Contingent Liabilities Definition
Contingent Liabilities refers to the potential liability of the company which may arise on some future date on basis of a contingent event that is beyond control of company and this will be recorded by the company in its balance sheet only in case if it becomes certain that contingency is likely in company and amount of such liability can be estimated reasonably.
In simple words, it is defined as the obligations or liabilities in the future, which may or may not arise due to uncertain events or situations. These liabilities are also recorded in the accounting books if the amount of the liability can be estimated.
These liabilities will be like if a person X obtains a loan from the Bank and Y is signed as a guarantee for that loan and the bank will release the funds based on that guarantee if the person X fails to repay the loan than the guarantee Y has to pay it, this, in turn, is referred to as contingent liability. They are generally not recognized as financial assets or liabilities on the balance sheet before the conditions are met.
List of Contingent Liabilities
#1 – Potential Lawsuits
Potential lawsuits arise when an individual gives the guarantee on the other person’s behalf when the actual person or individual fails to pay that the person who provided the guarantee must pay the money.
#2 – Product Warranty
When a product is manufactured and ready to sell than some companies give product warranty, i.e., a minimum guarantee for a certain period and when the product fails to perform within the warranty period than the product has to be replaced or repaired by the company which is a liability to the company.
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Let us see the example where a person has purchased a motorcycle from a showroom and has a warranty for the engine and the motorcycle for two years, and the engine failed to work within six months of the purchase, then the company has to replace the engine. Hence, this is a contingent liability to the company.
#3 – Pending Investigations
Any pending investigation or a court case by law if found that the individual or the company is defaulter than they were supposed to bear the penalty as prescribed the court of law.
Types of Contingent Liabilities
#1 – Explicit Contingent Liabilities
These are some of the specific kinds of obligations of the government or legal obligations that are established by law or which is authorized by law.
Some of the examples are:
- Central government guarantee for non-sovereign borrowing.
- Insurance schemes: i.e., Government insurance schemes on bank bonds, bank deposits, and some of the pension funds.
- Central bank obligations or liabilities.
- A mortgage loan, student loans, agriculture loans, etc.
- Civil service pensions.
- Central government guarantees on private investments.
- Indemnities that are accepted for the loss or damage of another party;
- Legal claims in which the court orders to pay the sum of money or penalty towards the pending cases.
- Currency exchange rates.
Type #2 – Implicit Contingent Liabilities
These are the legal obligations that are recognized generally after the occurrence of the event or after the realization of it, in such cases Governments to make the amount for such types of causes. These are not officially recorded as they may occur or may not occur.
Some of the examples are :
- Environmental recovery, disaster relief, Floods, Cyclones, Tsunami, and any natural disasters. In such cases, the government will take the necessary steps for making payments or help to the affected areas and affected people and property.
- Social security benefits.
- Bank failures to repay the money.
- Municipality defaulters.
- Failure of a non guaranteed pension fund;
- The default of the central bank on its obligations (trading of currency, the balance of payment stability);
- Trade credit and advances.
When to Record Contingent Liabilities?
- Probable – Record this type of liability when there is a probability that the event or loss may occur and when we can reasonably estimate the amount of the loss that happened to a specific range.
- Reasonably Possible – Reveal the existence of this liability when in the financial statements if the obligation or the liability is reasonably possible but not probable.
- Remote – There is no need to record or reveal this contingent liability if the chances of its occurrence are remote.
What is the Need for Calculating Contingent Liabilities?
Contingent liabilities that may occur in the future are much needed to be calculated because there is an economic and financial impact involved in these liabilities. It will be challenging to accurately assess the financial position of the economy or the entity if these liabilities are not captured or measured.
It will be good if we record an entity’s or government’s contingent liabilities. Designing the budget to keep an eye on such liabilities will be good for the economy of the country. It will also be good for the entities as it will not spoil the company’s reputation, as mentioned in the financial statements earlier. It’s good to have a record, even though these aren’t full and accurately. By taking into account past effects, only some countries like Australia, New Zealand, and Canada mention it.
There are both the advantages and disadvantages of contingent liabilities, as it can be a benefit to the beneficiary and a loss to the person concerned or who is supposed to make the payment to the beneficiary. It will be good for anyone who may record and mention it on their financial statements. Estimation plays a vital role here. In the case of implicit contingent liabilities, it will be difficult to estimate when natural disasters occur. In such cases, the liabilities are only measured after the occurrence, and the government will pay money or repair the areas affected. In general, such liabilities may or may not occur, but it is better to keep track of or record what is likely to occur.
This article has been a guide to Contingent Liabilities and its definition. Here we discuss its meaning, types, and categories of contingent liabilities along with detailed explanations. You can learn more about accounting from following articles –