The article discusses contingent liabilities, their types, how to recognize and deal with them, and reasons to highlight them.
Contingent liabilities are those probable obligations that may arise in the future due to present or past situations and may imply the company payment or the fulfillment of an obligation.
Examples include endorsements, retirements, guarantees, pension plans, and lawsuits.
- Contingent Liability In A Company
- Types of Contingent Liabilities
- How To Deal With A Contingent Liability?
- Recognition of a Contingent Liability
- Why Highlight Contingent Liability in Accounting?
- Characteristics of the Contingent Liabilities
Contingent Liability In A Company
A company usually has third parties in commercial relationships, which may lead to controversial or litigious issues. These liabilities arise because companies usually have obligations contracted long ago. Such liabilities may lead the company to assume a responsibility that may imply a high financial cost.
Future consequences may arise from a present or past event or transaction. The company must anticipate this possible liability, which may affect its financial situation to the extent that it involves the outflow of unforeseen resources.
Must Read – What is Finance?
Types of Contingent Liabilities
There are three main types of contingent liabilities, which are discussed as follows:
Any financial obligation with at least a 50% chance of happening in the future is a probable contingency. The loss is therefore considered a probable contingent liability.
For example – If a company faces a lawsuit and the plaintiff has a strong case, it is a case of contingency. The legal team usually analyzes the merits of such a lawsuit and calculates its likelihood. If the probability of a loss is 50% or more, the loss is expressed in monetary terms, which should be recorded in the company’s books.
You May Like – What is Income Tax and How to Calculate It?
A potential contingency occurs when liability may or may not happen. The chances of such a contingency happening are lower than that of a probable contingency, i.e., less than 50%.
This is why a possible contingency is usually stated in the footnotes rather than being recorded in the books.
Another reason a potential contingency needs to be documented in the books is that it cannot be described in monetary terms since its chances of happening is low.
As previously remarked, any contingency that does not meet the two criteria will not be recorded in a company’s books.
A remote contingency is a liability with low chances of occurring and is inconceivable under normal conditions.
Because the likelihood of such events resulting in corporate losses is thin, they aren’t recorded anywhere, neither in the books nor acknowledged in footnotes.
How To Deal With A Contingent Liability?
For accounting purposes, keeping contingent liability obligations in the daily books would need to be more accurate and practical since these expenses cannot be quantified.
For this reason, the company must have an accounting record of provisions. This means that provisions are uncertain future payments that, whether or not they are met, a company must have set aside as a preventive measure.
The main advantage for the company of keeping a book of provisions is that it will be financially prepared to satisfy the obligation at any time. This is known as “risk and expense.”
Must Read – Difference Between Direct and Indirect Tax
International accounting standards establish that when there is uncertainty in a present obligation due to its expiration date and amount, a provision must be recognized in accounting. Subsequently, if said provision is less likely to exist, then mention the contingent liability in the notes. And if the said contingent liability is far from occurring, then any obligation to report such an event is exempted.
1. Any possible obligation arising from past events will be confirmed only if the referred events occur and are not under the company’s control.
2. Any present obligation arising from past events not recognized in the financial statements because it is not probable that the company will need to make expenditures or that the amount of said obligation cannot be measured reliably.
Recognition of a Contingent Liability
Requirements for contingent liability recognition are –
- Occurrence is probable.
- Measurement of the occurrence is either estimable or inestimable.
Why Highlight Contingent Liability in Accounting?
Possession of the liabilities affected by certain contingencies means that the company must be prepared to highlight such contingencies and must take into account the following points:
- Accounting must satisfy these contingent liabilities with provisions. In this way, it will be financially prepared even before the appearance of a particular contingency and satisfy the obligation it has contracted.
- These provisions are commonly referred to as risks and expenses in accounting, which might lead to some adjustments in the financial statements.
- The main objective is to assume that a company acts economically, running a series of risks. For this reason, it must prepare to act prudently at a particular moment.
- The accounting standards do not permit recording any positive contingencies.
The correct arrangement for such an event in the books is often the subject of theoretical economic debate since it is not based on specific facts but on payment possibilities based on a series of conditions.
Characteristics of the Contingent Liabilities
- It generates an obligation; hence it is configured as a liability.
- It is foreseeable but uncertain; therefore, it is a contingency.
Contingent liabilities are likely to be realized if specific events occur. These liabilities are categorized as being –
- Likely to occur and is estimable
- Likely to occur but not estimable
- Not likely to occur.
As per Generally accepted accounting principles (GAAP), liabilities that are likely to occur and estimable should be recorded in a company’s financial statements. We hope this article was helpful.
Top Trending Finance Articles:
Financial Analyst Interview Questions | Accounting Interview Questions | IFRS Certification | CPA Exams | What is Inflation | What is NFT | Common Finance Terms | 50-30-20 Budget Rule | Concept of Compounding | Credit Cards Rewards System | Smart Budgeting Approaches
Download this article as PDF to read offlineDownload as PDF