A contingent liability is defined as a loss that may potentially occur at a future point, once some uncertainties are solved. Though it is not yet an actual liability, a contingent liability does impact the financial decisions of an organization. The financial impact of a contingent liability is shown in both the balance sheet and/or the income statement. In determining which contingent liability should be presented in the books of accounts, it’s important to determine the status of the contingency liability i.e. high probability, medium probability or low probability.
High probability; a contingency liability with a high probability has the greatest financial implication in the books of accounts. If a contingency has a high probability of occurrence and the loss amount can be estimated to some reasonable degree then such a loss should be recognized in the financial statements. The loss is recognized in the income statement by reducing the net income and by increasing the liabilities in the balance sheet. Besides such a contingent liability needs to be described in the notes to the financial statements of the company.
A contingent liability is said to have medium probability of occurrence in scenarios where the potential loss of an adverse outcome cannot be determined but the event has a reasonable probability of occurring. Such a liability needs to be disclosed adequately in the company’s financial statements.
Low probability; a contingent liability deemed to be far-fetched or remote has no financial implications in the decisions of the company. Such a contingency is neither used in the adjustment of financial statements nor is it disclosed in the accompanying financial statements.
Examples of contingent liabilities include; a government investigation, an expropriation threat or a decision of a lawsuit. A warrant is also an example of a contingency liability.
References
Davies, M., & John, A. (2010). Auditing Fundamentals (pp. 234-137). Pearson.
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