Contingent liabilities are possible future liabilities that will only become certain in the event of a future event. It is less certain that a contingent liability than a provision : the latter is expected to occur, a contingent liability might occur.
Contingent liabilities are not shown in the balance sheet , but must be disclosed in the notes .Common types of contingent liabilities include guarantees and the results of legal disputes. Guarantees can be given on behalf of an associate company , or as part of a larger business (banks often give guarantees of various sorts as part of their business).
Contingent liabilities often never become real liabilities. If they are large they can nevertheless be quite of a risk to have a significant impact on the assessment.
Shareholders should look out for large, unusual or potentially problematic contingent liabilities such as:
- guarantees given without apparent or sufficient reason
- contingent liabilities that do not fit in with the usual course of business.
The term “contingent” is used for liabilities that are not recognized in the financial statements of the companies because their existence depends on one or more uncertain future events that are not entirely under the company’s control. The Financial Statements of companies controlled by the State reflect this accounting treatment, that is, events that imply a probable risk of cash outflow are accounted for as provisions and those where such outflow is only possible are highlighted, in explanatory notes, as contingent liabilities. Observing the peculiarities of each company, since the field of action is vast and differentiated, the contingent liabilities highlighted are mostly related to labor, civil, tax and, in some cases, environmental causes.
Examples of Contingent Liabilities
It is not possible to determine exactly what a contingent liability may be, as this varies from company to company. However, some of the most common are the amounts to be paid as a result of labor, civil, tax and environmental lawsuits.Most companies are subject to lawsuits at some point. However, it is not possible to specify whether this will happen, when, or what the cost will be for the organization.
For this reason, unless there is already a lawsuit and a judgment, these amounts are merely contingent liabilities. In order to estimate a value, the support of the legal sector, controllership, internal audit, in addition to the accounting team, is required.
Contingent Liabilities and Joint Liability
There are many situations in which a company is jointly and severally liable for damage.
Imagine, for example, that a person suffers public embarrassment due to an error in the payment of the credit card bill, causing their card to be rejected at an establishment. According to the most common understandings of the courts, both the bank that collects the payment and the administrator of the card that should have been discharged are jointly and severally liable for the moral damage suffered.
In other words, the two companies are responsible for this damage, compensating and indemnifying. In general, they share the obligation; but if one does not comply, the other may be charged for the full amount.
Using this example, then, we know that the card administrator is jointly and severally liable for the moral damage of the customer. Thus, it must bear a portion of the indemnity, while the bank will bear the rest.
Suppose, then, that the judge ordered the administrator to pay R $ 5,000.00 and the bank to pay R $ 3,000.00. In the management’s financial statements, R $ 5,000.00 will be recorded as a provision and R $ 3,000.00 as a contingent liability. This is because the portion that falls to the bank may eventually fall on the administrator.
Change in the recognition of contingent liabilities
We know that the contingent liability is an outflow of money that, at first, is not expected to actually happen. However, the situation may change; at some point, the likelihood of this contingent materializing may increase.
When this happens, the contingent liability should start to be recognized in the company’s accounting. Then, from the statement of the period in which the probability estimate changes, the contingent liability should now be recorded as a provision.As a result of this possibility of change in recognition, it is advisable to periodically reassess the company’s contingent liabilities.