Definition: Contingent Liability refers to an anticipated financial obligation that springs from events that happened in the past and whose existence is validated by the happening or non-happening of the uncertain future event, which is not under the control of the enterprise.
Also, it can be a present financial obligation, whose payment is not likely or whose amount cannot be measured with certainty.
There exists uncertainty as to the timing and extent of the payment, as well as there is possibility of payment not becoming due at all. So, we can say that future events can determine whether it is actually a liability or not. And these are called contingent liability because of the uncertainty attached to it.
Disclosure of contingent liability helps the firm to be prepared for the obligation that may arise at a future date.
These are not actual liabilities of the firm, but a potential one, that may turn out as an actual liability in the future, when the uncertain future event occurs.
Treatment of Contingent Liability
A contingent liability is required to be disclosed but not recognized in the books of accounts of the firm
Though it is an off-balance sheet item, which means that its value does not appear in the amount column at the liabilities side of the balance sheet. Therefore, it is clearly indicated as a footnote in the “Notes to Accounts” except when the possibility of monetary outflow is remote. Contingent liability is accounted for, in the financial statements only if it is expected to occur and its amount can be estimated with reasonable accuracy.
When and Where to Record?
The likelihood of the loss can be divided into – probable, reasonably possible, or remote, as per GAAP:
Probable (More likely than not)
If the probability of the occurrence of the event is greater than the probability of its non-occurrence, the event will be considered probable. So these liabilities are expected to occur and so the amount of loss can also be determined to a certain extent. Hence, they appear as liabilities in the financial statements.
Reasonably Possible (Less than likely)
The term ‘reasonably possible’ means that the possibility of the occurrence of the event is greater than remote but less than probable. As the amount cannot be evaluated with certainty, these appear in the form of notes.
Such liabilities are evaluated at frequent intervals, so as to ascertain whether the monetary outflow representing economic benefits is probable. Hence, when it comes out to be probable with regard to the monetary outflow will be needed for an item that is earlier treated as a contingent liability, a provision is made in the financial statement of the concerned period, in which the change in probability took place, except when the reliable estimate cannot be made.
Further, the estimation helps in setting aside the amount to be paid, when the liability occurs.
An event whose possibility of future settlement is quite small, is regarded as remote. Companies do not record such liabilities.
Types of Contingent Liability
- Explicit Contingent Liabilities: Contingent Liabilities rely on contract, law, or direct policy commitments of the government with regard to payment when a specific event occurs. These are either determined by law or authorized by law. So, it covers:
- Loan guarantee
- Export Guarantee
- Other financial guarantees like exchange rate guarantee, minimum pension guarantee, deposit guarantee, etc.
- Government insurance program
- Legal claims against the government
- Uncalled capital
- Implicit Contingent Liabilities: The financial obligation of these liabilities should be recognized after the event, i.e. when the crisis or disaster occurs. Also, the official recording of these contingent liabilities is not made by the government due to its uncertainty. It may include:
- Natural disaster relief
- Banking system bailouts
- Environmental cleanup spending
- Municipality defaults
Examples of Contingent Liability
- Liquidated Damages
- Product Warranty
- Long pending lawsuit
- Government investigation
- Guarantee given by Surety
- Value of bills discounted
- Claims against firm not recognized as debts
A Word from Business Jargons
Contingent Liability implies the amount that may be owed by the firm, however, its amount or even becoming a liability greatly depends on the future event which is uncertain. Therefore, it is a possible expense based on a future event.