It’s common that unpredictable events can happen in business, often creating losses. These potential losses are contingent liabilities that companies need to plan for and report to investors. Learn how to deal with contingent liabilities in a business financial system.
Contingent Liability Definition and an Example
A liability is something owed by someone—it sets up an obligation or a debt. In practice, liabilities create legal responsibility.
A lawsuit or other situation with a potential for loss can create a liability for a business, but it’s often difficult to know what the amount of the liability will be. These unknown future potential losses are contingent liabilities. Businesses may need to account for these possibilities based on two factors, according to the Financial Accounting Standards Board (FASB):
- Probability that the contingent liability will become an actual liability
- Accuracy of estimating the amount
Say an employer pays an employee “off the books” in cash and doesn’t report the income or the taxes, or pay the unemployment insurance for this employee. If the employee is laid off and tries to file an unemployment claim, the case may come before a state unemployment board. This creates a contingent liability, because the employer may have to pay an unknown amount for the claim, in addition to fines and interest.
Regulations for Reporting Contingent Liabilities
Businesses must record contingent liabilities on its financial statements according to accounting standards set by two independent not-for-profit agencies:
- The FASB (in the U.S).
- The International Financial Reporting Standards Foundation (IFRS) for international financial markets.
Contingencies may be positive as well as negative, but accounting practices only consider negative outcomes.
Types of Contingent Liabilities and Questions to Consider
Here are some common types of contingent liabilities:
- Employment situations like whistleblower actions or discrimination lawsuits against a company: What might a court decide? How much might the court award the employee?
- Product warranties and claims: How many people will have claims? How many will need service or replacement?
- Customer insurance claims: How many customers might file claims? What is the claim limit? What if many people file claims?
- Claims by creditors in business bankruptcy: How much does the business owe its creditors? How many claims can be settled? What’s the maximum amount?
How Contingent Liability Accounting Works
The process of including a contingent liability in business reports has two steps: recognizing the liability and estimating the amount.
First, the company must decide if the contingent liability should be recognized with an accounting transaction created and included in its reports. This process looks at the probability of the occurrence and whether the cost of the occurrence can be estimated.
Based on an analysis of both these factors, the company can know what’s required for including the contingent liability in its financial statements. In some cases, the accounting standards require what’s called a note disclosure (a footnote) in the company’s reports.
|If the contingent liability is:||The required reporting is:|
|Probable and estimable||Must include in the financial statement with note disclosures|
|Probable but not able to be estimated||Don’t include in financial statements, but include a note disclosure|
|Reasonably possible, but not probable/ may or may not be able to be estimated||Don’t include in the financial statement; is close in notes only with available details.|
|Unlikely to occur/may or may not be able to be estimated||Don’t include in financial statements; no note disclosure necessary.|
Effects of Contingent Liabilities
As part of the due diligence process, some potential investors look at a company’s prospectus, which must include all the information on its financial statements. Investors pay particular attention to items that reduce the company’s ability to generate profits, like contingent liabilities.
Contingent liabilities also can negatively affect share price, depending on the probability of the event and other factors. If the company has a strong cash flow and its earnings are high, the liability may not be as important.
The analysis of contingent liabilities, especially when it comes to calculating the estimated amount, is sophisticated and detailed. As noted above, the process is supervised by accounting standards boards. To make sure a business’s financial reports comply with regulations, a public accounting firm must assess these reports.
- A contingent liability is a possible negative financial situation that could occur in the future, and eventually become costly to a company.
- Some sources of contingent liabilities are lawsuits, product warranties, bankruptcy claims, and customer insurance claims.
- A contingent liability may need to be recorded on the business’s financial statements, depending on the probability of the event occurring and the possibility of estimating the potential amount.
- Information on contingent liabilities can affect a company’s share price and influence the decisions of investors and shareholders.