When looking at the inner workings of a company, it is important to understand that while a company might ordinarily seek to establish a pace of operations that is smooth and productive, arriving at this state and maintaining the same isn’t always easy. On occasion, for instance, a company might incur a liability (if not multiple liabilities) that serve as the company’s obligations for which it needs to make financial settlements in the future. This sort of scenario is frequently quantified such that it can be recorded in a company’s ledgers. When looking at liabilities, therefore, there exist three major subtypes i.e., current liabilities, non-current liabilities, and contingent liabilities. Read on to understand all that contingent liabilities entail.
Defining Contingent Liabilities
A contingent liability can be understood to be a financial event that has the potential to evolve (or not evolve) into an obligation as the company continues to operate in the future. What is worth noting here is that there is a potential future expense that is dependent on an event that is capable of being triggering and converting the expense into a loss. When considering a contingent liability example, therefore, a lawsuit pertaining to a given company is relevant.
While the definition provided above has the potential to be vague, a way of narrowing down its scope when considering contingent liabilities is as follows.
Whether the event in question has a 50 percent or more chance of arising in the future.
Whether the event in itself is capable of being expressed in financial terms.
Provided the aforementioned two yardsticks are fulfilled, the contingency is satisfied, and the event can be listed under a company’s ledgers. The contingent liability occupies a place in a company’s profit and loss account first, prior to being recorded under the liabilities section in said company’s balance sheet.
Understanding the Types of Contingent Liabilities
Contingent liabilities exist in varied forms which indicate where they stand in terms of their likeliness of occurring in the future. These differing types of contingent liabilities have been examined below.
A financial obligation that has the potential of occurring with the likelihood of being 50 percent or more in the future can be understood to be a probable contingency. The ensuing loss that is likely to follow is understood to be the probable contingent liability.
When considering a scenario wherein a company is slapped with a lawsuit where the plaintiff is backed by a strong case, the company in question is said to experience a probable contingency. Professionals who might advise the company on the same, such as a legal counsel, will review the lawsuit and the weight it occupies, consider the likely outcome and probability. Should they determine the chances of the company experiencing losses are 50 percent or greater, they will proceed to express this loss in financial terms. The same would then be made clear on record in the company’s ledgers.
Understanding why this contingency is recorded despite there being a 50 percent chance of the liability occurring is owed to the fact that the law of conservatism dominates accountancy. This means that the potential of a loss occurring is always there and ought to be recorded should the chance of it occurring amount to 50 percent or more. Conversely, within the domain of accountancy, profits aren’t likely and must not be recorded on ledgers until they have been realized or their chances of arising exceed those of a loss.
A possible contingency can be understood to be a situation wherein a liability may or may not arise but the chances of it arising fall below that of a probable contingency i.e., the likelihood of their arising falls below 50 percent. Owing to this fact, a possible contingency isn’t ordinarily recorded in the ledgers of a company. Instead, it might find itself mentioned in the footnotes.
Additionally, a possible contingency may not find itself recorded because of its nature which isn’t capable of being expressed in monetary terms. This lack of monetary expression is owed to the limited likeliness of its occurrence.
Remote contingencies refer to those liabilities whose chances of occurring are minimal and which wouldn’t ordinarily arise under normal circumstances. Owing to the fact that the chances of such contingencies transforming into losses a company might incur are remote, they aren’t mentioned in any capacity in the company’s ledgers.
Identifying a Contingent Liability
The process of identifying and including or excluding a contingent liability for a company is not an easy process. A rule of thumb that companies must consider is availing of the services of professional that are fluent in these matters. Not only do companies then follow through on the guidelines laid forth by the Securities and Exchange Board of India (or SEBI) but they then also have substantial standing when they are audited.
Take for instance a scenario wherein a company faces litigation. Said company could then avail of the services of a lawyer and rely on their discretion pertaining to whether a liability should be included or excluded in the company’s ledgers. Should a case’s outcomes be determined ambiguous and the lawyer’s instructions have been followed, the contingency should only be mentioned in the footnotes.
Understanding How Investors are Affected by Contingent Liabilities
When the potential of a loss is brought to the attention of a company, they have the opportunity to create scenarios that counter or mitigate the chances of such losses arising in the future. However, this isn’t the sole reason as to why said contingencies are recorded as liabilities in a company’s ledgers. Instead, when this information is made available to the public including the shareholders and auditors, it is meant to arm shareholders against potential losses.
Although the public may be able to follow a lawsuit pertaining to a given company closely, not all information is made available to the public which includes shareholders. Take for instance a warranty that serves as a form of contingent liability that cannot be accessed with ease by shareholders.
By virtue of making clear contingent liabilities to shareholders and those interested in making investments, it is possible for investors to make sound investment decisions.
Identifying contingent liabilities and determining whether they ought to be mentioned or not is a challenging process which is why companies ought to avail of the services of licensed professionals.