What is a Contingent Liability? 

A contingent liability can be defined as a liability the occurrence of which is dependent upon the happening of an uncertain future event. It is generally recorded in the books only when the amount of liability can be reasonably estimated and the contingency is likely to occur shortly. 

A contingent liability is sometimes also referred to as "potential liability" The Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Principles (IFRS) make it mandatory for the companies to record any contingent liability taking the principles of full disclosure, materiality and prudence into consideration. 

What is a Provision? 

A provision can be defined as a liability the amount of which is uncertain and requires an estimation. A provision is usually recognized in the balance sheet when its reliable estimation is made and where the present financial obligation arose as a result of any past event. 

Accounting Principles have taken into consideration for recording Contingent Liability 

As per the GAAP and IFRS, three accounting principles facilitate the recording of contingent liabilities: 

Full Disclosure Principle 

It is a concept cited under the GAAP which makes it mandatory for the company to disclose all important information in the financial statement so that the potential investors and the stakeholders are fully aware of the company's financial position and are not misled. The information that is to be disclosed can be anything related to the anticipated losses, future events, etc. that might play a major role in influencing the decision of the investor. 

Example: Alex Ltd., a private limited company owned a commercial plot that was under construction. A passer-by was badly injured by the iron rods which were lying unattended on the plot. 

As a result, the passer-by decided to file a lawsuit seeking compensation of $10,000 from Alex Ltd. on grounds of gross negligence. 

So, according to the full disclosure principle, Company X is required to disclose the anticipated loss from the lawsuit even if the lawsuit is still pending. The disclosure should be made at the footnotes of the financial statements. 

Materiality Principle 

Under this principle, it is stated that a company, if required, violates another accounting principle if the amount in question is small enough to affect the net income of the company and impair its financial statements. 

The main objective of the principle is to provide sufficient guidance to the accountants in the preparation of financial statements and also ensuring that the information so provided results in better decision making. The materiality of the amount in question depends on the circumstances and size of the organization. 

Example: In a big multinational firm, a prepaid expense of $200 is incurred as miscellaneous expenses which are to be spread over 4 months. 

Under the matching principle, it is mandatory to apportion the expense for 4 months, however even if this principle is ignored and the amount of $200 is entirely charged to expense in the current period, then it will not make any material difference to the net income or alter the financial statements of the company where it is rounded off to nearest thousand dollars. 

Prudence Principle 

The prudence principle states that a company must not underestimate the losses, expenses, or any liabilities that might occur in the future. It is also stated that any assets, profits, or revenues must never be overestimated. 

The prudence principle of accounting helps in increasing the trustworthiness of the figures that are quoted in the financial statements and shows a realistic picture of the company’s assets, revenues, expenses, or liabilities. 

The principal emphasizes the fact that revenues or profits should be recorded only when their occurrence is certain, whereas any loss or an expense needs to be recorded even if the probability of its occurrence is 50%. 

Example: Under the International Accounting Standards inventory valuation is always done at the Original Cost or Net Realizable Value, whichever is lower. So, if the cost of the inventory is $10,000 and it can be sold in the market for $12,000, the inventory will be valued at $10,000, being the lower of the two. 

Conditions under which Contingent Liability shall be recorded 

Under the GAAP, the contingent liability must fulfill two basic conditions for it to get recorded in the financial statements: 

• The amount of contingent liability should be capable of being estimated. 
• The likelihood of its future occurrence should be at least 50% or more. 

Types of Contingent Liabilities as recognized by the GAAP 

• Probable Contingency: When the occurrence of any financial obligation has at least 50% chances shortly it is referred to as "probable contingency" and the less likely to be incurred in the future is realized in the books of accounts as "probable contingent liability".  

As per the principle quoted in GAAP, the loss is always recorded in the books even the occurrence of it shortly has only 50% chances, on the other hand, profits are recorded in the books only when it is realized. For Example pending lawsuits, product warranties, etc. 

• Possible Contingency: When the occurrence of liability is less likely shortly as compared to probable contingency, it is referred to as "possible contingency”. The probability of its occurrence is less than 50%. Since the possible contingency cannot be expressed in monetary value it is not recorded in the books of accounts and is instead mentioned in the footnotes. 
• Remote Contingency: When the occurrence of any liability shortly is very minimal or negligible under normal circumstances, it is referred to as "remote contingency". They are neither recorded in the books of accounts nor mentioned in the footnotes of financial statements. For Example pointless lawsuits. 

Contingent Asset 

A contingent asset can be defined as a future economic benefit that is dependent upon the happening of an uncertain event that is not in the control of the company. The contingent asset is usually recognized in the period in which the change occurred. A contingent asset is generally disclosed in a statement of the director. 

Example: In a case where a Company ABC filed a lawsuit against Company Honda for infringement of its trademarks. In the given case even if there is the likelihood of Company ABC winning the case against Honda company, it will still be considered as a contingent asset and shall only be recorded in the books once the lawsuit is settled. 

Accounting Treatment of Contingent Asset 

As per the International Accounting Standard 37 (IAS 37) which is part of IFRS, a contingent asset is usually recorded in the financial statements only when the economic benefits that are to be derived from it can be reasonably ascertained, until then it is generally mentioned in the footnotes. 

Related Concepts 

• Accounting Principles 
• Adjustment Entries 
• Current Liabilities and Probable Liabilities 

Context and Application 

This topic is significant in the professionals for: 

• B.com (Honours) 
• M.com 
• Chartered Accountants (CA) 
• Company Secretary (CS) 
• MBA (Master of Business Administration) (Finance) 
• CMA (Certified Management Accountant).