Contingent Liabilities Definition
Contingent Liabilities refers to the possible liability of the firm which may occur on some future date on basis of a contingent event that is beyond control of company. It is recorded by the company on its balance sheet only in case if it becomes evident that contingency is possible in company and amount of such liability can be estimated reasonably.
Understanding Contingent Liability
In simple words, Continent Liability 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 assetsFinancial AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash. or liabilities on the balance sheet before the conditions are met.
Some of the types of contingent liabilities are given below
#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.
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.
When to Record Contingent Liabilities?
- Probable – Record this type of liability on the balance sheet 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 statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. 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.
This article has been a guide to Contingent Liabilities and its meaning. Here we discuss when to record a contingent liability on the balance sheet along with explanation. You can learn more about accounting from following articles –