Last editedOct 20212 min read
In order to manage their cash flow effectively, businesses need to hope for the best while preparing for the worst. Good financial management means planning for every contingency. Even if it’s the kind of contingency that keeps you awake at night.
While this applies to all aspects of your operations, it’s especially important when undertaking a new contract. When you enter into a contract, you need to account for both current and contingent liabilities in order to protect your business’s finances and reputation. Let’s take a look at the term “contingent liability”, and what it means for businesses like yours.
Contingent liability legal definition
As part of their accounting best practices, businesses should record contingent liabilities in their regular financial statements. This helps them to prepare for all possible outcomes that may arise as a result of entering into a contract.
But what is the legal definition of a contingent liability?
According to the Australian Accounting Standards Board, there are two ways to define a contingent liability:
A potential obligation that may arise as a result of uncertain future events outside the control of any party involved in the contract
A current obligation that arises from previous events, but it is impractical or impossible to accurately estimate the amount of the obligation
Essentially it is a liability that may or may not occur as a result of an uncertain future. By planning for contingent liabilities, businesses can mitigate the effects of worst-case scenarios on their finances.
Types of obligation
A contingent liability results in an obligation for your business if unforeseen events occur. They may arise under the following circumstances:
As a result of outcome of the legal proceedings
When income tax is disputed
When one party has failed to repay a debt to another party
Where a liability cap has been implemented
Where might businesses encounter contingent liability?
There are three common instances where businesses may encounter a contingent liability. In these instances, the wording of your contract will directly influence your company’s liabilities. As such, businesses need to walk a line between providing reassurance for the customer while limiting (or at least providing clear parameters for) their own liability.
When companies offer a warranty, they promise a specific remedy to the customer should something go wrong with one of their products. If the remedial action taken does not meet the standards implied in the warranty, this may make the company liable for losses or damages sustained by the customer.
Some contracts require a third party (known as a guarantor) to cover any losses that occur if a party fails to meet their contractual obligation. This is fairly common in loan agreements. Loans can be co-signed by a guarantor enabling them to make payments on the borrower’s behalf if they default on their agreement.
An indemnity requires one party in a contract to cover the loss of the other if certain events occur. Because this is contingent upon unforeseen events taking place, this is a prime example of a contingent liability.
Disclosing contingent liabilities
Recording contingent liabilities in your accounts helps to make your accounting more comprehensive while also helping you prepare for an uncertain future.
When disclosing contingent liabilities in your accounting be sure to include:
The nature of the liability itself
What makes the occurrence of this event uncertain
The financial impact of the liability
The potential for reimbursement