- #1 - Lawsuit
- #2 - Product Warranty
- #3 - Pending Investigation or Pending Cases
- #4 - Bank Guarantee
- #5 - Lawsuit for theft of Patent/know-how
- #6 - Change of Govt. Policies
- #7 - Change in Foreign Exchange
- #8 - Liquidate Damages
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- A contingent liability refers to the probability of a company incurring a potential liability based on the happening or non-happening of a contingent beyond the company’s control.
- Various examples of contingent liability include lawsuits, product warranties, changes in government policies, foreign exchange fluctuations, pending cases/investigations, lawsuits of patents, and bank guarantees.
- Due to a minor change in government policies, tax rates will change, which will cause a further change in the spending on welfare funds, thus creating a contingent liability in the company's books.
Let us discuss each one of them in detail –
#1 - Lawsuit
A customer has filed a lawsuit of $100 against a company for providing a defective product and a dented customer service. The company’s legal department believes that the customer has substantial evidence to prove his case and win in a court of law.
In the above case, there is a possibility that the company may lose this case, and a staggering liability of $100 will arise; therefore, the company will record this liability in its financial statements by debiting the legal expenses and crediting the accrued costs.
Suppose the company believes the customer will not win this case in the above example. Then, the company will have to report a contingent liability in its accounts notes.
#2 - Product Warranty
Some companies provide a warranty on their product. For example, suppose a company X Ltd. was selling a car and supplying three years of proof on the vehicle’s engine, which costs around $1,000. However, if the company sells 5000 units, they will have to estimate how many cars may come for engine replacement during the warranty period. Accordingly, the company has to provide contingent liability in its financial statements.
Assume in the above example that the company estimates 25% of cars, i.e., 1250 units, will have to replace the engine; in that case, the company has to provide (1250*$1,000) as their contingent liability.
#3 - Pending Investigation Or Pending Cases
Suppose there are pending investigations or court cases against a company. In that case, the company has to disclose contingent liability in its books of accounts.
#4 - Bank Guarantee
There are two companies, X Ltd. and Y Ltd.
Suppose Y Ltd. takes a loan of $1,000 million and X Ltd. guarantees Y Ltd’s behalf for that loan. In that case, if Y Ltd., for any reason, fails to make the payment, then X Ltd. will be answerable to the bank. Therefore, X Ltd. has to disclose this contingent liability in its books of accounts.
#5 - Lawsuit For Theft Of Patent/Know-How
Suppose ABC Ltd. is a pharmaceutical company developing a formula of medicine that cures diabetes. At the same time, another pharmaceutical company XYZ Ltd. filed a lawsuit of $1,000 million against ABC Ltd. for theft of its patent/know-how. ABC Ltd. feels they will lose the lawsuit and have to pay XYZ Ltd. In that case, ABC Ltd. records this contingent liability in their books of accounts.
#6 - Change Of Govt. Policies
Suppose a company has reason to believe there will be a change in government policies due to their product cost getting pricier. It would imply that tax rates change, or the company has to spend some percentage of their profit on welfare funds; thus, the company will have to disclose and note contingent liability in their notes of accounts.
#7 - Change In Foreign Exchange
Suppose a company does import-export business by procuring raw materials from one country and supplying finished goods. However, the company must make foreign currency payments, and exchange rates might fluctuate because of global economic conditions. Due to this, the company will have to make more payments to its creditors than its actual cost. As a result, the company will record a contingent liability in its books of accounts. However, the company will receive more money from its debtors than its selling price. Therefore, technically, they will not record this contingent asset in their books of accounts because of accounting principles.
#8 - Liquidate Damages
Liquidated damages are an amount of money agreed upon by parties under a contract that one party will pay to others upon breaching the contract. The non-defaulting may file a case and obtain a judgment for the number of liquidated damages; on the other hand, the defaulting party may record/disclose a contingent liability in the books of accounts.
Frequently Asked Questions (FAQs)
Are contingent liabilities current liability?A current liability is a liability the company presently incurs in the accounting books. However, contingent liability is a liability the company expects to incur in the future.
How to record contingent liabilities?Rules require contingent liabilities to be recorded in the accounts when a future event is likely to occur. Here, one can reasonably estimate the amount of the liability. A loss (debit) would be recorded, and a liability (credit) would be established before the settlement.
Are contingent liabilities deductible for tax purposes?A seller cannot claim a tax deduction for contingent liabilities until it comes determinable and fixed. So, one cannot consider it an expenditure while computing taxable income.
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This has been a guide to Contingent Liability examples. Here we discuss the top 8 most common examples of contingent liabilities and provide detailed explanations. You can learn more about Accounting from the following articles –
- Contingent Assets
- Commitments and Contingencies
- Journal Entries of Contingent Liabilities
- Contingent Shares
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