What it means
Businesses face obligations that may or may not crystallise. A customer sues; the company may win or lose.
A subsidiary borrows and the parent guarantees; the subsidiary may or may not default. A tax authority questions a deduction; the position may or may not be upheld.
The accounts must say something about these exposures without treating them all as certain, and the contingent liability framework is the answer. The framework has three tiers.
If the obligation is present (the past event has created it), the outflow is probable (more likely than not under IFRS; "likely" under US GAAP, a somewhat higher threshold), and the amount can be reasonably estimated, the company recognises a provision: a liability on the balance sheet, an expense in profit, measured at the best estimate (the expected value, or for a single obligation the most likely outcome, discounted where material). If the obligation is only possible, or is present but the outflow is not probable, or cannot be measured, the company discloses a contingent liability in the notes: the nature of the exposure, the uncertainties, an estimate of the financial effect where practicable, and the possibility of any reimbursement.
If the possibility of outflow is remote, no disclosure is required (though guarantees are often disclosed regardless). The judgements are difficult and contested.
The probability of losing a lawsuit depends on legal advice that is itself uncertain; companies and their lawyers may prefer not to write down a probability that could be discovered in litigation. The amount of a tax exposure depends on the authority's position and the appeal route.
A guarantee's likelihood of being called depends on the guaranteed party's finances. Auditors obtain legal letters and management representations, review board minutes and correspondence, and test the reasonableness of the classification, and the notes on contingencies are among the most scrutinised in the accounts.
Two special cases are worth noting. In a business combination, contingent liabilities of the acquired company are recognised at fair value even if an outflow is not probable, because the acquirer has paid for the risk.
And where a company is jointly liable with others, it provides for its share and discloses the rest as contingent, unless the others are unlikely to pay. For readers, the contingent liabilities note is where the balance sheet's silences are explained.
A company with no provisions and a note describing $200 million of possible litigation losses is not without exposure; it has judged the losses not probable. The trend matters: exposures that migrate from the notes into provisions over successive years show a company whose contingencies are crystallising.
And guarantees disclosed in the notes can be larger than the balance sheet debt they sit behind. Internally, contingent liabilities are managed through a register maintained by finance and legal: each exposure, its status, the probability assessment and its basis, the estimate, the accounting treatment, and the actions being taken.
The register is reviewed each reporting period, and changes in assessment are documented, because the transition from disclosure to provision is a charge to profit that the board and the auditors will want to understand.
In practice
Real-world examples.
Example
A bank discloses $30 billion of guarantees and letters of credit as contingent liabilities, none provided for, with a note on its assessment of the risk.
Example
A pharmaceutical company provides $400 million for a patent dispute after an adverse first-instance ruling raises the probability of loss above 50%, having disclosed it as contingent for three years.
Example
A parent company discloses a contingent liability for a subsidiary's pension deficit that it has undertaken to support if the subsidiary cannot.
Think of it
“A contingent liability is like knowing you might have to pay for car repairs after an accident, but the insurance claim hasn't been decided yet.
Formula
Calculation
Recognition test: Present obligation + Probable outflow + Reliable estimate = Provision (recognised)
Possible obligation, or present obligation with outflow not probable or not measurable = Contingent liability (disclosed)
Remote = No disclosure (except certain guarantees)
Provision amount (single obligation) = Most likely outcome, considered with the range
Provision amount (population of similar obligations) = Expected value = Sum of (Outcome x Probability)
Discounting: Provision = Expected outflow / (1 + r) to the power n, where the time value of money is material
Worked example. A consumer products company's year-end review of contingencies:
1. Product liability lawsuit: a class action claims $12,000,000 for injuries from a product. Legal advice: the company has a strong defence on causation; probability of losing about 30%; if lost, damages likely $8,000,000 to $12,000,000. Assessment: outflow not probable. Treatment: contingent liability disclosed in the notes, describing the claim, the company's position, and the range of $8,000,000 to $12,000,000 if unsuccessful. No provision. Legal costs of defence are accrued as incurred.
2. Regulatory fine: a competition authority has issued a statement of objections alleging price coordination; the company's lawyers assess the probability of a fine at 70% and the likely amount at $4,000,000 to $6,000,000, with $5,000,000 the most likely. Assessment: present obligation (the conduct occurred), outflow probable, estimable. Treatment: provision of $5,000,000 recognised; expense $5,000,000; disclosure of the uncertainty and the range.
