Contingent liabilities: Overview, definition, and example
What are contingent liabilities?
Contingent liabilities are potential financial obligations that may arise in the future, depending on the outcome of a specific event or situation. These liabilities are not certain and will only become actual debts if certain conditions or events occur. For example, if your business is involved in a lawsuit, the amount your company may need to pay as a result of the lawsuit would be considered a contingent liability. Until the case is resolved, the liability is not guaranteed, but if the company loses, the liability would then become real.
For example, a company might have a contingent liability if it is being sued and could be required to pay damages, but the case is still pending and the outcome is uncertain.
Why are contingent liabilities important?
Contingent liabilities are important because they represent potential future obligations that could significantly impact the financial health of a business. While they may not immediately affect cash flow or financial statements, they need to be disclosed and managed, as they can become actual liabilities that require payment. Understanding and accounting for contingent liabilities ensures that businesses are prepared for any financial impacts that may arise in the future.
For SMBs, properly identifying and disclosing contingent liabilities is crucial for managing risk, maintaining financial stability, and making informed decisions about budgeting, investments, and future planning.
Understanding contingent liabilities through an example
Imagine your small business is facing a lawsuit from a competitor who claims your product infringes on their patent. While the case is still in progress, your business does not know the outcome, and there is no actual obligation to pay at the moment. If the court rules in favor of the competitor, your business may be required to pay damages or royalties. Until then, this is a contingent liability because the obligation depends on the outcome of the case.
In another example, your business has guaranteed a loan for a partner company. If your partner defaults on the loan, your business could be required to cover the debt. This guarantee is a contingent liability because it will only become a real liability if your partner defaults.
An example of contingent liabilities in action
Here’s how contingent liabilities might be referenced in a financial statement or contract:
“The company has a contingent liability arising from an ongoing legal dispute. The outcome of the lawsuit is uncertain, and the potential obligation is estimated at $500,000, which will be payable if the company is found liable.”
Conclusion
Contingent liabilities are potential future obligations that depend on specific events or conditions. For SMBs, it is essential to identify and disclose contingent liabilities to maintain financial transparency and prepare for possible financial impacts. Properly managing contingent liabilities helps businesses mitigate risk, make informed decisions, and avoid unexpected financial strain if these potential obligations turn into real liabilities.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.