Contingent Liabilities

08/07/2020 1 By indiafreenotes

A contingent liability is a potential liability that may or may not become an actual liability. Whether the contingent liability becomes an actual liability depends on a future event occurring or not occurring.

In accounting, some contingent liabilities and their related contingent losses are:

  • Recorded with a journal entry
  • Are limited to a disclosure in the notes to the financial statements
  • Not recorded or disclosed

We have another Q&A that discusses the recording of contingent liabilities.

Examples of Contingent Liability

A company’s supplier is unable to obtain a bank loan. The company agrees to guarantee that the supplier’s bank loan will be repaid. As a result of the company’s guarantee, the bank makes the loan to the supplier. The company has a contingent liability. If the supplier makes the loan payments needed to pay off the loan, the company will have no liability. If the supplier fails to repay the bank, the company will have an actual liability.

If a company is sued by a former employee for $500,000 for age discrimination, the company has a contingent liability. If the company is found guilty, it will have an actual liability. However, if the company is not found guilty, the company will not have any liability.

A product warranty is also a contingent liability.

Types of Contingent Liabilities

Contingent liabilities are of two types which are:

  1. Explicit Contingent Liabilities
  2. Implicit Contingent Liabilities

Let us know more in details about the types

  1. Explicit Contingent Liabilities

These liabilities are specific types of obligations that are created by government or obligations which are legal in nature that are established by the law.

Some of the examples are:

  • Government insurance schemes on pension funds, bank bonds or bank deposits.
  • Student loan, mortgage loan
  • Currency exchange rates
  • Legal claims in which court orders to pay penalty for pending cases.
  1. Implicit Contingent Liabilities

These types of liabilities are legal obligations that are identified after the occurrence of an event. Government sets the amount for the liability in such cases. They are not recorded in the books as these events may occur or may not occur.

Some examples are:

  • Disaster relief fund for people affected by natural disaster.
  • Failure of central bank on paying its obligations like balance of payment
  • Social security

Let us discuss some of the contingent liabilities’ examples

  1. Product Warranty

This is one of the most common types of contingent liability examples. It occurs when a company launches a product with a warranty period with the condition that if the product fails to work within the period, it has to be repaired or replaced which becomes a liability for the company.

  1. Lawsuits

Lawsuits are legal proceedings by an individual, party or parties against another in civil court of law.

  1. Pending Investigations

If an individual or company is found to be defaulting in any form of payment, then they have to pay fine or penalty as ordered by court.

Recording of Contingent Liabilities

Contingent liabilities do not get recorded in financial statements of a company. These are obligations that are yet to occur but there is a probability that it may occur in future. Therefore, no accounting treatment exists for contingent liabilities.

But as accounting follows a conservative approach, there must be disclosure and therefore contingent liability needs to be updated in final statements of the company in the form of footnotes. Such a disclosure is made only when there is an obligation from a past event and the amount of the liability can be measured reasonably.

Difference between Provision and Contingent Liability

Provisions are a sum of money that is set aside in order to cover a probable expense that will happen in future. In this case the obligation is already present but the amount for such an obligation cannot be determined exactly.

Contingent liabilities are liabilities that are uncertain expenses that may or may not happen in future, but companies maintain it in order to encounter future uncertainties.

Provisions are recorded in the accounts. They get debited in Profit and Loss accounts whereas contingent liabilities are recorded as footnotes in financial