Contingent Liability
Potential future liability dependent on uncertain events or outcomes
What Is a Contingent Liability?
A Contingent Liability is a possible liability or a potential loss that may or may not occur based on the result of an unexpected future event or circumstance. These liabilities will get recorded if the liability has a reasonable probability of occurrence.
A contingent liability can be very challenging to articulate in monetary terms. As it depends on the probability of the occurrence of that specific circumstance, that probability can vary according to one's judgment.
As this concept hovers around ambiguity and uncertainty about the amount of money one should set aside for the expense, here are two questions one must ask before accounting for any potential unforeseen obligation.
- Is the probability of the occurrence of that event over 50% or more?
- Can we express it in monetary figures?
If any potential liability surpasses the above two provided conditions, we can record the event in the books of accounts. Some examples of such liabilities would be product warranties, lawsuits, bank guarantees, and changes in government policies.
When the probability of such an event is extremely low, it is allowed to omit the entry in the books of accounts, and disclosure is also not required. It can be recorded only if estimation is possible; otherwise, disclosure is necessary.
This type of liability is not similar to an actual liability like a debt obligation or accounts payable owed by the business. Instead, such liabilities are typically associated with liabilities that are difficult to predict.
The most common examples of items considered contingent liabilities are:
- Lawsuits
- Product Warranties
- Shareholder guarantees
- Letter of credit issued
- Guarantees issued by a company
- Natural disasters
- Fines imposed on the pharmaceutical sector
- Investigations on a company
- Change in government policies
- Foreign exchange transactions
One can always depict this type of liability on the company’s financial statements if there are any. It is disclosed in the footnotes of the financial statements as they have an enormous impact on the company’s financial conditions.
According to the US Generally Accepted Accounting Principles(US GAAP), these liabilities are separated into three sections:
- Probable liability
- Possible liability
- Remote liability
Key Takeaways
- Contingent liability refers to a potential future liability or loss that may or may not occur due to unexpected events or circumstances, and it is recorded if there is a reasonable probability of occurrence.
- Assessing contingent liabilities can be challenging as they depend on uncertain probabilities and may not be easily expressed in monetary terms.
- Two critical questions to ask before accounting for a contingent liability are: Is the probability of occurrence over 50%? Can it be expressed in monetary figures?
- Examples of contingent liabilities include product warranties, lawsuits, guarantees, natural disasters, and changes in government policies.
- Contingent liabilities are classified into three categories based on probability: Probable, Possible, and Remote, each with different accounting treatment and disclosure requirements.
Why are Contingent Liabilities recorded?
First, we need to get hold of three basic accounting principles. Three accounting principles are associated with why contingent liabilities are recorded.
They are as follows:
1. Principle of Prudence
The principle of prudence is a crucial principle that states that a company must not record future anticipated gains into the books of accounts, but any expected losses must be accounted for.
This ensures that income or assets are not overstated, and expenses or liabilities are not understated.
A great example of the application of prudence would be recognizing anticipated bad debts. Prudence can be helpful if certain liabilities might occur but aren't certain; here contingent liabilities.
2. Principle of materiality
The principle of materiality states that all items with some monetary value must be accounted into the books of accounts. Items can be considered to have a monetary value if their inclusion or exclusion has an impact on the business.
An example of this principle is when a $ 100 invoice to a company with net assets of $ 5 billion would be immaterial, but a $ 50 million invoice to the same company would be materialistic.
Also, materiality would vary from organization to organization as all organizations aren’t of the same size. A $ 10,000 invoice would be material to one organization but immaterial to another.
3. Principle of full disclosure
The full disclosure principle states that all necessary information that poses an impact on the financial strength of the company must be registered in the public filings.
Note
Statements that have a material impact on the company’s operations or any decisions must be disclosed
This principle plays an important role in ensuring reduced information asymmetry between the shareholders and the management. This can help investors make informed decisions.
This can help encourage clarity between the company's shareholders and investors and reduce any potential con activities.
Classifications of Contingent Liabilities
Contingent liabilities are classified into three types by the US GAAP based on the probability of their occurrence.
They are explained in detail below:
1. Probable Contingencies
Any liabilities that have a probability of occurring over 50% are categorized under probable contingencies. These liabilities must be reflected in the company's financial statements.
Here the principle of prudence and materiality is always applied. For example, when a company is fighting a legal battle and the opposite party has a stronger case, and the probability of losing is above 50%, it must be recorded in the books of accounts.
However, if there is more than a 50% chance of winning the case, according to the prudence principle, no benefits would be recorded on the books of accounts.
2. Possible Contingencies
A possible contingency is when the event might or might not happen, but the chances are less than that of a probable contingency, i.e., less than 50%. This liability is not required to be recorded in the books of accounts, but a disclosure might be preferred.
Note
Possible contingency is not recorded in the books of accounts because it is very difficult to articulate the liability in monetary terms due to its limited occurrence.
Possible contingencies are just disclosed to the investors by the management during the Annual general meetings (AGMs).
3. Remote Contingencies
As the name suggests, if there are very slight chances of the liability occurring, the US GAAP considers calling it a remote contingency.
