Potential liability from an uncertain future event
Potential liability from an uncertain future event
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, 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 reasonable 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.
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.
According to the full disclosure principle, all material and 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. Such events must be disclosed as per the full disclosure 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 financial statements. A contingent liability can negatively impact a company’s financial performance and health; the knowledge of it might influence the decision-making of different users of the financial statements.
Prudence is a key accounting concept that makes sure that assets and income are not overstated and liabilities and expenses are not understated. Since contingent liabilities cannot be accurately predicted; the probability of the occurrence of the contingent event is estimated and if it is more than 50%, a liability and a corresponding expense is recorded. Hence, recording contingent liabilities prevents understating of liabilities and expenses.
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 looking to invest in the concerned company. An investor invests in a company to gain a future share of its profits. Since a contingent liability reduces a firm’s ability to generate profits, the knowledge of it can dissuade an investor from investing in it, 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 looking to lend capital to a company if they find a reason to believe that the contingent liability may arise and impact the ability of the company to repay its debt.
Contingent liabilities are likely to make 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 the contingent liabilities actually arising and the amount associated with them. Due to the uncertain nature of contingent liabilities, it is difficult to estimate and quantify the exact impact that they might have on the company’s share price. The level of impact also depends on the financial health of a company.
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 rapidly growing earnings. The nature of the contingent liability and the associated risk also plays 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.
As per GAAP, contingent liabilities can be broken down into three categories based on the likelihood of occurrence of each contingent event. 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 does not satisfy either but not both of the parameters of a high probability liability. 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 “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 a disclosure for such liabilities as well.
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.
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The accounting of contingent liabilities is a very subjective topic and requires professional judgment. Contingent liabilities can be a tricky concept for a company’s management, as well as 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. However, contingent liabilities should be analyzed with a skeptical eye as depending on the situation as they can sometimes cost a company several millions of dollars. Sometimes contingent liabilities can arise suddenly and could be completely unforeseen. The $4.3 billion liability for Volkswagen related to its 2015 emissions scandal is one such contingent liability example.
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