What Is Contingent Liability and How Do Companies Deal with It?
Businesses function in an uncertain environment with many pulls and pressures that can lead to situations whose eventual outcomes cannot be guaranteed. It may involve a pending lawsuit, insurance claims, pending approval from regulatory bodies, etc. In short, these outcomes may have unplanned financial implications.
All this brings us to the introduction of an important concept named contingent liability. It is a liability that may arise based on the result of an uncertain future event. Companies make a provision for these kinds of liabilities if there is a reasonable chance of estimating costs from such circumstances.
What Are the Types of Contingent Liabilities?
Here are the two types of contingent liabilities:
- Implicit Contingent Liability
It consists of legal obligations identified only after an event has occurred. The government has the authority to determine the legal payouts in these cases. Moreover, it does not form a part of the financial statements of the liable company as there is uncertainty about its occurrence.
- Explicit Contingent Liability
These liabilities have statutory recognition, i.e., they are legally enforceable in a court of law. One significant example of explicit contingent liabilities is state insurance schemes related to pension funds, bank deposits, etc. Other examples include mortgage and student loans, claims in which the court orders a penalty.
How to Deal with a Contingent Liability?
The treatment of contingent liability is a bit different from other forms of liability. This is because organisations cannot accurately quantify the actual cost associated with this. Hence, it is essential that companies make an accounting record of provisions. Provisions are a type of uncertain future obligation. As per legal definition, provision is a preventive measure to meet uncertain future commitments.
The biggest benefit that a company has by maintaining provisions is that it is ready to meet its obligations if they arise. This will help them in avoiding a default.
What Are the Differences Between Provision and Contingent Liability?
Here are some differences between provision and contingent liability:
|Provisions are those payments which can be estimated with reasonable accuracy.
|Contingent liability is a future obligation which may or may not occur. However, measuring the same with any degree of accuracy is tough.
|Companies record this in their books of account under the corresponding heads.
|It is not recorded in the books of accounts. Even if a company wants to record it officially, it can only get recorded in the footnote or annexures.
Contingent liability is a type of uncertain future obligation that companies have to deal with due to their nature of business. It is difficult to quantify this cost as there are lots of complexities involved in the same. This article will help our readers gain knowledge about the working of this concept.
Frequently Asked Questions
What are some significant examples of contingent liabilities?
Product warranty, ongoing investigations and lawsuits are some of the major examples of this liability. Warranty means that a company launching a product gives a guarantee and is responsible for all faults occurring in the product within a stipulated time frame. On the other hand, lawsuits mean legal proceedings against the business filed by entities.
What is the impact of contingent liability on stock price?
It has a negative influence on company’s share prices. This is because it is an uncertain future obligation which, if paid, will reduce the organisation’s profits.
What are the features of contingent liability?
You can forecast or foresee this liability, but it is difficult to quantify actual outflow. Moreover, companies record them in their accounts depending on the likely occurrence of such liability.