Contingent liabilities are liabilities that may be incurred by an entity depending on the outcome of an uncertain future event such as the outcome of a pending lawsuit. These liabilities are not recorded in a company’s accounts and shown in the balance sheet when both probable and reasonably estimable as ‘contingency’ or ‘worst case’ financial outcome. A footnote to the balance sheet may describe the nature and extent of the contingent liabilities. The likelihood of loss is described as probable, reasonably possible, or remote. The ability to estimate a loss is described as known, reasonably estimable, or not reasonably estimable. It may or may not occur.
Before understanding contingent liabilities, one must learn about what is considered as a liability in the accounting and economic context. A liability is any financial event that poses as an obligation to a company, and the company needs to make a monetary settlement regarding it in the future. In other words, it refers to the financial obligations of a company.
These events need to be quantified into monetary terms to be recorded in the books of a company.
Majorly, liabilities are categorised into three subtypes i.e non-current liabilities, current liabilities, and contingent liabilities. A contingent liability is thus a type of financial event that might or might not evolve into an obligation in the future for the company. As per the definition provided by General Accepted Accounting Standards (GAAP), a contingent liability is any potential future expense that depends on a “triggering event” to convert it into an actual loss. A contingent liabilities example is a lawsuit.
As the concept of contingent liability borders on vagueness and considerations regarding which event is recognisable as a potential expense are unclear, there are two yardsticks to follow when dealing with a contingent liability:
- Whether an event is 50% or more likely to occur in the future.
- Whether it can be expressed in monetary figures.
If any contingency satisfies these two yardsticks, such an event can be posted in the books. A contingent liability is recorded first as an expense in the Profit & Loss Account and then on the liabilities side in the Balance sheet.
Types of Contingent Liabilities
Contingent liabilities are classified based on the scale of their probability, i.e. likeliness of an event occurring in the future. These types are mentioned below.
Any financial obligation that has at least 50% chance of occurring in the future is considered a probable contingency, and the loss thus to be realised is considered as a probable contingent liability.
For instance, if a company faces a lawsuit where the plaintiff poses a strong case, then such an event can be considered as a probable contingency. A professional such as a legal counsel will assess the weight of a lawsuit, derive its probability, and if chances of a loss are 50% or higher then express the loss in monetary terms. Following that, it shall be recorded in the books of the company.
Here, it is essential to note why a contingency is recorded in the books even when there is only a 50% chance of a liability arising. It is because, in accountancy, law of conservatism is followed which states the principle that loss is always impending and thus, shall be recorded at a 50% or higher probability of occurrence; whereas profits are unlikely and hence, recording them in the books shall be withheld till profit realisation, or chances are more likely than a loss.
A possible contingency is when a liability might or might not arise, but chances of its occurrence are less likely than that of a probable contingency, i.e. lower than 50%. Therefore, a possible contingency is usually not recorded in the books, but rather mentioned in the footnotes.
Another reason behind why a possible contingency is not recorded in the books is because it cannot be expressed in monetary terms due to its limited likeliness of occurrence. As mentioned earlier, any contingency that does not satisfy the two yardsticks shall not be recorded in the books of a company.
As the name suggests, any liability that has minimal chances of occurring and is not possible under normal circumstances is known as a remote contingency. As chances of such contingencies translating to losses for the company are negligible, they are not recorded in the books or mentioned in footnotes.
How to Recognise a Contingent Liability?
Contingent liability has a broad definition, and it is challenging for companies to either rule out or include a contingent liability in their books.
Hence, it is always advisable that companies shall consult professionals who are reasonably adept in the subject matter. This way, companies abide by the rules of GAAP and also possess a substantial argument when being audited.
For instance, if a company faces litigation, it shall consult a lawyer and rely upon his/her discretion regarding inclusion or exclusion of a liability in the books.
Like, if as per precedent and the discretion of a lawyer, a case’s outcome is deemed as ambiguous, then such contingency shall only be mentioned in the footnotes. In this manner, companies shall navigate the vagaries of contingent liabilities.
How Does Contingent Liability Affect Investors?
When a company can recognise in time the possibility of a loss, it then has the opportunity to set up provisions against such losses, thus attempting to attenuate the impact of such future loss. However, that is not the motive behind the recording of a contingency as a liability in the books.
Rather, when a contingent liability is recorded in the books of a company, that information becomes available to the shareholders and auditors as well. Hence, it can be construed that registering a contingent liability is to safeguard shareholders against probable losses.
Even though cases such as lawsuits can be closely followed by shareholders of a company, information regarding warranty, which is also a form of a contingent liability, is not easily accessible by shareholders.
Therefore, to safeguard investors’ interests, probable contingent liabilities (chances of occurrence of at least 50%) of all kinds shall be recorded in a company’s books. It allows individuals to make sound investment decisions.