Definition of Contingent Liability
Contingent liabilities are the kind of obligations that may occur in the future as a result of events that are not in the control of the business and these liabilities are reported in the financial statements of the company only if there is certainty about the occurrence of an event and the amount of the obligation that may arise can be reasonably estimated otherwise the disclosure is required to be given in the notes that accompany the financial statements of the company.
Contingent liabilities are the kind of liabilities that may or may not occur in near future because of some uncertain events. These liabilities can be reported in the balance sheet of the company if the amount of the liability can be reasonably estimated and there are high chances of the occurrence of the event that would result in the creation of a liability. If the chances are less than 50%then the disclosure in the footnotes to the financial statements is required to be given and if the chances are remote (very less) then no disclosure is made. Examples of contingent liabilities are the pending law suits against the company, bank guarantees, etc.
Examples of Contingent Liabilities
There was a company of electrical wires manufacturing named electroplate company. The company was supplying electrical wires to another company named John incorporation. One day, a dispute between both parties arises due to loss of materials in transit where john incorporation filed a case against electroplate claiming that electroplate has not dispatched the materials so they want a full refund with the amount of compensation. The total selling price of the goods supplied was $200,000. The chances of winning are very low i.e.it is almost certain that they will lose the case and the compensation that was estimated by the electroplate company amounted to $5,000. Now we need to comment upon the above transaction and their impact on the books of accounts of the electroplate company.
In the above transaction, the liability will occur if the decision of the court is against the electroplate company. The chance of winning is low and the amount is also reasonably estimated. Therefore, the amount of $205,000($200,000+$5,000) should be booked as an expense and then reported as a liability in the balance sheet of the company.
If in the above example, the chance of winning is low or the amount cannot be estimated reasonably then the disclosure about this contingent liability should be given in the footnotes accompanying financial statements so that the users can know about the details and the existence of pending law suit.
Types of Contingent Liabilities
There are two types of contingent liabilities. They are as follows:
- Explicit Contingent Liability: the explicit contingent liability is the type of obligation that may arise to the government departments if any specific events occur. The example of this liability can be central bank liabilities, government guarantees, obligations that may arise from insurance schemes of governments.
- Implicit Contingent Liabilities: The implicit contingent liabilities refer to the legal obligations that are to be recognized generally after the event is occurred. These events are uncertain and occur unexpectedly. For example disaster (floods, cyclones, etc.) relief, failures to repay the amount by the bank, etc.
Recording of Contingent Liabilities
The recording of contingent liabilities is divided into three categories:
- The contingent liability is recorded in the financial statements if it is probable i.e. there are high chances (more than 50% chance) that the event will occur and liability will arise and can be reasonably estimated.
- If the chance of the occurrence of an event is probable but the amount cannot be estimated reasonably or vice versa, then the disclosure of the same is to be given in the footnotes accompanying financial statements.
- If the chances of occurring of an event that may result in an obligation are remote (very less) and also the amount cannot be estimated then at that time even the disclosure of the same is not required to be made.
How to Recognise Contingent Liability?
The contingent liability is initially recognized in the footnotes of the financial statements but if it becomes certain that the liability will result in the outflow of the resources then the provision is to be made for the same and the amount should be estimated reasonable by the management.
Impact of Contingent Liabilities
The contingent liability may have a negative impact on the minds of the users about the financial performance of the company and can influence the investor’s decision. Also, the share price of the company may fall due to the disclosure of contingent liability.
Even the creditors/lenders can get influenced after knowing the existence of the contingent liability in the books of the company they are planning to deal with.
Importance of Contingent Liabilities
The contingent liability disclosure is important because these liabilities can have an effect on the financial position of the business so the users of the financial statements must know the existence of such liabilities to evaluate the actual financial position of the company. Even the reporting of contingent liabilities ensure that the government organizations, non-government organizations & other companies are ready for meeting any emergency that may occur in the future.
Contingent Liability vs Current Liability
The difference between contingent liabilities and current liabilities are as follows:
- Contingent liability refers to the possible obligations that may arise if an event occurs in the future whereas a current liability is the present obligations that arise from the event that happened in past and the same will result in the outflow of money within a year.
- Examples of contingent liability are product warranties, penalties that may arise from government investigations whereas the example of current liabilities is the accounts payable, short-term debts of the company, etc.
Disadvantages of Contingent Liabilities
Disadvantages of contingent liabilities are as follows:
- Contingent liabilities may result in a heavy outflow of resources if they.
- The judgment errors in the estimation of the amount of contingent liability may occur which may result in the inaccurate reporting of expense/liability.
Therefore, contingent liabilities refer to the liability that may or may not arise in the future because of some uncertain event. Generally, organizations prefer to disclose the contingent liability in the footnotes that accompany the financial statements of the company. The contingent liability disclosure is beneficial for the investors to evaluate the financial position of the company before investing their funds in the business.
This is a guide to Contingent Liability. Here we also discuss the definition and how to recognise contingent liability? along with importance and impact. You may also have a look at the following articles to learn more –