Contingent Liability: Definition & Meaning
Businesses need to plan for the worst case scenario while proactively hoping for the best in order to properly manage their cash flow. Planning for every eventuality is essential for sound financial management.
While this is true for all facets of your business, it’s crucial when starting a new contract. In order to safeguard your company’s finances and reputation, you must take both existing and potential obligations into consideration when you engage into a contract.
Read on as we take a look at contingent liability, the different types, why it is recorded, and whether or not they impact share prices.
Table of Contents
- A contingent liability is a specific type of liability that could happen in the future.
- Contingent liabilities get recorded to make sure that financial statements are accurate. They are also recorded to adhere to and meet IFRS and GAAP requirements.
- The contingent liability will be recorded in the accounting records of the firm if it is likely to occur and the amount is reasonably estimated.
What Is Contingent Liability?
A contingent liability is a specific type of liability that could happen based on the outcome of an uncertain future event. This type of liability only gets recorded if the contingency is a possibility, and also if the total amount of the potential liability is reasonably and accurately estimated.
Usually, the contingent liability will be outlined and disclosed in a footnote on the financial statement. It would not be disclosed in a footnote, however, if both conditions are not met. For a contingent liability to become relevant, it depends on its timing, its assurance, and whether or not it will become an actual liability.
Types of Contingent Liability
Within the generally accepted accounting principles (GAAP) there are three main categories of contingent liabilities. These include probably, possible, and remote.
- Probable contingent liabilities mean they can be reasonably estimated, and they always need to be reflected within the financial statements of a company.
- A possible contingent liability is likely to occur, but they’re also just as likely not to. These only need to be disclosed in the footnotes of the financial statements of a company.
- Remote contingent liabilities are ones that have a very limited possibility of occurring and these don’t need to be included at all in the financial statements of a company.
Why Is Contingent Liability Recorded?
The International Financial Reporting Standards (IFRS) and GAAP outline certain requirements for companies to record all of their contingent liabilities. This is because of their connection with three discount accounting principles.
These accounting principles include the prudence principle, the materiality principle, and the full disclosure principle. Let’s take a closer look at each and see why they’re important for recording contingent liabilities.
The Prudence Principle
The prudence Principle is an important and key accounting concept. It ensures that the assets and income of a company aren’t overstated. As well, it makes sure that liabilities and expenses aren’t understated.
The outcome of contingent liabilities isn’t always a certainty, so the probability of a contingent event occurring needs to be estimated. If the possibility is greater than 50% then both the liability and the associated expense will get recorded. Doing this, it helps prevent liabilities and expenses from being understated.
The Materiality Principle
The materiality principle outlines that any and all important financial information and matters must be disclosed in a company’s financial statements. For an item or event to be considered to be material, it means that having knowledge of it occurring could change certain economic decisions for those that use the company’s financial statements.
Within this principle, referring to the term material also refers to the liability being significant. Since some contingent liabilities can have a negative impact on the financial performance and health of a company, having knowledge of it can influence decision-making when it comes to financial statements.
The Full Disclosure Principle
The full disclosure principle requires that any relevant and significant facts that are related to financial performance must be disclosed in the company’s financial statements.
Contingent liabilities can pose a threat to the reduction of net profitability and company assets. This means that they can potentially negatively impact the health and financial performance of a company. Ultimately, this is why these situations or circumstances must get disclosed in the financial statements of a company.
Example of Contingent Liability
Some of the best contingent liability examples include warranties and pending lawsuits. Warranty liability is considered to be a contingent liability since it’s often unknown how many products could be returned under a warranty.
As well, pending lawsuits are also considered contingent liabilities because the outcome of the lawsuit is entirely unknown. This can come with estimated liability or a need to determine contingent liability legitimacy.
Do Contingent Liabilities Impact Share Price?
The understatement of liabilities can impact the share price of a company since they can be likely to have a negative impact on the ability of a company to generate future profits. That said, the level of impact is dependent on how likely a contingent liability is to happen, as well as the amount that could be associated with it.
It’s difficult to estimate or even quantify the impact that contingent liabilities could have because of their uncertain nature. Plus, the impact they could have will also depend on how sound the company is in its financial obligations.
For example, investors might determine that a company is financially stable enough to absorb potential losses from a contingent liability and still decide to invest in it. But a contingent liability needs to be large enough to be able to truly affect a company’s share price.
So if a company has a strong cash flow position and can experience rapid growth earnings, it can probably avoid the impact being too large.
Contingent liabilities are potential liabilities that have a possibility of occurring sometime in the future. These liabilities get recorded in the financial statements of a company if the contingency is likely to happen and the amount can be reasonably estimated. Sometimes, the contingent liability is recorded in the footnote of a financial statement.
As well, there are three primary principles that outline and indicate whether or not a contingent liability is recorded. These are the prudence principle, the materiality principle, and the full disclosure principle.
Considering and accounting for contingent liabilities requires a broad range of information and the ability to practice sound judgment. They can be a tricky endeavor for both management and investors to navigate since the likelihood of them occurring isn’t guaranteed.
That said, there can be a variety of techniques to use to help evaluate contingent liabilities and weigh their risk. These can include expected loss estimation, risk simulations of impacts, and pricing methodology.
FAQs About Contingent Liability
What Is the Difference Between a Contingent Liability and a Liability?
A contingent liability is an amount that you might own in the future depending on certain events. A current liability is an amount that you already owe.
What Are the Three Required Conditions for a Contingent Liability to Exist?
There are three primary conditions that need to be met for a contingent liability to exist. They are that the liability is probably, possible, and remote.
Is Contingent Liability a Good or Bad Thing?
It all depends on the type of liability and the event that ends up occurring. The basic nature of contingent liability is important to know, recognize, and understand.
How do Contingent Liabilities Affect An Audit?
Essentially, the effect that contingent liabilities have on an audit depends on their likelihood of occurring in the first place. As well, the impact on financial statements depends on the likelihood of the contingency occurring and the total amount of the transaction.
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