Contingent liability arises when there is a present obligation that is probable. If there is no probability or likelihood that the current event will lead to an obligation of the company to pay a lump or huge sum of money, then this term will not arise. In this article, let’s define and explain it.
Definition of Contingent Liability
Contingent liability means a present obligation that is likely to occur in the future as a result of a past event that will lead to an outflow of economic resources from the organization affected.
In simple terms, contingent liability will occur sometime in the future but must be recognized now because of a potential outflow of economic resources (e.g cash) which may influence users’ decisions.
Contingent liability is a present obligation. This means the entity is expected to resume payment of the obligation as soon as possible. The use of the word obligation is also in line with the International Financial Reporting Standards (IFRS) definition of a liability. Also, an outflow of economic resources is expected from the future event that arises. For example, a lawsuit that the company may lose. The economic resources might be in cash or in-kind. An in-kind economic resource is the sale of the business’s non-current asset.
The future event will have a great impact on the entity. And that’s why the contingent liability must be disclosed in the financial statement of the organization. By reporting such financial information, users will be able to make informed economic decisions. For example, knowing that the figure for contingent liability is huge may give a warning to potential investors. The investor will decide either to invest or not to do so. Other users like banks and creditors can use the information to decide on current and future loans provided to the company.
To illustrate, a bank may have provided a huge loan facility to the entity facing a future event that could lead to contingent liability. Such awareness will enable the bank to assess the current risk of the loan in the hands of the entity. Also, it will enable the bank to know the probability of default applicable when estimating impairment charges on its financial assets. More so, the bank could decide if it should pursue the recovery of the loan immediately.
Categories and Disclosure of Contingent Liability
There are three categories of contingent liability as stipulated by IFRS. It can be probable, possible, or remote. The one that is probably can be estimated so it can be presented in the financial statement. For the one that is possible, the liability cannot be estimated but is likely to occur. This is disclosed in the note to the financial statement. While remote contingency is not disclosed in the financial report.
Examples of Contingent Liability
Here, I will examine three examples of contingent liability. They are; Warranty, lawsuit, and a Guarantee.
For warranty, it is not possible to know the quantity of a product that will be returned within a year. So, it is normal for the entity to estimate the number of quantities of the goods that might be returned and multiply them by the price. To illustrate, a smartphone company may estimate that 1000 of its phones may be returned within the year as a result of a warranty obligation. If the retail price of one phone is 56,000 Naira. Then the estimated warranty for the year shall be 56,000,000 Naira. At the end of the year, the company will adjust the estimated warranty with the actual one.
Lawsuits may arise if the business has bridged the country’s privacy law. Or one company may sue another as a result of an event. In a recent case, Samsung sued Apple, the maker of iPhones, for using their product without paying patent rights. Also, the Dutch government is planning on suing Google on bridging its competition laws. Things like this lead to contingent liability. Why? The company may lose the case and will pay a huge fine. However, the value of the fine is unknown and it is still likely that the company may win the case. So, an estimated value of the liability is kept in an account pending when the case is settled.
The third example is a guarantee. If the company has guaranteed another company, it will not need to provide for contingent liability. However, if the major economic event has a bad impact on the company guaranteed, this will result in making provision for such an event. This is because there is a present obligation from a past event.
Contingent liability is a present obligation from past event that is probable. The estimated value of the liability is known so it is recognised in the financial report. Examples of it is guarantee, warranty and lawsuit.