Accounting is a very diverse topic. Terms like Assets, Liabilities, Profit, and Income etc. are known to all. Even a person who is not in accounting profession would be familiar with these concepts unlike Contingent Liabilities. Contingent Liabilities is a term which is not so commonly used by everyone hence not known to many.
In this article, let us understand what these Contingent Liabilities are and why is it important to analyse them.
A Contingent liability is a probable liability that may occur, depending on the outcome of an uncertain future event. A contingent liability is recorded in the accounting records if the contingency is probable and the amount of the liability can be reasonably estimated.
Contingent liabilities depend on a future event occurring or not occurring. For exampleif an employee sues the company and claims AED 500,000, the company should record a contingent liability of AED 500,000. If the company is found guilty, it will have a liability. However, if the company is not found guilty, the company will not have an actual liability.
When do you recognise a Contingent Liability?
There are three scenarios for contingent liabilities, all involving different accounting treatments. They are:
- High probability: Record a contingent liability when it is probable that the loss will occur, and you can reasonably estimate the amount of the loss. If you can only estimate a range of possible amounts, then record that amount in the range that appears to be a better estimate than any other amount; if no amount is better, then record the lowest amount in the range. “Probable” means that the future event is likely to occur. You should also describe the liability in the footnotes that accompany the financial statements.
- Medium probability. Disclose the existence of the contingent liability in the notes accompanying the financial statements if the liability is reasonably possible but not probable, or if the liability is probable, but you cannot estimate the amount. “Reasonably possible” means that the chance of the event occurring is more than remote but less than likely.
- Low probability. Do not record or disclose the contingent liability if the probability of its occurrence is remote.
Contingent liabilitiesare very important accounting and audit items because they generally represent risks that are easily misunderstood. In order to carry out right accounting practices and to give a true and fair picture of accounting records to the stakeholders of the business, Contingent Liabilities should be carefully analysed and recorded.