Such contingency is neither recorded on the financial statements nor disclosed to the investors by the management. This shows us that the probability of occurrence of such an event is less than that of a possible contingency.
The most common example of a remote contingency would be a frivolous lawsuit. If the lawyer and the company decide that the lawsuit is frivolous, there won't be any need to provide a disclosure to the public.
Examples of Contingent liabilities
These obligations result from previous transactions or occurrences, and they are contingent on future events and indeterminate in nature.
We will examine some examples of contingent liabilities that firms could experience and how they might affect financial reporting and decision-making below:
Example #1
Imagine a business being sued for copyright infringement by a rival business. The business projects a $5 million loss if the firm loses the case, but the legal department of the business believes the rival firm has a strong case.
The company sets an accounting entry to debit (increase) legal expenses for $5 million and credit (raise) accrued expenses for $5 million on the balance sheet because the liability is probable and simple to estimate.
The accrual account enables the company to record expenses without requiring an immediate cash payment. If the case is unsuccessful, $5 million in cash is credited (reduced), and the accruing account is debited.
Let's assume that the litigation would likely cost $5 million and would be feasible but not likely.
In this situation, the corporation discloses the contingent liability in the financial statements' footnotes.
Note
The business is exempt from disclosing the possible liability if it considers that the risk of it happening is remote.
Example #2
Another fantastic example of contingent liability would be product warranties. Let’s say a mobile phone manufacturer produces many mobiles and sells them with a brand warranty of 1 year.
Let's say that the manufacturer has estimated that out of all the mobile phones produced, about 2,000 mobiles would be called back due to fault reasons.
So the mobile manufacturer will record a contingent liability in the P&L statement and the balance sheet, an amount at which the 2,000 mobile phones were made.
Applicability of Contingent liabilities in investing
Contingent liabilities greatly impact one’s decision-making purposes. Since it has the potential to affect the company’s Cash flow and net income negatively, one has to take important steps to decide the impact of these contingencies.
The impact of contingent liability can also hamper a company’s ability to take debt from the market as creditors become more stringent before lending capital due to the uncertainty of the liability. If the liability arises, it would negatively impact the company’s ability to repay debt.
These liabilities can harm the company's stock price because contingent liabilities can negatively impact the business's future profitability. The magnitude of the impact depends on the time of occurrence and the amount tied to the liability.
The soundness of the company's finances will also have an impact. The liability won't significantly affect the stock price if investors believe the company has strong and stable cash flows and can withstand the damage.
Note
Contingent liabilities are inherently unknown. Determining and quantifying their exact influence on a company's stock price is impossible.
Even if it appears likely that the contingent obligation may become an actual liability, investors may choose to invest in the firm if they believe the company is in such sound financial standing that any losses resulting from the contingent liability would be easily absorbable.
A great example of the incorporation of analysis of contingent liabilities in our investments is given below:
- An investor considers purchasing a stock having huge potential for upside in the stock’s price. The company fundamentals also seem very promising. But the investor has only one concern.
- The company has a contingent liability recorded in the financial statements, and the liability is of a massive amount and can decrease the price by over 30% of its current value.
- Now, the investor can be in a dilemma whether to invest in the stock, as it has huge upside potentials, but the liability can also push the stock price downwards.
Difference Between Types of Liabilities
Liabilities are related to the financial obligations or debts that a person or a company has to another entity. There are numerous different categories of liabilities, each with special characteristics and implications for the creditor and debtor.
Understanding how different categories of responsibilities differ is necessary for managing financial risks and making well-informed financial decisions. Below is a table that differentiates between the three types of liabilities:
| Parameter of difference | Contingent Liabilities | Non-current Liabilities | Current Liabilities |
|---|---|---|---|
| Definition | A possible liability or a potential loss that may or may not occur based on the result of an unexpected future event or circumstance. | Obligations that won't arise shortly or at least one operating cycle are non-current liabilities. | Obligations written off from the financial statements within one operating cycle are current liabilities. |
| How are they recorded? | These are recorded on the balance sheet in the long-term liabilities header. | These are recorded on the balance sheet in the current liabilities header. | If it has a 50% or greater chance of occurrence, then it is recorded in both the P&L statement and the balance sheet. |
| Monetary values | One has the exact idea of the monetary value affecting the company. | One has the exact idea of the monetary value affecting the company. | Monetary values are only reliable to a certain point as they are estimated and not an actual obligation. |
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Contingent Liability FAQs
Contingent liabilities are recorded on the P&L statement and the balance sheet if the probability of occurrence is more than 50%.
Contingent liabilities aren’t current liabilities. One major difference between the two is that the latter is an amount you already owe someone, whereas the former is contingent upon the event occurring.
The nature of contingent liability is important for deciding whether it is good or bad. Not all contingencies are necessarily bad for a company.
Even if the outcome is based on the probability of occurrence of the event, it is considered an actual liability. But it will be recorded in the books only if the probability is more than 50%.
Although it is not realized in the books of accounts, a contingent liability is credited to the accrued liabilities account in the journal.
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