Contingent Liability Definition


Contingent liability, sometimes referred to as indirect liability, is a responsibility that occurs based on the outcome of a particular event that provides coverage for losses to a third party for which the insured is vicariously liable. Depending on the way that event unfolds, financial obligations might arise in which the company that holds the liability would be accountable to see it through. If the contingency is probable with a reasonably estimated amount, it is recorded in a financial statement. If both of those conditions cannot be met, the contingent liability could be inserted in the footnote of a financial statement. Some common examples of contingent liabilities are product warranties and pending lawsuits because they both have uncertain end results, but still pose a potential threat.A contingent liability is a possible negative financial situation that could occur in the future, and eventually become costly to a company. Whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity. Part of the reason contingent liabilities must be included in financial statements is to give the readers of the statement accurate information. The company agrees to guarantee that the supplier’s bank loan will be repaid. As a result of the company’s guarantee, the bank makes the loan to the supplier. If the supplier makes the loan payments needed to pay off the loan, the company will have no liability.

  • Contingent liabilities should be analyzed with a serious and skeptical eye, since, depending on the specific situation, they can sometimes cost a company several millions of dollars.
  • Companies may also need to report them on private offerings of securities, too.
  • Learn how to deal with contingent liabilities in a business financial system.
  • Accounting and reporting of contingent liabilities are regulated for public companies.
  • The existence of the liability is uncertain and usually the amount is uncertain because contingent liabilities depend on some future event occurring or not occurring.
  • A contingent liability is a liability that may occur, depending on the outcome of an upcoming event.

Contingent liabilities can be a tricky concept for a company’s management, as well as for investors. Judicious use of a wide variety of techniques for the valuation of liabilities and risk weighting may be required in large companies with multiple lines of business. A contingent liability that is expected to be settled in the near future is more likely to impact a company’s share price than one that is not expected to be settled for several years.

Recognition Of A Provision

If the lawsuit does not go in their favor, the company will pay the money which will add to its expenses. Contingent liabilities are recorded to provide accurate financial documents that meet GAAP accounting requirements. Learn accounting fundamentals and how to read financial statements with CFI’s free online accounting classes.Total liabilities are the combined debts, both short- and long-term, that an individual or company owes. The offers that appear in this table are from partnerships from which Investopedia receives compensation.If you can only estimate a range of possible amounts, then record that amount in the range that appears to be a better estimate than any other amount; if no amount is better, then record the lowest amount in the range. You should also describe the liability in the footnotes that accompany the financial statements. When a company becomes involved in a lawsuit, it’s time to understand more about contingent liability. The company’s lawyer might feel the other party’s case is fairly strong, which is a situation that’s going to lead to damages. The company would then post an entry on their accounting budget to increase legal expenses. Situations involving contingent liability often arise when companies work with contractors, subcontractors, or agents, where both the company owner and the party primarily responsible for the injury or damage can be held liable. Prudence is a key accounting concept that makes sure that assets and income are not overstated, and liabilities and expenses are not understated.

contingent liability definition

Based on an analysis of both these factors, the company can know what’s required for including the contingent liability in its financial statements. In some cases, the accounting standards require what’s called a note disclosure in the company’s reports. IAS 37 Provisions, Contingent Liabilities and Contingent Assets outlines the accounting for provisions , together with contingent assets and contingent liabilities . Provisions are measured at the best estimate of the expenditure required to settle the present obligation, and reflects the present value of expenditures required to settle the obligation where the time value of money is material.

Contingent Liability Definition And An Example

When a liability is disclosed in footnotes, the firm can determine whether the likelihood of occurrence is more remote than probable, and if so, does not have to disclose the potential of it. General provisions are balance sheet items representing funds set aside by a company as assets to pay for anticipated future losses.A “medium probability” contingency is one that satisfies either, but not both, of the parameters of a high probability contingency. These liabilities must be disclosed in the footnotes of the financial statements if either of the two criteria is true. According to the full disclosure principle, all significant, relevant facts related to the financial performance and fundamentals of a company should be disclosed in the financial statements. A contingent asset is a potential economic benefit that is dependent on future events out of a company’s control. Do not record or disclose a contingent liability if the probability of its occurrence is remote.

History Of Ias 37

If a court is likely to rule in favor of the plaintiff, whether because there is strong evidence of wrongdoing or some other factor, the company should report a contingent liability equal to probable damages. Suppose a lawsuit is filed against a company, and the plaintiff claims damages up to $250,000.If the likelihood of a contingent liability is less than 50%, it typically is not included in the financial statement. A contingent liability in budgetary terminology is identified when a transaction has occurred, and future outflow or other obligation of resources is probable, and such obligation may be measured. In fact, 469 of the 957 companies contacted in the AICPA’s annual survey of accounting practices reported contingent liabilities resulting from litigation.34 Outside the framework of 31 U.S.C. § 1501, however, Congress has provided special treatment for certain contingent liabilities in order to better capture their budgetary impact. See Chapter 11, section B, for a detailed discussion of the budgetary and obligational treatment of loan and loan guarantee programs under the Federal Credit Reform Act.

