Contingent Liabilities Definition

Understanding Contingent Liability

In simple words, Contingent Liability is defined as future obligations or liabilities that may or may not arise due to uncertain events or situations. These liabilities are also recorded in the accounting books if the amount of the liability can be estimated.

These liabilities will be like if a person X obtains a loan from the Bank and Y is signed as a guarantee for that loan, and the bank will release the funds based on that guarantee; if the person X fails to repay the loan, then the guarantee Y has to pay it, this, in turn, is referred to as contingent liability. They are generally not recognized as financial assetsFinancial AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more or liabilities on the balance sheet before the conditions are met.

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Some of the types of contingent liabilities are given below

#1 – Potential Lawsuits

Potential lawsuits arise when an individual gives the guarantee on the other person’s behalf; when the actual person or individual fails to pay that the person who provided the guarantee must pay the money.

#2 – Product Warranty

When a product is manufactured and ready to sell then some companies give a product warranty, i.e., a minimum guarantee for a certain period, and when the product fails to perform within the warranty period, then the product has to be replaced or repaired by the company which is a liability to the company.

Let us see the example where a person has purchased a motorcycle from a showroom and has a two-year warranty for the engine and the motorcycle. If the engine fails to work within six months of the purchase, the company has to replace the engine. Hence, this is a contingent liability to the company.

#3 – Pending Investigations

If any pending investigation or a court case by law found that the individual or the company is a defaulter, then they were supposed to bear the penalty as prescribed by the court of law.

When to Record Contingent Liabilities?

  • Probable – Record this type of liability on the balance sheet when there is a probability that the event or loss may occur and when we can reasonably estimate the amount of the loss that happened to a specific range.Reasonably Possible – Reveal the existence of this liability when in the financial statementsFinancial StatementsFinancial statements are written reports prepared by a company’s management to present the company’s financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more if the obligation or the liability is reasonably possible but not probable.Remote – There is no need to record or reveal this contingent liability if the chances of its occurrence are remote.

This article has been a guide to Contingent Liabilities and their meaning. Here we discuss when to record a contingent liability on the balance sheet and explain. You can learn more about accounting from the following articles –

  • Journal Entry for Contingent LiabilitiesContingent Asset MeaningContingent SharesLiabilities in Accounting