Contingent Liability: What Is It?

A contingent liability is a cost that might happen in the future. "Contingent" means only if something occurs. "Liability" means you're responsible for something. When the term "liability" is used, it often involves a lawsuit. Accountants use contingent liability to help a company manage its finances.

Common Types of Contingent Liability

  • Lawsuits (including patent infringement)
  • Guarantors
  • Changes in government legislation
  • Product warranties
  • Government investigation
  • Expropriation threat
  • Product recalls

For example, guaranteeing an apartment or a car loan qualifies as a contingent liability. If the person on the lease or loan doesn't pay, then the guarantor would be liable for the cost.

For mortgages, business loans, or other types of loans, the lender may want to see a list of contingent liabilities before approving the loan.

Contingent Liability: General Accepted Accounting Principles

How an accountant handles contigent liabilities depends on likelihood:

  • If the contingent liability is highly probable, an accountant would place it under accounts payable with a description in the footnotes. Accountants typically require the lowest possible estimate when no precise estimate is available.
  • If it is only possible (not probable) or has a moderate chance of happening, the accountant does not need to put it in the books. However, adisclosure is required.
  • A remote possibility does not need documented or disclosed. This term is used when something is not likely or has a low chance of happening.

Having contingent liabilities does not mean the company has to set aside money for to cover the potential debt, nor do contingent liabilities change the cash flow.

It's not always possible to protect against contingent liabilities. They are hard to predict when they arise suddenly. For example, the Deep Horizon oil spill was a huge liability that the accountants could not have foreseen.

A related term, "gains contingencies," means you have potential gains instead of a potential debt. An accountant does not record gains contingencies until they actually receive the cash or know they are getting the money.

Investor Concerns with Contingent Liabilities

A contingent liability's probability is subjective. If a company is applying for a loan or looking for investors, they might have reason to downplay a liability. Investors should closely examine the books of a company and check the news, press releases, and other sources to find any potential liabilities.

Contingent Liability in Practice

Lawsuits and Potential Lawsuits

CFG Limited, a company that created products in California, received notice of potential patent infringement at the end of the calendar year. The company had no way to know how much it might potentially owe. This was still a contingent liability, but the accountants only documented it in the footnotes.

Warranty Liabilities

Companies often offer warranties on their products, which means they may have to issue refunds or replacements. In such cases, the accountant would use past information to estimate the potential cost of the warranty, then add the contingent liability to the company's accounting records.

Product Recalls

If there is a chance that a product might be recalled, then the company might have a big cost to pay back or replace the recalled item.

Contingent Liability and Audits

Accountants have a lot of flexibility for determining contingent liability labels. This makes it difficult for auditors to check contingent liabilities.

The following terms are often by auditors and accountants when dealing with contingent liabilities.

Audit Evidence

The facts an auditor finds during an investigation that helps the auditor form their professional opinion.

Audit Risk

The chance an auditor might find something deceptive or incorrect during an audit.

Control Risk

Control risk refers to a company's internal processes. It's the risk that a company won't catch a mistake.

Due Professional Care

Due professional care means taking the proper amount of time to gather evidence to show that the financial statements are free from errors or incorrect information.

Generally Accepted Auditing Standards

The standards for conducting and reporting audits.

Going Concern

The belief or expectation that a business will be open for at least 12 more months.

Independence

Independence means that the auditor doesn't have any special relationships with the company or client being audited.

Inherent Risk

The chance that a company might have inaccurate accounting issues based on the type of business.

Internal Controls

Internal controls are the ways that a company works toward avoiding errors.

Management Assertions

The management assertions are the way the managers of a company represent the company on their financial statements.

Materiality

Materiality refers to the overall significance of an area of financial reporting.

Objectivity

An auditor must check records without having earlier beliefs or conceptions about the person's financial records.

Professional Skepticism

An auditor must look at records with a skeptical mindset.

Sampling

Sampling refers to picking an important but small sample of records to represent all the files.

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