Contingent Liabilities

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What are Contingent Liabilities? Meaning.

Contingent Liabilities are liabilities which are shrouded in uncertainty as to whether or not an obligation really exists, as their existence depends on the outcome of future events. In other words, a contingent liability is a liability that is not currently a liability but may become one upon the happening of some future event.

Example of a Contingent Liability

An example might be a potential settlement from a lawsuit filed by Company A against Company B for infringement of Company A’s patent. If it is probable that Company B will lose the lawsuit and will have to pay an estimated amount of money, Company B has a contingent liability.

Contingent liabilities arise from past events and factors such as litigation, industrial accidents, debt guarantees and product warranties, and in addition to the potential liability, also cause a contingent loss.

Insurance

There are a number of insurance types against various types of liabilities of companies and their officers, such as Environmental Insurance, Errors and Omissions Insurance, Professional Liability Insurance and Directors and Officers Liability Insurance.

Accounting Treatment of Contingent Liabilities

For financial reporting purposes, two questions about contingent liabilities must be answered:

1. When do loss contingencies need to be measured and recognized in financial statements?

   The rules for measuring and recognizing loss contingencies in the financial statements are very similar to the rules governing revenue recognition. Under U.S. GAAP (SFAS No. 5), a loss contingency should be accrued if it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements (i.e. the future event is likely to occur), and the amount of the loss can be reasonably estimated. However, if the loss probability is only reasonably possible (i.e. the chance of occurrence is more than remote but less than likely) or remote (i.e. the chance of the future event is slight), no loss accrual needs to be made in the financial statements.

2. Under what circumstances do these contingencies need to be disclosed in footnotes, even when no liability is recorded on the balance sheet itself?

   Footnote disclosure of loss contingencies is necessary when the loss is both reasonably possible and can be reasonably estimated. In the latest Exposure Draft (ASC 450) issued by the Financial Accounting Standards Board (FASB) in regard to loss contingencies, it is foreseen to also include remote loss contingencies in the footnote disclosure, if the loss contingencies due to their nature, potential magnitude or potential timing could have a severe impact on the normal functioning of a company.

The criteria for recognizing and/or disclosing loss contingencies under IAS/IFRS (IAS 37) are very similar to the conditions mentioned under U.S. GAAP. However, due to a broader definition of the word 'probable' under IAS/IFRS (i.e. more likely than not), it is argued that U.S. GAAP has a higher recognition threshold than IAS/IFRS.

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