What is the Importance of Contingent Liability
Created on 30 Aug 2019
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Updated on 07 Oct 2020
To answer this question, first, we have to understand what contingent liability is. A contingent liability is the potential or uncertain loss that may occur at some point as an outcome of a specific event. It is not an absolute obligation; it may or may not happen depending on how the future unfolds itself.
It is recorded only if the liability amount can be estimated relatively.
According to the practice of disclosure in the conservative approach of accounting, the liability may be disclosed as a footnote in the financial statements of a company or not reported if conditions are not met. Therefore, the contingent liability has no such accounting treatment — for example, potential lawsuits, product warranties, and pending investigation.
Contingent liabilities are possible obligations, which may or may not occur in the future and disclosed in the notes to the accounts.
Generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS) require companies to consider known contingent liability due to three accounting principles:
1. Full disclosure principle
2. Materiality principle
3. Prudence principle
Importance of proper analysis of contingent liability:
o With Contingent liabilities, analysts can tell which events can turn out to be a negative factor for the survival of the company.
o These are significant to analyze because it usually represents risks that are easily manipulated or left out.
o They also influence the decision of lenders of the company. For example, if they have a reason to believe that the liability may arise and the company will not be able to repay debt, the decision of lending can be negatively impacted.
o The contingent liability does reduce not only the company's assets but also impact the company's cash flow and net profit.
o The magnitude of impact on the share price of the company also depends on contingent liabilities arising and the amount associated with it. The level of effects also depends on the financial soundness of the company. If the analysis shows that the company is financially sound to absorb the losses that may arise from the contingent liability, then investors can choose to invest in the company.
As per GAAP, contingent liabilities are categorized into three parts based on the likelihood of its occurrence in the future:
1) High Probability: chances of arising liabilities are more than 50%, i.e., it might drain the cash flow of the company.
2) Medium Probability: Chances of occurring a liability is 50-50. In case of its occurrence, our investment decision might change.
3) Low Probability: Since the chances are meager, these types of contingent liabilities can be considered suitable for investing.
A contingent liability is a very subjective issue and needs an eye for detail with sound judgment. The status of contingent liability varies from industry to industry and company-to-company, some companies have high probability contingent liability, and some have low. Management of the company must decide the disclosure of contingent liability as investors value it.
It is imperative to consider the contingent liability in financial statement analysis because it can cost a company several million and affect the net profitability.
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