Contingent Liability is the best guesstimate by the company of a situation that might turn into a liability. Whether or not a contingent liability turns into an actual liability depends on the happening of a future event. Suppose an employee sues a company for $100,000. Whether or not a company will pay this amount depends on the outcome of the case.
Companies create a provision for a contingent liability in anticipation of any future liability or liabilities. By making a provision, the company makes sure that they are ready for any such situation, even if such liability may or may not occur.
Lets’ understand the concept with the help of a simple example. A company takes a guaranteed loan from a bank to run its business. In case the company fails to make the payment, the bank would sell the assets that the company has put as collateral. So, the company makes some provisions to avoid the situation of default.
There could be various forms of contingent liabilities that the company might have to make provision for. Some examples are fulfilling the warranty claims by customers, any potential lawsuits, or any other form of investigation.
Types of Contingent Liability
There are two types of contingent liabilities:
Such liabilities are the obligation of the government to make payments in case any specific event occurs. Assessing the explicit contingent liabilities could be tough since these items do not appear until they occur. Such liabilities are a huge burden and, therefore, could be a drain on the future government finances. Some of the examples of explicit contingent liabilities are:
- Government insurance schemes on deposits, bank bonds, and so on.
- Mortgage Loans, student loans, civil service pensions, etc.
- Central Government guarantees for non-sovereign borrowings.
- Currency exchange rates.
- Any probable case wherein the court orders to pay the penalty or specific sum of money towards specific cases.
These are the legal obligations that need to be recognized, usually after the occurrence of an event. The government does not officially record such contingent liabilities as there is no certainty of their occurrence. A few examples are disaster relief (Floods, Cyclones, tsunamis, and more), environment management, municipality defaults, etc.
Importance of Contingent Liabilities
- Recording contingent liabilities ensure that the companies, government, and non-government organizations are ready for any emergency in the future.
- Recording such liabilities help to correctly assess the financial position of the economy or the company.
- It helps a company or government to better plan its budget.
- Credit companies also consider the amount and nature of contingent liabilities while extending a loan to a company.
- Before investing, investors might also want to know the probable liabilities that the company might have to pay in the future.
Companies and other entities may record a contingent liability as a loss or expense in the income statement. The organizations may also show it as a liability on the balance sheet. In some cases, a company may also disclose such liabilities by a mere note in the financial statements. Whether or not the company shows such a liability in the income statement or balance sheet depends on certain criteria (discussed later in the article).
On the other hand, there are a few contingent liabilities that companies don’t show in the financial statement or even as a footnote. For instance, a case against a company with almost zero chances of getting proved (on the basis of the historic success rate of such cases against the companies).
When and Where to Record?
Companies record the contingent liability as a note to the financial statement or in the books in the following cases:
As the name suggests, the company might be expecting the liability to occur in the future. Also, the company will be able to estimate the loss amount due to such liability to a certain extent. Product warranties are a good example of this. Companies show such liabilities in their financial statements.
Organizations may record the existence of such contingent liabilities in case they believe there is a reasonable possibility of any liability to occur but not probable. Since it is not possible to quantify such liabilities, companies show them as notes.
Companies don’t need to record the liabilities that are only remotely possible to happen. Such liabilities don’t come in the books, nor does the company shows them in the notes.
Contingent Liabilities and Audit
Companies should go through the audit process to protect the integrity of the financial system. Audit becomes more important in the case of companies dealing with securities and loans from third parties. Auditors should closely watch the contingent liabilities to confirm the claims of the company. And, if they find no mismatch, they must approve the claims.
In case the auditor finds some misappropriation or wrong claim as a contingent liability in the company’s account, it is their duty to rectify it. An auditor should never take the word of the company at its face value and always do their due diligence.
Along with determining the likelihood of any contingent liability, an auditor must determine the materiality of such liability. The materiality here means the impact that it could have on the company if it occurs. For instance, a $1000 liability is not material for a company like Apple, even if it has a 95% chance of occurring.
So, after determining the materiality, it is up to the company and auditor to decide how or if they want to show it in the books. In the US, FASB (Financial Accounting Standards Board) lays down the criteria for how to assess, disclose and audit contingent liabilities.