Question

Define contingent liabilities and describe the types of events that might create a contingent liability. Describe places auditors might look for contingent liabilities.

Answer 1

“Contingent liability” refers to a probable financial liability that may occur due to a future event which is uncertain in nature. An example of “Contingent liability” would be a probable payment of $10,000 to a customer against a lawsuit in consumer court, if company believes that the customer has a strong chance of winning the lawsuit.

“Contingent liability” can be segregated into three parts depending upon their probable outcome.

1) First type of contingent liability is such a liability that needs to be recorded in the financial books of the company as the liability is very much probable to occur and the probable liability can reasonably be estimated. An example of this type of contingent liability would be a lawsuit, wherein your lawyer believes that you would lose the case.

2) Second type of contingent liability is such a liability, which doesn’t need to be recorded in the financial statements but they need to be disclosed. This may happen due to lesser likeliness of probable loss or an estimate of loss is not possible. An example would be a probe going on against your company for violating environmental guidelines, wherein you are not sure, if you will be found guilty or what penalty would be imposed on you.

3) The last type of contingent liabilities is those liabilities which are very less likely to really occur. Such a liability neither needs to be recorded not disclosed in the financial statements. There is no treatment required for such liabilities.

In an ideal scenario, companies must disclose or record any contingent liability that has a probability to occur. However, this always does not happen. So, the auditors need to carefully look all the financial document and important management reports of the company, such as minutes of meetings of management in regards to any lawsuit. Another place to look for contingent liability is expense records of the company, which may provide a view related to any possible contingent liability occurring out of an uncertain events such as product warranties.