Contingent Liabilities Definition, Types & Example

The full disclosure principle states that all necessary information that poses an impact on the financial strength of the company must be registered in the public filings. A great example of the application of prudence would be recognizing anticipated bad debts. Prudence can be helpful if certain liabilities might occur but aren’t certain; here contingent liabilities. If the person or company in question does not take the responsibility, they may be legally sued. A liquidated damages compensation can help in safeguarding the party against future discrepancies. The company gives a certain guarantee to another stakeholder on behalf of their third party.

A contingent liability is not recognized in the statement of financial position. However, unless the possibility of an outflow of economic resources is remote, a contingent liability is disclosed in the notes. Contingent liabilities are defined as those potential liabilities that may occur in a future date as a result of an uncertain event that is beyond the control of the business. A contingent liability will only be recorded in the balance sheet when the probability of its occurrence is certain, and the extent of such liability can be determined. As a general rule, contingent liabilities, whether recognized or not, must be disclosed. If any of these elements cannot be calculated reliably, that fact should be stated.

Examples of Contingent Liabilities

To understand the concept of legal liability, let us take an example of a business owner. The liquidated damages are written as legal contracts and are bound by the law. In the example of ACE Ltd, the claim will materialize into monetary outflow for the company and the company should reliably estimate such amount. One of their customers has filed the legal claim against the company for delivering the product which was defective.

Any probable contingency needs to be reflected in the financial statements—no exceptions. Possible contingencies—those that are neither probable nor remote—should be disclosed in the footnotes contingent liabilities example of the financial statements. As part of the due diligence process, the acquiring company investigates the target company’s financial condition, including its contingent liabilities.