Definition: A contingent liability is a potential obligation or requirement to make a payment if an uncertain event occurs in the future. In other words, it’s an obligation that could exist if something happens in the future.
What Does Contingent Liability Mean?
The most basic example of a contingent liability is a pending lawsuit from a previous event. For example, a hang gliding manufacturer could be sued because their equipment was faulted and caused serious injuries to a small number of their customers. The customers band together and sue the company for $10M. There is no way to know the outcome of the lawsuit or even when the suit will be settled.
We just know that if the company loses the suit to its customers, it will owe $10M in damages. This potential obligation is considered a contingent liability because it depends on the outcome of the lawsuit.
There are a few different rules when a contingent liability is reported as a liability on the balance sheet, disclosed in the footnotes, or simply ignored. These rules are based on whether the future event is probable and the liability amount can be estimated.
First, let’s look at the probability the lawsuit will have a negative outcome. GAAP breaks probability into three different categories. Probable means the event will likely happen. Reasonably probable means the event could occur and a remote probability means the event will most likely not occur.
If the negative lawsuit outcome is probable and the liability can be estimated, it must be recorded as a liability on the balance sheet.
If the negative outcome is reasonably probably but the liability can’t be estimated, it should be disclosed in the financial statement footnotes.
If the negative outcome is remote, the company can simply ignore the contingent liability without reporting it on the balance sheet or footnotes.