Contingency means a possible event that can happen in the future but the happening of that event cannot be predicted with certainty. A contingent liability is a possible liability, that may or may not result in recognition of a liability in future depending upon the outcome of an uncertain future event (contingency).
Following are the two types of contingent liabilities.
Accounting of contingent liabilities
After determining that the possible obligation or a present obligation meets the definition of a contingent liability, the next question is how to account for that contingent liability.
A contingent liability is not recorded in the books of account. A contingent liability is disclosed in the notes to the financial statements. Purpose of disclosing the contingent liabilities is to provide useful information about the possible obligation to the users of the financial statements. Such information may include the following:
- Description of the nature of contingent liability.
- Description of the uncertainties involved.
- If possible, an estimate of the financial effect of the contingent liability.
Example of contingent liability
A customer has filed a complaint in the court against a company claiming damages caused by the provision of faulty products. The event (provision of faulty products) happened before the year end, however, the case is pending adjudication. It is a possible obligation as a result of past event that will be confirmed upon the decision of the court. The company will disclose this contingent liability in the financial statements.