What are Contingent Liabilities? Meaning & Examples of contingent liabilities

Introduction

Contingent liabilities mean a planned financial commitment that results from previous events, whose status is determined by the occurrence or non-occurrence of an unpredictable future event that is outside the control of the business.

It can also be a current debt whose repayment is uncertain, or the exact amount is unknown.

The timing, size, and viability of the payment are all undetermined, and it’s also possible that it won’t be required at all. Therefore, we can claim that further occurrences will determine whether or not it genuinely constitutes a liability. And because of the element of uncertainty involved, these are referred to as contingent liabilities.

Apart from that, disclosure of contingent liabilities enables the company to be ready for any responsibility that could emerge in the future. These are possible liabilities for the company rather than actual liabilities, which could arise in the future if unpredictable circumstances occur.

That’s why it is not acknowledged on par with other aspects of the financial statements and is instead displayed as a footnote in the balance sheet. Now after understanding what is content liabilities, let’s check out its usability and importance.

Why do we make provisions for contingent liabilities?

By including contingent liabilities, firms have the chance to assess the circumstance and make preparations.

Let’s use an illustration to explain further why a corporation must make provisions for contingent liabilities.

Furniture producer Finoflex ltd. is based in Bhopal. One of its clients has launched a lawsuit against them, accusing it of providing a poor product. When the client first reported it, the business turned down the claim; consequently, the consumer filed a lawsuit against them.

Let’s examine the aforementioned case to see how and why it’s beneficial to make provisions for contingent liability.

  • As a result of earlier events, there is a current responsibility (legal or constructive).

The present duty in FinoFlex Ltd.’s case is the lawsuit a client has filed against the company. And the corporation delivered the flawed product and denied the customer’s claim in the past.

FinoFlex Ltd should report damages in the Footnotes to the financial statement in this case rather than making a provision for them in the main body of the financial statement. The reason is that a future event’s existence might or might not result in liability.

  • To pay the commitments, it is likely that resources, including financial gains, will require to spend.

It is apparent in the instance of FinoFlex Ltd that if claims against the business materialize, there may be an outflow of funds to satisfy the obligation.

  • On the obligations, a reliable estimation is possible.

In the case of FinoFlex Ltd, the claim will result in a financial outflow for the business, and the business should accurately estimate this amount.

In this case, disclosure to investors and other individuals who use financial statements is required since the result will affect investment decisions.

Types of Contingent Liabilities

You must take into account the following events to identify the contingent liability. The term “types of contingent liabilities” is frequently used to describe these situations.

Probable

The event will be regarded as probable if its occurrence is higher than the possibility that it won’t. Because these obligations are anticipated, it is possible to estimate the size of the deficit to a limited level. As a result, they show up in the financial statements as liabilities.

Possible

When something is described as “possible,” it means there is a chance it will happen is remote but lower than likely. These take the form of notes since it is impossible to determine the quantity precisely.

These obligations are regularly assessed to determine the possibility of the financial outflow representing economic gains. 

Therefore, a provision is included in the accounting records of the relevant period in which the change in possibility occurred, when it becomes likely that a financial outflow would be required for an item that was previously handled as a contingent obligation unless a valid estimate cannot be established.

Remote

If the possibility of the contingent obligation occurring is remote, it is not recognized or stated in this case. Remote here denotes the absence of both a reasonable chance of occurrence and probability of the contingencies.

More concisely, it is classified into two types: explicit contingency liability and implicit contingency liability.

Explicit Contingency Liabilities Contingent Liabilities rely on government agreements to make payments when a specified event occurs through contractual, legal, or direct policy commitments. These are either decided upon or permitted by legislation. It includes uncalled capital, loan guarantee, etc.

Implicit Contingency Liabilities These obligations’ financial requirements should be acknowledged post-event, that is, after the catastrophe or tragedy has taken place. Additionally, the government does not formally register these potential liabilities because of the ambiguity.

What Are Examples of Contingent Liability?

Common contingent liabilities include pending lawsuits and warranties. Because the results of ongoing legal proceedings are uncertain, they have been deemed contingent liability. As far as warranties are concerned, it is impossible to predict how many items will be recovered under warranty.

Some More Contingent Liabilities Examples :

  • The business gives guarantees and counter guarantees. A corporation may provide a guarantee to another individual on behalf of a third party in the shape of a loan to a business or a promise that another business would uphold contractual responsibility.

  • Product Warranty

  • Guarantee to the investor

  • Issuance of letter of credit

  • Bill discounted

  • Liquidated damages

Accounting Rules for Contingent Liability

  • There are a few rules which guide us on where to record the provisions related to contingent liabilities:

  • A contingent liability should not be considered in the statement of financial condition.

  • It should only be stated in the notes to the financial statements unless it is highly unlikely that any economic advantages would be transferred.

Conclusion

Contingency liability accounting is a highly personalized subject that calls for professional judgment. It can be a difficult subject to understand for investors as well as the management of the organization. Therefore, a business should handle contingent liabilities with prudence and caution because, depending on the situation, they may cost significant amounts of money. 

Reference

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