3. Guarantee of a joint venture's bank loan: the company has guaranteed 50% of the joint venture's $20,000,000 loan. The joint venture is performing and its covenants are met; the probability of the guarantee being called is assessed as remote. Treatment: no provision; disclosed as a guarantee (the standards and most frameworks require disclosure of guarantees regardless of probability) with the maximum exposure of $10,000,000.
4. Warranty claims: the company sells with a two-year warranty. Historical experience: 3% of units claim, average cost $40 per claim, on 500,000 units sold in the last two years still under warranty. Assessment: present obligation, probable outflow across the population, estimable by expected value. Treatment: provision = 500,000 x 3% x $40 = $600,000. This is a provision for a population, not a contingent liability, though each individual claim is uncertain.
5. Tax position: the company has claimed a deduction of $3,000,000 that the tax authority has questioned in correspondence; the company's advisers consider the position more likely than not to be sustained (60%). Under the specific rules for uncertain tax positions (IFRIC 23 and ASC 740), the company recognises the tax effect based on the most likely amount or expected value; here, with the position more likely than not, it recognises the full benefit but discloses the uncertainty. Tax effect at 25%: $750,000 at risk, disclosed.
6. Environmental remediation: a former site is known to be contaminated. The regulator has required a survey but has not yet required remediation; the company's environmental consultants estimate remediation, if required, at $2,500,000 and the probability of a requirement at 55%. Assessment: probable outflow (over 50%), present obligation arising from the contamination, estimable. Treatment: provision of $2,500,000 (the most likely single outcome if remediation is required; some would argue for expected value, but for a single obligation the most likely outcome is used), discounted at 5% over the expected three-year timing: $2,160,000.
Summary: provisions recognised $5,000,000 + $600,000 + $2,160,000 = $7,760,000, charged to profit (less any prior-year provision already held). Contingent liabilities disclosed: the lawsuit ($8,000,000 to $12,000,000), the guarantee ($10,000,000 maximum), the tax uncertainty ($750,000). Total possible exposure beyond the provisions: up to about $22,750,000, none of it on the balance sheet.
Following year: the class action is settled for $3,000,000 (provided when settlement became probable, then paid); the fine is imposed at $5,500,000 ($500,000 additional charge); the guarantee is not called; the tax position is agreed without adjustment; remediation is required and begins. The register tracks each transition.Case study
Seen in the real world.
An engineering group had for four years disclosed a contingent liability for a dispute with a client over a failed installation, describing the client's claim of $25,000,000 as "without merit" and providing nothing. Each year the auditors obtained a legal letter supporting the assessment. In the fifth year, an expert report in the litigation found that the group's design had been at fault; the group's lawyers revised the probability of loss to 70% and the likely amount to $15,000,000 to $20,000,000.
The group recognised a provision of $17,000,000, which eliminated the year's profit and breached a covenant. Shareholders asked why the exposure had been described as without merit for four years; the audit committee's review found that the legal assessment had been sound at each date on the evidence then available, that the expert report was genuinely new, and that the disclosure had been adequate, but it also found that the board had never seen the underlying legal advice, only management's summary of it.
The committee adopted a practice of reviewing the contingent liabilities register with the general counsel each quarter, seeing the legal opinions directly for any exposure over $5,000,000, and requiring a written explanation of any change in probability assessment. The chairman's comment was that the note had been accurate every year and that the board had not understood how quickly accurate could become expensive.
Watch out
Common mistakes.
- Providing for every exposure regardless of probability, which overstates liabilities and creates reserves that can later be released to flatter profit, or providing for none, which understates them.
- Treating a large population of individually uncertain claims (warranties, returns, small litigation) as contingent liabilities rather than providing for the expected value.
- Netting expected insurance or third-party recoveries against a provision. The provision is gross; the recovery is recognised separately when virtually certain.
Questions
People also ask.
What is the difference between a provision and a contingent liability?
A provision is a recognised liability for a probable, estimable outflow. A contingent liability is disclosed but not recognised, because the outflow is only possible, or not probable, or not measurable.
How is "probable" defined?
Under IFRS, more likely than not (above 50%). Under US GAAP, "likely", a higher and less precise threshold; US GAAP also accrues the low end of a range where no amount within it is more likely than others, and discloses the additional exposure.
Must guarantees be disclosed even if unlikely to be called?
Generally yes. Most frameworks and many regulators require disclosure of guarantees and similar commitments regardless of probability, because they represent potential claims on the company's assets.
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