Conditions Before a Contingency Can Be Charged Against Income

Contingent liability is a debt forecast a public company performs to determine the likelihood of certain conditions occurring that may cause financial loss. Examples of contingent liability include incomplete contracts, actions by employees and even lawsuits. Classifying a contingent liability also plays a large role in how a company must disclose the liability and the affect the liability has on the company's financial statements.

Contingent Liability Definition

A contingent liability is a hypothetical liability that depends on a specific event or financial condition to occur before it becomes a real liability. The catalyst for changing the hypothetical liability into a legitimate liability varies by industry and even businesses within those industries. The Statement of Financial Accounting Services Standards, SFAS, No. 5 identifies three types of contingent liability: probable, reasonably probable and remote. Each type carries its own set of variable circumstances where a borrower is responsible for the contingent liability according to a 2009 article in "The RMA Journal."

Planning for Liability

A business should plan for a contingent liability in accordance with the liability's likelihood of becoming a real debt. A company usually accomplishes this goal by setting capital aside to pay the liability and by developing risk management strategies to mitigate the financial loss associated with the liability. The company may also employ risk management strategies to reduce the contingent liability's chances of becoming a real debt. Moving a probable contingent liability into the "reasonably probable" category can have a positive affect on a company's financial statements and restore investor as well as lender confidence in the business.

Probable Contingent Liability

Under SFAS rules, a company is only responsible for a contingent liability when the financial loss from the liability is probable and the business can reasonably quantify or estimate the loss. If the business meets only one of these conditions, the business does not charge the contingent liability against its income. This allows a publicly traded company to keep contingent liability from dragging down its revenue stream when it reports income in an official financial statement to investors or the U.S. Securities and Exchange Commission.

Considerations

Just because a company's accountants cannot directly quantify a contingent liability does not necessarily mean the liability isn't real. All it means is that the conditions to legitimize the liability are not available or that the accountants consider the conditions unlikely. A public company must disclose a contingent liability in the notes section of a financial statement's balance sheet if the company deems the liability "reasonably probable" but this notation has no affect on the company's total debt figures, income or overall net worth.