A contingent liability is a potential obligation that may or may not arise in the future and is dependent on the outcome of an uncertain event in the future. Its relevance is dependent on whether it becomes an actual liability, and the timing and accuracy with which the amount that is associated with it, can be calculated. A company warranty or a company lawsuit are examples of such liabilities. Both these indicate the probable losses that occur to a company but are dependent on an unforeseen future event.
A contingent liability is recorded or disclosed in the books of accounts if the contingency is likely to happen and/or the liability amount can be calculated with reasonable accuracy. A product warranty is the most common type of contingent liability. Other examples include liquidated damages, debt guarantees, government investigations, and pending lawsuits. Let’s get an insight into the finer details of contingent liabilities.
Did you know?
Almost 40% of business failures are caused due to inadequate financial management.
What are Contingent liabilities?
A contingent liability is a potential future obligation to a third party for an unknown amount as a result of previous activities. A contingent liability must meet three conditions to exist:
(1) There is the possibility of future payment to a third party or the impairment of an
asset as a result of an existing condition.
(2) There is uncertainty about the amount of the future payment or impairment
(3) The outcome will be determined by some future event or events.
Why is it important to record a Contingent Liability?
Both IFRS ("International Financial Reporting Standards") and GAAP (Generally Accepted Accounting Principles) require businesses to record contingent liabilities because of their connection with the following three important accounting principles.
1. Full Disclosure Principle
The Full Disclosure Principle states that all significant and relevant facts about a company's financial performance and health should be disclosed in its financial statements/records.
A contingent liability adversely impacts the company's assets and net profitability and thus has the potential to harm a company's financial health and performance. So, according to the Full Disclosure Principle, such situations and events must be disclosed in a company's financial statements.
2. Materiality Principle
According to the Materiality Principle, all significant financial matters and information should be disclosed in financial statements. A material item is one that, if known, could influence the economic decisions of users of the company's financial statements.
The term "material" is essentially synonymous with "significant" in this context. A contingent liability can harm a company's financial health and performance; hence, knowing about the liability can influence the decision-making of various users of the company's financial records.
3. Prudence Principle
Prudence is an important accounting concept that ensures income and assets are not overstated while expenses and liabilities are not understated. Since the result of contingent liabilities cannot be predicted with certainty, the probability of the contingent event occurring is calculated, and if it is more than 50%, an expense and a corresponding liability are recorded. The recording of the contingent liabilities in the financial books prevents liabilities and expenses from being understated.
Examples of Contingent liability
Listed below are some of the examples of contingent liabilities.
- One of the company’s suppliers is unable to obtain a loan from the bank. The company decides to guarantee the repayment of the bank loan taken out by the supplier. The bank makes the loan to the supplier based on the company's guarantee. The guarantee becomes the company's contingent liability. If the supplier repays the loan on time, the company will have no liability; however, if the supplier fails to repay the loan on time, the company will be held accountable and will have actual liability.
- If a company is being sued by a former employee for any reason, the company has a contingent liability. If employers are found guilty, the company will be held liable; otherwise, there will be no liability.
- A product warranty is another type of contingent liability. The assumption is that product warranties are likely to result in a quantifiable liability. When goods are sold to customers, warranty costs should be recorded as expenses, with a credit to the Warranty Liability account. The Warranty Liability is reduced as warranty work is completed, and Cash is credited. As a result, the expense and sales are recorded at the same time.
Recording of Contingent liabilities
According to GAAP, contingent liabilities are classified into three types based on the probability of occurring.
A "high probability" contingency means that there is a greater than 50% chance of the liability occurring. Also, the liability amount can be calculated with reasonable accuracy. Such occurrences are liabilities on the balance sheet and expenses on the income statement.
A "medium probability" contingency meets one of the two parameters of a "high probability" contingency but not both. If either of the two criteria is met, these liabilities should be disclosed in the footnotes to the financial statements.
All the other contingent liabilities are classified as "low probability." Because the likelihood of a cost arising from these liabilities is extremely low, accountants need not report them in financial statements. However, companies will sometimes include disclosure of such liabilities.
Importance of Contingent liabilities for investors and creditors
As a contingent liability can adversely impact a company's cash flow & future net profitability and also reduce a company's assets, knowing about a contingent liability can influence an investor's decision.
An investor purchases stock in a company to earn a future share of the company’s profits. A contingent liability may negatively impact a company's ability to generate profits, knowing about it can discourage an investor from investing their money in the company. An investor’s decision may also depend on the liability amount and the nature of the contingency involved.
Similarly, knowing about contingent liability can influence a creditor's decision to lend money to a company. The contingent liability may turn into actual liability which will harm the company's ability to repay its debt.
Impact of contingent liabilities on a company’s share price
A company's share price is likely to decline as a result of contingent liability. This is because such liabilities threaten the company's ability to generate profits in the future. The impact on the stock price will be determined by the likelihood and value of any resulting contingent liability. Because contingent liabilities are uncertain, it is difficult to quantify or estimate the impact they may have on a company's share price.
The company's financial stability also has a role to play here. Regardless of contingent liabilities, investors may choose to invest in a company if they believe the company's financial situation is strong enough to absorb any losses that may result from such liabilities.
If a company has strong fast-growing earnings and a steady cash flow position, a contingent liability will have little impact on its stock price unless it is huge. The type of contingent liability and the risk that goes along with it are important considerations.
Company share prices are more likely to suffer from a short-term liability than a long-term liability that will not be settled for years. If contingent liabilities take a long time to settle, there is a chance that they may not become actual liabilities.
Adding Contingent liabilities to a Financial Model
Because of the level of subjectivity involved, modeling contingent liabilities can be a challenging concept. Analysts are divided on whether or not to include contingent liabilities in financial statements.
As a general rule, the impact of these liabilities on a company’s cash flow should be accounted for in a financial model if the likelihood of the contingent liability becoming an actual liability is more than 50%. In a few cases, an analyst may present two scenarios, one that includes the impact on the company’s cash flow and one that does not.
Contingency liability accounting is a highly subjective matter that requires expert judgement. For both the company's management and investors, contingent liabilities can be a challenging concept. Large corporations with multiple lines of business may need a wide range of techniques for the risk weighing and valuation of liabilities.
Options pricing methodology, risk simulation, and expected loss estimation based on changes in macroeconomic conditions are some of the techniques used in advanced analyses. Contingent liabilities should be approached with caution and skepticism, as they can cost a company millions of rupees depending on the circumstance. We hope these details have proved to be informative about Contingent liabilities.