Contingent liabilities - Meaning and Examples
Contingent liabilities refer to potential liabilities that a company may incur due to any future or past events. These could include unforeseen legal cases against the company, warranty-related complaints etc.
Simply put, contingent liabilities depend on the occurrence or non-occurrence of a future event.
Different Types of Contingent Liabilities
The likelihood of an event occurring in the future is used to categorize contingent liabilities. We'll discuss these subtypes in more detail below.
Probable Contingent liabilities are losses realized due to any financial obligation with at least a 50% chance of occurring in the future.
For instance, if a plaintiff sues a business with a solid case, such a situation is a likely contingency. A qualified expert, such as an attorney, will evaluate the significance of a lawsuit, calculate the likelihood of a loss, and quantify the loss in monetary terms if the possibility of a loss is 50% or greater. After that, it will be included in the official company records.
A potential contingency is one in which liability could develop, but the likelihood of this happening is lower than the probability of a probable contingency, usually below 50%. Therefore, a potential scenario is rarely written down but instead mentioned in the footnotes.
An uncertain event would not be accounted for because its financial impact might be too little to warrant formal recognition. As was previously indicated, a company's books should not reflect any occurrence that does not meet the two criteria.
A remote contingency is a liability with extremely low odds of arising and is impossible under normal conditions. Since the likelihood of such events leading to monetary losses for the business is extremely low, they are not factored into the books or acknowledged in footnotes.
Contingent Liabilities with Examples
Here are some examples of contingent liabilities:
● The provision of company guarantees and counter guarantees.
● Third-party guarantees (such as loans made to subsidiaries or assurances that another company will fulfil its contractual obligations) are issued by one company on behalf of another.
● Guaranteed replacement or money back.
● Assured by the support of stockholders.
● The Letter of Credit has been Issued.
● Possible unfavorable evaluation (cases regarding any financial dispute).
Does Contingent Liability Affect Investors?
Contingent liabilities are an inevitable part of any company's balance sheet because they usually arise in corporate operations. As the name implies, a contingent liability (CL) could develop depending on the results of an uncertain future event. As such, if the liability affects the business significantly, the effect could spill over into the stock prices and thus, hurt investors.
What do contingent liabilities mean?
Commercial banks generate significant non-interest income from commitment fees charged to their customers due to the investments and loans they make on their behalf. However, if customers default on their loans, the bank may be obligated to fulfil these promises.
Before the scandal at Punjab National Bank, investors never gave contingent liabilities a second thought. A non-fund instrument known as LOU was to blame for the issue (letter of undertaking). By issuing an LOU on behalf of a customer, a bank provides reassurance that the other bank would extend credit to that customer in the foreign country where the LOU's foreign branch is located. The bank may try to shift the blame on a select group of employees, but that does not relieve it of responsibility.
Before the theft at Punjab National Bank, Contingent liabilities never troubled investors. The trouble started with a non-fund instrument known as LOU (letter of undertaking). Depending on which foreign branches give credit to the customer, one bank may issue a letter of the project (LOU) on the customer's behalf to other banks with abroad branches. It doesn't matter how much the bank tries to pin the responsibility on a select group of workers; it still has to pay.
Q. When should unresolved risks be recorded?
An organization must record a liability in its books if it is probable that the liability will arise and the amount of the obligation can be anticipated with some degree of accuracy. The purpose of recording contingent liabilities is to produce reliable financial statements by GAAP or IFRS standards.
Q. When and how should a company declare a contingent obligation in its financial statements?
The contingent liability is noted in the notes to the financial statements when this occurs. A company has no obligation to disclose a potential risk if it feels the likelihood of the liability is low.
Q. What action should be taken concerning a possible liability?
The accrued liability account must be credited, and an expense account must be debited when a contingent liability is incurred. When a debt is paid off, it is removed from the liability section of the balance sheet and credited to the cash section. An entry is also recorded in the income statement's related expense section.