What distinguishes contingent liabilities from general uncertainties?

A potential obligation arising from a past event that may/may not result in future liabilities depending upon how future events occur. … These uncertainties are distinguished from contingent liabilities because they arise from future rather than past events.For example, if a company has several contingent liabilities in various forms, investors might worry that investing money could be a potential risk. Knowing this allows investors and others to make well-informed financial decisions. Since it presently is not possible to determine the outcome of these matters, no provision has been made in the financial statements for their ultimate resolution. Various lawsuits and claims, including those involving ordinary routine litigation incidental to its business, to which the Company is a party, are pending, or have been asserted, against the Company.

Effects Of Contingent Liabilities

If the contingent loss is remote, meaning it has less than a 50% chance of occurring, the liability should not be reflected on the balance sheet. Any contingent liabilities that are questionable before their value can be determined should be disclosed in the footnotes to the financial statements. However, sometimes companies put in a disclosure of such liabilities anyway.

contingent liability definition

Two classic examples of contingent liabilities include a company warranty and a lawsuit against the company. Both represent possible losses to the company, yet both depend on some uncertain future event. A contingent liability is an issue or concern that may take place as an outcome of a certain event such as a lawsuit, warranties or recalls. A company’s decision to record a contingent liability on its financial documents often depends on the liability’s likelihood and an accurate estimation of its cost. If the company can’t meet those two requirements, it may mention the situation in a financial statement footnote or not disclose it at all. The reason contingent liabilities are recorded is to meet IFRS and GAAP requirements and so the company’s financial statements are correct.“Reasonably possible” means that the chance of the event occurring is more than remote but less than likely. On the one hand, it is by definition not sufficiently definite to support the recording of an obligation. Yet on the other hand, sound financial management may dictate that it somehow be recognized. Indeed, if completely disregarded, a contingent liability could mature into an actual liability and result in an Antideficiency Act violation. Agencies have a legal obligation to take reasonable steps to avoid situations in which contingent liabilities become actual liabilities that result in Antideficiency Act violations. This may include the “administrative reservation” or “commitment” of funds, as well as taking other actions to prevent contingencies from materializing. A contingent liability may need to be recorded on the business’s financial statements, depending on the probability of the event occurring and the possibility of estimating the potential amount.

Contingent Liability

Often, the longer the span of time it takes for a contingent liability to be settled, the less likely that it will become an actual liability. Therefore, such circumstances or situations must be disclosed in a company’s financial statements, per the full disclosure principle. The company hires a professional accounting firm to calculate how much the warranty may add to their expenses and if it is actually beneficial to their business.However, if the company is not found guilty, the company will not have any liability. A contingent liability is a liability that may occur, depending on the outcome of an upcoming event. Sophisticated analyses include techniques like options pricing methodology, expected loss estimation, and risk simulations of the impacts of changed macroeconomic conditions. Modeling contingent liabilities can be a tricky concept due to the level of subjectivity involved. The opinions of analysts are divided in relation to modeling contingent liabilities. The cost of debt is the return that a company provides to its debtholders and creditors. Deferred long-term liability charges are future liabilities, such as deferred tax liabilities, that are shown as a line item on the balance sheet.In context of liabilities, those liabilities that do not yet appear on the balance sheet (ie. guarantees, supports, lawsuit settlements). For support or recourse, the trigger may occur at any time in the future, and the loss or expenditure is highly uncertain. Once timing and the quantification of expenditure becomes clearer, provisions should be raised in respect of the contingent liability. When the amount or the timing of the contingent item becomes certain, then it ceases to be a contingent item and should be entered into the balance sheet. Normally, the company would list this potential expense as a contingent liability. However, its accountants cannot accurately predict the possibility of the issue.When creating financial statements, some accounting organizations require companies to list potential issues or concerns that may affect their overall company finances. Companies often list these as contingent liabilities to help ensure their economic standings are realistic and honest. In this article, we discuss what contingent liability is and why it’s recorded using helpful examples. According to FASB Statement No. 5, if the liability is probable and the amount can be reasonably estimated, companies should record contingent liabilities in the accounts. However, since most contingent liabilities may not occur and the amount often cannot be reasonably estimated, the accountant usually does not record them in the accounts. Instead, firms typically disclose these contingent liabilities in notes to their financial statements. Record a contingent liability when it is probable that a loss will occur, and you can reasonably estimate the amount of the loss.