If you’re an accountant, you’ve probably heard of Contingent Liabilities.
But what exactly are they?
Those amounts can turn out to be a Liability depending on the occurrence of an event.
Consider a Law Suit.
It is an event which is not in the hands of the entity
If there is any unfavorable decision from such an event, then it can result in a Liability.
Further, it is important to understand the following aspects of it
- What are Contingent Liabilities?
- Why do they matter? and
- How to record those liabilities?
Let’s try to understand the answers to all these questions.
Table of contents
- What Are Contingent Liabilities?
- How about a practical scenario to understand this?
- Examples Of Contingent Liabilities
- Accounting For Contingent Liabilities
- Can entities get rid of disclosures of Contingent Liability?
What Are Contingent Liabilities?
Contingent liabilities involve uncertain events like lawsuits, product liability claims, milestone payments due to vendors or contractors, warranties, and insurance contracts.
Before the occurrence of specific event or condition, they are not actual obligations.
In other words, until a specific event occurs, there is no obligation on part of the business to make any payments.
How about a practical scenario to understand this?
For example, a contingent liability might arise from a lawsuit where the outcome is unclear, and we cannot determine the damages until the outcome of a lawsuit is public. We need to consider the potential Liability as contingent until then. On the other hand, something like a loan repayment due in six months would not qualify as contingent liability because its occurrence is certain.
We can refer to those as “off-balance sheet liabilities” because they are not part of the financial unless they become definite liabilities.
Also Read: Contingent Asset
Examples Of Contingent Liabilities
- The best example of contingent Liability is providing Guarantee on behalf of another entity’s debt. There is a risk of repayment in case of default by the entity which took the debt.
- Legal disputes in a court of law are another classic example of this type of Liability. These might turn out to be of having a significant impact on the company’s financial position.
- There can be businesses which involves installing Massive Plants & Machinery, which might receive a pushback in the form of environmental liabilities for reasons such as pollution, or long-term contracts with suppliers and customers that contain certain guarantees or warranties. Non Fulfillment of warranties might result in incurring extra costs by the business.
Accounting For Contingent Liabilities
We can recognize the Contingent Liabilities only if the following things are satisfied.
- Certainty regarding the happening or not happening of an event and
- Proper Estimation of the liability amount. It need not be super accurate. If the estimation is with reasonable certainty, then it does the job.
However, companies need to settle down with disclosure of the same if there is the possibility of an event (should be unfavorable), but it’s not probable.
On the disclosure side, companies must provide information about their contingent liabilities in their financial statements to give investors an accurate view of their financial health.
It includes providing the following:
- Description of Contingent Liability
- Details about potential costs associated with any unresolved legal cases or pending product liability claims as well as any expected losses from warranties or insurance contracts (Quantify the amount)
Can entities get rid of disclosures of Contingent Liability?
Suppose the amount is immaterial, and there is the very least possibility of the event’s occurrence. In that case, the entity can eliminate those disclosures in the financial statements.
Contingent Liabilities Examples
A contingent liability occurs when another party sues a firm, and it is uncertain whether they will win or lose. If they lose, they must pay a set amount to the other party as established by the court ruling. Another example would be if a corporation agreed with another party requiring them to pay for any damages caused by their negligence.
How Are Contingent Liabilities Recognized?
When there is adequate proof that contingent liabilities exist and can be reliably calculated, they need to be recorded on the balance sheet. They are classified as probable or possible responsibilities, depending on how likely they are to materialize.
The amount at which we recognize the liability shall also include an estimate of the cost of settling this Liability if it triggers.
When Should Contingent Liabilities Be Disclosed?
Disclosure requirement is applicable
- Any contingent liabilities that are both material and probable,
- There is a strong possibility that these liabilities will need to be paid out shortly.
These disclosures should include qualitative (such as what type of incident could cause this payment) and quantitative (such as expected amounts) information.
In short, understanding and accounting for contingent liabilities is essential for providing accurate information about a company’s financial health to investors and creditors alike.
By ensuring disclosure and accrual requirements are met when dealing with contingent liabilities, companies can ensure that all stakeholders have access to reliable information about current and future costs associated with unresolved events such as lawsuits or product liability claims.
With this knowledge, companies can better prepare themselves financially for whatever may come their way in the future. This gives them peace of mind knowing that they will not be any surprise costs.