What is a Contingent Liability?

A contingent liability is a potential liability that may or may not occur,

depending on the result of an uncertain future event. The relevance of a
contingent liability depends on the probability of the contingency becoming
an actual liability, its timing, and the accuracy with which the amount
associated with it can be estimated.

A contingent liability is recorded in the accounting records if the contingency

is probable and the related amount can be estimated with a reasonable level
of accuracy. The most common example of a contingent liability is a product
warranty. Other examples include guarantees on debts, liquidated
damages, outstanding lawsuits, and government probes.

Why is a Contingent Liability Recorded?

Both GAAP (Generally Accepted Accounting Principles) and IFRS (International

Financial Reporting Standards) require companies to record contingent
liabilities, due to their connection with three important accounting principles.

 
 

1. Full Disclosure Principle

According to the full disclosure principle, all significant, relevant facts related
to the financial performance and fundamentals of a company should be
disclosed in the financial statements. A contingent liability threatens to reduce
the company’s assets and net profitability and, thus, comes with the potential
to negatively impact the financial performance and health of a company.
Therefore, such circumstances or situations must be disclosed in a company’s
financial statements, per the full disclosure principle.

2. Materiality Principle:

The materiality principle states that all important financial information and
matters need to be disclosed in the financial statements. An item is considered
material if the knowledge of it could change the economic decision of users of
the company’s financial statements. In this context, the term “material” is
basically synonymous with “significant”. A contingent liability can negatively
impact a company’s financial performance and health; clearly, the knowledge
of it might influence the decision-making of different users of the company’s
financial statements.

3. Prudence Principle

Prudence is a key accounting concept that makes sure that assets and income
are not overstated, and liabilities and expenses are not understated. Since the
outcome of contingent liabilities cannot be known for certain, the probability
of the occurrence of the contingent event is estimated and, if it is greater than
50%, then a liability and a corresponding expense is recorded. The recording
of contingent liabilities prevents understating of liabilities and expenses.

Using Knowledge of a Contingent Liability in Investing

Since a contingent liability can potentially reduce a company’s assets and

negatively impact a company’s future net profitability and cash flow,
knowledge of a contingent liability can influence the decision of an investor.
An investor buys stock shares in a company to gain a future share of its
profits. Since a contingent liability may reduce a firm’s ability to generate
profits, the knowledge of it can dissuade an investor from investing in the
company, depending on the nature of the contingency and the amount
associated with it.

Similarly, the knowledge of a contingent liability can influence the decision of

creditors considering lending capital to a company. The contingent liability
may arise and negatively impact the ability of the company to repay its debt.

Impact of Contingent Liabilities on Share Price

Contingent liabilities are likely to have a negative impact on a company’s

share price, as they threaten to negatively impact the company’s ability to
generate future profits. The magnitude of the impact on the share price
depends on the likelihood of a contingent liability actually arising and the
amount associated with it. Due to the uncertain nature of contingent liabilities,
it is difficult to estimate and quantify the exact impact that they might have on
a company’s share price.

The level of impact also depends on how financially sound the company is. If
investors believe that the company is in such a solid financial situation that it
can easily absorb any losses that may arise from the contingent liability, then
they may choose to invest in the company even if it appears likely that the
contingent liability becomes an actual liability.

A contingent liability, unless very large, will not affect a company’s share price
in a major way if the company maintains a strong cash flow position and is
rapidly growing earnings. The nature of the contingent liability and the
associated risk play an important role. A contingent liability that is expected to
be settled in the near future is more likely to impact a company’s share price
than one that is not expected to be settled for several years. Often, the longer
the span of time it takes for a contingent liability to be settled, the less likely
that it will become an actual liability.

Recording

Per GAAP, contingent liabilities can be broken down into three categories
based on the likelihood of occurrence. The first category is the “high
probability” contingency, which means that the probability of the liability
arising is greater than 50% and the amount associated with it can be
estimated with reasonable accuracy. Such events are recorded as an expense
on the income statement and a liability on the balance sheet.

A “medium probability” contingency is one that satisfies either, but not both,
of the parameters of a high probability contingency. These liabilities must be
disclosed in the footnotes of the financial statements if either of the two
criteria is true.
Contingent liabilities that do not fall into the categories mentioned above are
considered “low probability.” The likelihood of a cost arising due to these
liabilities is extremely low and, therefore, accountants are not required to
report them in the financial statements. However, sometimes companies put in
a disclosure of such liabilities anyway.

Incorporating Contingent Liabilities in a Financial Model

Modeling contingent liabilities can be a tricky concept due to the level of

subjectivity involved. The opinions of analysts are divided in relation to
modeling contingent liabilities. As a general guideline, the impact of
contingent liabilities on cash flow should be incorporated in a financial model
if the probability of the contingent liability turning into an actual liability is
greater than 50%. In some cases, an analyst might show two scenarios in a
financial model, one which incorporates the cash flow impact of contingent
liabilities and another which does not.

Launch our financial modeling courses to learn more!

Summary

The accounting of contingent liabilities is a very subjective topic and requires

sound professional judgment. Contingent liabilities can be a tricky concept for
a company’s management, as well as for investors. Judicious use of a wide
variety of techniques for valuation of liabilities and risk weighting may be
required in large companies with multiple lines of business.

Sophisticated analyses include techniques like options pricing methodology,

expected loss estimation, and risk simulations of the impacts of changed
macroeconomic conditions. Contingent liabilities should be analyzed with a
serious and skeptical eye, since, depending on the specific situation, they can
sometimes cost a company several millions of dollars. Sometimes contingent
liabilities can arise suddenly and be completely unforeseen. The $4.3 billion
liability for Volkswagen related to its 2015 emissions scandal is one
such contingent liability example.

Related Readings

Thank you for reading our explanation of contingent liabilities. To understand

more about the concept of liabilities in business accounting, see the following
CFI resources:

 Current Liabilities
 Current Portion of Long-Term Debt
 Accounting Cycle
 Analysis of Financial Statements