Contingent liabilities are any financial liability that might occur depending on how specific events play out in the future. They are a potential obligation that is not absolutely certain, but which could have significant financial repercussions for a business or individual should a particular situation unfold in a certain way. Businesses with shareholders and investors are especially obliged to assess any and all contingent liabilities as these could influence their financial decisions.
In many cases, the amounts involved in a potential loss can either be estimated or calculated exactly. By doing this, the company can set aside the amount so that it is ready to be paid out should an event unfold unfavourably.
Below we explain some common varieties of a contingent liability.
Examples of contingent liability
There are many examples of contingent liability as they can be pretty much any potential financial obligation that may or may not occur in the future. Here we look at two of the most common types.
Any kind of product warranty counts as a contingent liability, as there is the potential for the company to have to pay out for replacement products should any be faulty. Limited occurrences of such incidents are unlikely to be financially damaging to a large company, but should still be estimated and accounted for.
For example, when a company manufactures a set amount of product units in a year, with each having a one-year warranty, then they will need to estimate how many of those units could be returned under the warranty.
At the end of the year, the accounts will be amended to reflect the actual cost of the warranties over the previous year. This adjustment can then inform the warranty forecast and thus contingent liability for the next year.
Pending or potential lawsuits
Any pending lawsuit also counts as a contingent liability. The type of lawsuit doesn’t really matter, as long there is the potential for the company to lose the case and have to pay a sum in damages or compensation. One difference between lawsuits and any other contingent liabilities is that the likely outcome of the case can have an impact on how the contingent liability is reported.
For example, if the firm’s legal department determines that there is a strong possibility they will lose the case, then the amount that would be due in payment can immediately be set aside and reported in the financial records. If the lawyers believe the likelihood of losing the case is very remote, then the contingent liability may only be recorded as a footnote in the financial statements without the amount liable being stated or pre-emptively accounted for.
It is also possible to identify contingent liabilities in the form of potential lawsuits that have not yet occurred. Again, the legal department would determine the likelihood of such lawsuits occurring as well as the likelihood of losing them. This type of contingent liability would again simply be acknowledged in the footnotes without any cautionary adjustments being made to the finances.
Contingent liability principles
Contingent liability disclosure is required by both International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP). This is because of three accounting principles that dictate that companies must disclose any potential for future financial losses. The three principles are:
Full disclosure principle
Full disclosure principle
This principle requires all significant facts relevant to the financial performance of a company to be disclosed in its financial statements. This includes any contingent liabilities that could affect the company’s net profitability.
This principle refers to information that may influence the decisions of investors or shareholders. As a contingent liability has the potential to harm a company’s performance and returns, those with a financial stake in the firm must be made aware of any contingent liabilities via the financial statements.
The prudence principle ensures the likes of projected income and assets are not overstated in the financial statements, nor are expenses understated. All contingent liabilities have the potential to affect the expenses and thus the annual income of a firm.
We can help
If you’re interested in finding out more about contingent liabilities, or any other aspect of your business and its finances, then get in touch with our financial experts. Find out how GoCardless can help you with ad hoc payments or recurring payments.