Understanding the Types of Contingent Liability

The term “Contingent Liability” refers to an anticipated financial obligation that could be a probable liability that may or may not arise from a future event that is unpredictable and beyond the enterprise’s control.

Contingent Liability Definition: A contingent liability is a future financial obligation whose existence is verified by the occurrence or non-occurrence of an unpredictable future event that is beyond the enterprise’s control.

It can also be a current financial obligation that is unlikely to be paid or whose amount cannot be determined with confidence.

Contingent Liability

A contingent liability is a potential obligation that could develop in the future if one or more unpredictable events occur or do not occur.

To put it another way, a contingent liability is a potential liability that, depending on the outcome of circumstances, may or may not become a real liability. As a result, it appears as a footnote in the balance sheet and is not treated equally to other financial statement components.

Some common instances of contingent liabilities include the outcome of a long-pending lawsuit, a government inquiry into an organization’s business, and the possibility of expropriation. Even a warranty should be viewed as a potential risk.

There is uncertainty about the payment’s timing and scope, as well as the chance that payment will not be made at all. As a result, we can conclude that future occurrences will determine whether or not it is a liability. Because of the uncertainty, these are referred to as contingent liabilities.

The disclosure of contingent liability allows the company to be better prepared for future obligations.

Recognize a Contingent Liability

Consider the circumstances below in order to recognize the contingent responsibility. Types of contingent liabilities are a term used to describe these eventualities.

• Probable

In this case, contingent Liability is only recorded if the loss is likely to occur and the amount of loss may be reasonably estimated. The term “probable” refers to the likelihood of a future occurrence occurring. As a result, the liability must be described in the footnotes that accompany the financial statements.

• Possible

Contingent liabilities are only recognized in this case if the liability is reasonably estimable but not likely. “Reasonably possible” suggests that the likelihood of an event occurring is greater than remote but less than certain.

• Remote

If the probability of the contingent obligation occurring is distant, it is not recorded or disclosed in this case. The term ‘remote’ refers to eventualities that aren’t likely to happen and aren’t even remotely possible.

Accounting Rules for Contingent Liability

There are the following rules:

• In the statement of financial status, a contingent liability should not be included
• Unless the chances of a transfer of economic advantages are small, a contingent liability should be stated solely in the notes to financial statements

Contingent Liability Examples

• A company’s guarantees and counter-guarantees
• A guarantee is a promise made by a firm to another person on behalf of a third party (such as a loan to a subsidiary or a promise that another company would fulfil its contractual obligations)
• Warranty on the product
• The guarantee is provided by the shareholders
• A letter of credit has been obtained
• Potential adverse judgement

Types of Contingent Liability

Generally, there are two types of Contingent Liability:

• Explicit Contingent Liabilities

Contingent Liabilities are based on the government’s contractual, legal, or direct policy promises to pay when a specified event occurs. These are either mandated by law or permitted by it. So, it includes:

• Guarantee on a loan
• Export Assurance
• Other financial guarantees include exchange rate protection, minimum pension protection, deposit protection, and so forth
• Insurance programme run by the government
• Claims against the government in court
• Indemnities
• Uncalled capital

• Implicit Contingent Liabilities

After the event, i.e. when the crisis or tragedy occurs, the financial obligation of these obligations should be recognized. Furthermore, because of the uncertainty, the government does not make an official record of these contingent liabilities. It could include the following:

• Relief from natural disasters
• Bailouts of the banking system
• Spending on environmental cleaning
• Municipality Defaults

Treatment of Contingent Liability

A contingent liability must be disclosed but not recorded in the company’s books of accounts.

Although it is an off-balance sheet item, its value does not display in the liabilities side of the balance sheet’s amount column. Unless there is a distant probability of monetary outflow, it is clearly noted as a footnote in the “Notes to Accounts.” Only if a contingent liability is predicted to exist and its amount can be estimated with reasonable accuracy is it recorded in the financial statements.

Provision

A provision is an account in financial accounting that captures an entity’s present liability under the International Financial Reporting Standards (IFRS). The liability is recorded in the balance sheet and then matched to an appropriate expense account on the income statement. A provision is a cost according to Generally Accepted Accounting Principles ( GAAP). As a result, “Provision for Income Taxes” is a liability in IFRS but an expense in GAAP.

A provision might be a liability with an ambiguous deadline or amount. A liability, on the other hand, is an entity’s current obligation arising from previous events, the settlement of which is projected to result in an outflow of resources representing economic advantages from the entity. 

A provision should not be mistaken for a type of savings, despite what people think. Income tax liability, product warranty, environmental remediation, and so on are examples.

Conclusion

In this article, we have studied contingent Liability and its type.  A contingent liability is a potential obligation that could develop in the future if one or more unpredictable events occur or do not occur.

To put it another way, a contingent liability is a potential liability that, depending on the outcome of circumstances, may or may not become a real liability.

Contingent Liabilities are based on the government’s contractual, legal, or direct policy promises to pay when a specified event occurs. After the event, i.e. when the crisis or tragedy occurs, the financial obligation of these obligations should be recognized. Furthermore, because of the uncertainty, the government does not make an official record of these contingent liabilities.