Contingent Liabilities: Reading and Writing the Notes
- Three outcomes, three treatments
- Common examples
- A worked example: a legal claim
- How to read the note as an investor or lender
- How to write a useful note
- Why businesses get it wrong
- The mirror image: contingent assets
- Where this fits
A contingent liability is a possible obligation whose existence or amount depends on a future event the business does not control, such as the outcome of a court case or whether a borrower you guaranteed repays its loan. It is not recorded as a liability in the balance sheet. It is described in the notes to the accounts, so readers know about a risk that could become a real cost. When the outflow becomes probable and can be estimated reliably, it stops being contingent and is recorded as a provision instead.
For anyone reading a company’s accounts, the contingent liabilities note is one of the most important and least read pages. For anyone preparing accounts, the judgement about which side of the line an item falls on is one of the most scrutinised.
Three outcomes, three treatments
The general approach used in accounting standards sorts possible obligations by how likely an outflow is and whether it can be measured.
| Situation | Treatment |
|---|---|
| A present obligation, an outflow is probable, and a reliable estimate can be made | Record a provision in the balance sheet and an expense |
| A possible obligation, or a present one where the outflow is not probable or cannot be reliably measured | Disclose as a contingent liability in the notes |
| The chance of any outflow is remote | Nothing recorded or disclosed |
The precise definitions and thresholds depend on the accounting framework that applies to the business: AS 29, Provisions, Contingent Liabilities and Contingent Assets, for companies not on Ind AS and most other businesses, or Ind AS 37 for companies on Ind AS. Confirm the wording with your accountant before relying on a borderline judgement.
Common examples
- Legal claims. A customer or former employee sues for damages.
- Guarantees. The company guarantees a bank loan taken by a related company or a supplier.
- Disputed demands. A tax or regulatory demand that the business is contesting through appeal.
- Bills discounted with recourse. Receivables sold to a financier who can come back to the business if the customer does not pay.
- Performance guarantees and bonds issued by a bank on the business’s behalf for a contract.
A worked example: a legal claim
A customer files a claim for ₹40 lakh, alleging a faulty installation.
Year 1. The case is at an early stage. The company’s lawyers think the claim is weak but cannot rule out losing. An outflow is possible but not probable. The company discloses a contingent liability: the nature of the claim, the amount claimed of ₹40 lakh, and that it is defending the case.
Year 2. Evidence emerges that the installation was indeed faulty. The lawyers now consider it likely the company will lose, and estimate a settlement of about ₹25 lakh. An outflow is now probable and can be estimated. The company records a provision:
| Account | Debit | Credit |
|---|---|---|
| Legal claims expense | ₹25,00,000 | |
| Provision for legal claims | ₹25,00,000 |
Illustrative figures.
Year 3. The case settles for ₹22 lakh. The payment is set against the provision, and the unused ₹3 lakh is reversed.
How to read the note as an investor or lender
- Compare the total with net worth. Contingent liabilities of ₹3 crore against a net worth of ₹5 crore are a very different risk from ₹3 crore against ₹300 crore.
- Look at the trend. A figure rising year after year, especially in disputed demands, deserves questions.
- Look for guarantees to related parties. A company guaranteeing the debts of a group entity can end up paying them. Check the financial health of the entity guaranteed.
- Read the descriptions, not just the numbers. Vague wording such as “claims not acknowledged as debts” with a large figure and no detail is itself informative.
- Check whether items have moved into provisions. An item that was contingent last year and is provided for this year signals that a risk has crystallised.
How to write a useful note
A good disclosure lets a reader understand the risk without having to ask. For each significant item, or group of similar items, give:
- The nature of the obligation, in plain words.
- An estimate of its possible financial effect, where one can be made.
- The main uncertainties about amount or timing.
- Any expected reimbursement, such as insurance.
Keep a register of all claims, guarantees and disputes through the year, with the latest status and advice for each, so the year-end note is compiled from records rather than from memory.
Why businesses get it wrong
- Understating likelihood to avoid a provision that would reduce profit.
- Forgetting guarantees, which are signed once and then ignored until called.
- Omitting small items that are individually immaterial but significant together.
- Not updating assessments when a case or dispute moves forward.
The mirror image: contingent assets
A possible gain, such as a claim the business has made against someone else, is treated more cautiously. It is not recognised as an asset until receipt is virtually certain. Under Ind AS 37 a probable inflow is disclosed in the notes; under AS 29, which applies to companies not on Ind AS and to most other businesses, a contingent asset is not disclosed in the financial statements and is usually mentioned in the directors’ report or equivalent report instead. The asymmetry is deliberate: accounts should not count money that may never arrive.
Where this fits
- Where the note sits in the accounts: how to read a balance sheet
- A provision based on estimates: provision for doubtful debts
- Guarantees a lender may ask for: business loan term sheet explained
- Ratios that change once risks are included: financial ratios worth computing