence of one or more uncertain events.

To simplify the definition, a contingent liability is a potential liability which may or may not become an actual liability depending on the occurrence of events.  As a result, it is shown as a footnote in the balance sheet and not recognized in par with other components of financial statements.

The outcome of a long-pending lawsuit, a government investigation into organizations affairs, a threat of expropriation etc.  some of the common examples of contingent liabilities. Even a warranty be considered as a contingent liability.

Why do you Provision for Contingent Liability?

By nature, contingent liabilities are uncertain and for a business, these are the future expenses or outflows that might occur. By providing for contingent liabilities, it gives an opportunity for businesses to asses and be prepared for the situation.

Let’s understand why it is important for a business to provide for contingent liabilities with an example.

ACE Ltd, a spare part manufacturer located in Mumbai. One of their customers has filed the legal claim against the company for delivering the product which was defective.

Initially, when the customer had reported it to, the company refused to accept the claim and therefore, the customer has filed a legal claim against them.

Let’s analyze the above example and find how to provide for contingent liability and how it helps.

  • There is a present obligation (legal or constructive) as a result of past events.

In the example of ACE Ltd, the present obligation is the legal claim brought against it by a customer. And the past event is the company delivering the defective product and turning down the claim of the customer.

Here, instead of providing for damages in financial statements, ACE Ltd should disclose it by way of notes to the financial statement. The reason is that the future occurrence of an event may or may not turn into a liability.

  • It is likely that an outflow of resources including economic benefits will be required to settle the obligations.

It is clear in the case of ACE Ltd that the claim against the company, on materialization will involve possible outflow of resources to settle the obligation,

  • An estimate can be reliably made on the obligations.

In the example of ACE Ltd, the claim will materialize into monetary outflow for the company and the company should reliably estimate such amount.

Here, it becomes necessary to notify it to shareholders and other users of financial statements because the outcome will have an impact on investment related decisions.

To summarize, providing for contingent liabilities will help the business to track the future obligation owing to the past events, asses the outflow of resources required and estimated amount when the obligation materializes.

When to Recognize a Contingent Liability?

In order to recognize the contingent liability, you need to consider the below scenarios. These scenarios are often referred to as types of contingent liabilities.

 

Probable

Possible

Remote

 

Probable

Under this scenario, contingent Liability is recorded only when it is probable that the loss will occur, and you can reasonably estimate the amount of loss. Here, “Probable” means that the future event is likely to occur.

Therefore, it is also important to describe the liability in the footnotes that accompany the financial statements.

Possible

Here, contingent liabilities are recognized only when the liability is reasonably possible to estimate and not probable.

Here, “Reasonably possible” means that the chance for occurrence of an event is more than remote but less than likely.

 

To further simplify, the loss due to future events is not likely to happen but not necessarily be considered as unlikely. It could be a situation where the liability is probable, but the amount couldn’t be estimated.

Under this situation, the preparers of financial statements should disclose the existence of contingent Liability in the notes accompanying such financial statements

Remote

In this scenario, the contingent liability is not recorded or disclosed if the probability of its occurrence is remote.  Here, ‘remote’ means the contingencies aren't likely to occur and aren't reasonably possible.

Accounting Rules for Contingent Liability

  • A contingent liability should not itself be recognized in the statement of financial position.
  • A contingent liability should be disclosed only under notes to financial statements unless the possibilities of a transfer of economic benefits are remote.

Below table summarizes the different nature of contingencies and their treatment in the financial statement.

Level of probability of an outflow/inflow of resources

Liability

Virtually certain

Provide/recognize in financial statements.

Probable

Provide/recognize in financial statements.

Possible

Disclosure by way of notes to financial statements.

Remote

Not recognized or disclosed

Contingent Liability Examples

  • Guarantees and counter guarantees given by a company.
  • Guarantee that a company gives to another person on behalf of the third party (loan given to the subsidiary or the guarantee that another company will perform its contractual obligation.
  • Product warranty.
  • Shareholders guarantee.
  • Letter of credit issued.
  • Potential adverse judgement (cases regarding any financial dispute).
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