Updated July 18, 2023
Introduction of Contingent Liability
Contingent Liability example are liabilities that are dependent on a future outcome. If an uncertain but predicted event happens in the future, then the liability will arise. examples are lawsuit claim, warranties on product, fines imposed, natural disaster, etc.
Explanation
Contingent Liability examples are examples of liabilities that are not certain and linked to an uncertain event of the future. For a contingent liability to be recorded in the books, there are two conditions that should be met. The chance of the future event that will trigger the liability should be likely and the amount of liability can be measured properly. These leads to several contingent liability example.
Examples of Contingent Liabilities
Following are the examples are given below:
Example #1 – Lawsuit Claim
Company XYZ is fighting a legal case with Company ABC for 2 years. There was a transaction between both the companies 3 years back, where company ABC was supposed to transfer goods to company XYZ and company XYZ was supposed to pay $500,000 in return. The goods were delivered by ABC on time, but due to heavy rain during transit, few goods were damaged. Company ABC wanted to replace the damaged goods, but Company XYZ didn’t agree for replacement and denied payment to ABC.
Company ABC filed case in court against Company XYZ and demanded the full payment and compensation of $400,000 for the harassment. After 2 years, it seems that Company XYZ is losing the case and a total payment of ($500,000 + $400,000 = $900,000) is to be made to company ABC. As it is nearly certain that Company XYZ will lose the case and the liability amount is $900,000. So Contingent liability can be recorded in books.
Example #2 – Warranty on Product
Masong Ltd is a mobile phone manufacturing company. They are famous for making mobile phones targeted to elite class. The phone range starts from $1000 and goes up. The latest mobile phone that Masong launched is Alpha III. The price of the phone is $1,500. The Unique Selling Point of Masong’s phone is a complete Replacement warranty within 1 year. If there is any software issue, then Masong promises to completely replace the mobile phones in the market.
Recently there is a bug that is being found in Alpha III, which is causing the mobile phone to heat unnecessarily. More than 500 users reported the incident over social media and other platforms. The CEO of Masong is worried about the bug and he is planning to replace all the Alpha III phones in the market. In total 15,000 sets are already sold with that bug. This is a huge liability and is certain. So the books of Masong will reflect the Contingent liability.
Example #3 – Natural Disaster
Company XYZ is an American construction company which has got a contract of building the longest bridge in Japan. Japan is prone to earthquakes. The bridge will take approximately 5 years to get completed and most of the parts will be made at a different location and assembled at the site. The area where the bridge will be made is prone to earthquakes, but in last 5 years there has been no sign of earthquakes. As per recent reports published by seismologists, there is high chance of earthquakes in coming years.
This is a situation where the chance of a future event is quite probable, but the estimation of liability is difficult. The loss can’t be accurately measured. For this reason, the contingent liability can’t be recorded in the books, but can be shown in the Foot Notes.
Example #4 – Unpredictable Losses
Many US Oil exploration companies have adopted fracking as the mean to extract oil and gas from subterranean rocks, boreholes etc. The process is extremely costly and requires large amount of water. Pressurized water is injected in order to release oil and gas from rocks.
There are a group of activists who doesn’t support this technique as a huge amount of fresh water is used and it contaminates the water badly. So many groups have filed cases in order to stop the extraction. Oil Extraction companies have already spent a huge amount of money for the setup of the extraction. If any order is passed to stop the extraction, then the companies will incur huge losses.
In this case, both the certainty of the future event and the expected loss amount is unknown, so the contingent liability can’t be recorded in the books and should be mentioned in footnotes.
Example #5 – Fines Imposed
Baby products manufacturing companies need to go through several quality measures in order to send the product in market. The quality checks are extremely hard to pass. For this reason, it is seen that companies dealing with baby products end up paying huge penalties to the government every year. There are fines imposed on every breach of quality. So if any company wants to show the predicted fine of the future as the contingent liability, then the fine amount and certainty should be clear. If the company is sure that they have breached a quality standard and a penalty is certainly to be attracted. Then that can be recorded as the Contingent Liability in the books
Conclusion
Contingent Liability example are examples of liabilities that are expected to arise but are not certain. Recording of Contingent liability help management to utilize cash accordingly. If a law suit is expected to go against the company and it will attract a penalty of $500,000, then the management will set aside this amount and utilize the remaining cash in the business. Recording of contingent liability is extremely useful to companies but should be audited properly by auditors. It may happen that a company is recording contingent liability just to avoid taxes. Liability will reduce profit and tax may be saved. So external auditors should be careful.
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