What is a Contingent Liability?
A contingent liability is found in many business contracts. Read this guide to understand what they are and your obligations when reporting them.
It’s hard to predict the future at the best of times, which is why contingent liabilities account for this. The AASB137 Provisions, Contingent Liabilities and Contingent Assets defines this term. Thus, a contingent liability will be a liability that only takes effect if a certain event does, or does not happen. This article will explain what these liabilities are and where you’ll find them.
Where will I find them?
Loan agreements often contain clauses relating to contingent liabilities. This provides a level of protection for both the lender and the borrower.
When you borrow from a lender, a contingent liability provides them with a certain amount of protection from actions which may lead to a loss. Further, a contingent liability will be a risk for businesses if they don’t understand what their obligations are. Here are some other places they can be found:
An indemnity is a promise made by one party to cover the losses of another. This indemnity only takes effect if something goes wrong. This means that compensating the other party for a loss is contingent on what happens in the future.
Similarly, a warranty is a promise to offer a certain remedy if a future event occurs. A business should record this as a contingent liability, because they have effectively paid the price to offer the warranty even if it is never used.
In a guarantee, there are three parties. A guarantee is another contractual promise. A third party will act as a guarantor to compensate for loss owed to a beneficiary by an obligor. Further, an obligor will be the party that holds the responsibility for the loss.
A contingent liability will be formed if an outcome results in an obligation. Further, they can arise in the following circumstances:
- An income tax dispute
- The outcome of legal proceedings
- A failure of a party to pay a debt to another party
- Where a liability cap exists
There is no set rule when it comes to what can be a contingent liability. Therefore, when identifying a contingent liability you should make sure there is either:
- An obligation that has arisen from past events
- The obligation is dependent on the likelihood of a future act occurring
Contingent liabilities carry certain legal obligations that need to be met. Businesses will be required to notify the Australian Accounting Standards Board if they become aware of a contingent liability.
Every state has their own rules in regards to the disclosure of the contingent liabilities. Most contingent liabilities can be predicted to a reasonable extent. Thus, your business should record the liability in its accounts. Some contingent liabilities may be questionable, therefore your business’s financial statement should include them.
In your disclosure, make sure to include:
- The nature of the liability
- What the uncertainty is relating to the occurrence of an event
- The financial effect
- The possibility for reimbursement
Ultimately, a contingent liability will be an obligation that will or will not arise, depending on if a certain event occurs. If you’re unsure of whether something counts as a contingent liability, it is worth also speaking to a commercial lawyer.
Shrishti is in her third year of a Bachelor of Laws. She is a Legal Tech Intern for LawPath. She is Interested in Intellectual Property law, Information Technology Law and Consumer and Competition Law.