What Is A Contingent Liability?November 8, 2023
Contingent liabilities are an important – but often complicated – part of business and accounting.
In this article, we explain contingent liabilities including when you need to disclose them in your financial statements and their importance in insolvencies.
For context, a liability is defined as a debt or a service owed by a company. These are different to expenses, which make up the costs of a company’s operations, referring instead to a company’s debts or obligations – but in that case, what are contingent liabilities?
Contingent liabilities meaning
A contingent liability is a possible debt which could be payable by a company in the future if specific events occur.
Contingent liabilities can primarily be identified by their dependence on uncertain future events. However, where a liability is of uncertain timing and amount, it is called a provision.
GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) require companies to record contingent liabilities in the notes of financial statements. This helps to provide an accurate picture of a company’s financial position.
Examples of contingent liabilities
A contingent liability may occur in the form of a legal or constructive obligation. A legal obligation is one that a company is legally obliged to perform.
A constructive obligation arises from past events and any actions of a company that reasonably suggest it will accept certain responsibilities.
A contingent liability could involve:
- Pending litigation against a company or legal obligation
- Product warranties
- When a company acts as a guarantor for a loan
In each instance, a company may have to fulfil obligations if an uncertain future event occurs. For example, honouring the terms of a product warranty or paying out for legal obligations.
Why are contingent liabilities important?
A contingent liability may not always become a present obligation. However, they can be an important part of a company’s finances, as they represent potential expenditure of economic resources in the future.
According to FRS 102, the Financial Reporting Standard applicable in the UK and Republic of Ireland, contingent liabilities must be disclosed unless “the possibility of an outflow of resources is remote” – they may also be a present obligation that fails to meet the following criteria:
- It is probable that the company will be required to transfer resources embodying economic benefits in settlement
- The settlement amount can be measured reliably
Knowledge of a contingent liability can influence the decisions of an investor, as possible obligations in the future could negatively impact a company’s net profitability.
Disclosing contingent liabilities
Accurate financial reporting is vital in the case of a contingent liability. Contingent liabilities need to be properly disclosed in financial statements to comply with the UK’s accounting standards framework.
This disclosure of contingent liabilities in the notes of a company’s financial statements should include a brief description of the nature of each one and, when practicable:
- An estimate of its financial effect
- An indication of the uncertainties relating to the amount or timing of any outflow
- The possibility of any reimbursement
It must be stated if one or more of these disclosures can’t be made.
Failing to recognise contingent liabilities
Failure to recognise contingent liabilities in the notes of financial statements can have several repercussions.
Not appropriately disclosing a contingent liability contravenes three important accounting principles: full disclosure, materiality and prudence:
- Full disclosure asserts that businesses should report all necessary information in their financial statements
- Materiality is the determination of whether an omission or misstatement in a financial report would impact decision-making
- Prudence is the practice of ensuring income and assets are not overstated, which could lead to an overvaluation of a company
Misrepresenting a company’s financial position by not correctly disclosing contingent liabilities could lead to fines or legal action.
Directors could face personal liability if an undisclosed contingent liability results in the insolvency of their business. This could be due to directors paying themselves a salary, or declaring dividends, that the company could not support.
Also, where relevant, under director disqualification laws they may be barred for up to 15 years.
Contingent liabilities and insolvency
Therefore, contingent liabilities can have an important role in the circumstances around a company’s insolvency.
If a Members’ Voluntary Liquidation (MVL) is used to close a company, then a declaration of solvency must be signed. It is important to take into consideration any contingent liabilities when considering a company’s assets and declaring solvency.
However, if a present obligation arises from an uncertain future event which makes the company insolvent, then the MVL may need to be changed to a Creditors’ Voluntary Liquidation (CVL).
Final thoughts: What is a contingent liability?
Hopefully this article has given you a better understanding of what a contingent liability is.
It is important for companies to be aware of contingent liabilities and know when a disclosure is required on a balance sheet.
If your business is facing company liquidation, remember that contingent liabilities can affect this process too.