What Are Contingent Liabilities?

A contingent liability is a possible obligation arising from past events whose existence will only be confirmed by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the business. It can also be a present obligation where the amount cannot be measured reliably or where an outflow of economic resources is not probable.

Unlike a provision, which is recognised on the balance sheet as a liability, a contingent liability is disclosed in the notes to the financial statements but is not recognised as a balance sheet liability – unless it becomes probable that payment will be required.

Contingent Liabilities Under FRS 102

FRS 102 (Section 21) sets out the rules for provisions, contingent liabilities, and contingent assets. The treatment depends on the probability of the obligation crystallising:

The key distinction is between “probable” and “possible.” If the outflow is probable and can be reliably estimated, it is a provision, not a contingent liability.

Common Examples

Recognition Versus Disclosure

When to Recognise (Provision)

A provision is recognised on the balance sheet when all three conditions are met:

1. The entity has a present obligation (legal or constructive) as a result of a past event
2. It is probable that an outflow of economic benefits will be required to settle the obligation
3. A reliable estimate can be made of the amount

When to Disclose (Contingent Liability)

A contingent liability is disclosed in the notes when either:

• There is a possible obligation (not yet confirmed as present)
• There is a present obligation but the outflow is not probable or the amount cannot be reliably estimated

When Neither Recognition Nor Disclosure Is Required

If the possibility of an outflow is remote, no provision or disclosure is necessary.

Disclosure Requirements

When a contingent liability is disclosed, FRS 102 Section 21 requires the following information in the notes to the financial statements:

• A brief description of the nature of the contingent liability
• An estimate of its financial effect (where practicable)
• An indication of the uncertainties relating to the amount or timing of any outflow
• The possibility of any reimbursement (e.g., insurance recovery)

If it is not practicable to provide some of this information, that fact must be stated.

Example Note Disclosure

Contingent liabilities

The company is defending a claim brought by a former supplier alleging breach of contract. The claim is for £150,000 plus costs. Legal counsel has advised that the claim is unlikely to succeed, but the outcome cannot be determined with certainty. No provision has been made in these accounts.

Contingent Liabilities and the Balance Sheet

Contingent liabilities do not appear on the balance sheet. They are off-balance-sheet items. However, they are important for understanding the company’s true financial position because they represent potential future claims on the company’s assets.

Users of financial statements – lenders, investors, and creditors – pay close attention to contingent liability disclosures because:

• They may affect the company’s creditworthiness
• They could materially change the financial position if the liability crystallises
• They indicate potential future cash outflows not captured in the cash flow statement

Contingent Liabilities Versus Provisions

A contingent liability may become a provision if circumstances change and the outflow becomes probable and measurable. Equally, a provision may be released if the obligation is resolved without payment.

Contingent Liabilities in Group Accounts

In consolidated accounts, contingent liabilities require particular attention:

• Guarantees given by the parent for subsidiaries’ obligations are contingent liabilities of the parent’s individual accounts but may be eliminated on consolidation if the subsidiary’s liability is already recognised
• Cross-guarantees within a group (common in banking arrangements) create contingent exposure for each guarantor
• On business combinations (acquisitions), FRS 102 requires contingent liabilities of the acquired entity to be recognised at fair value at the acquisition date, even if they would not meet the normal recognition criteria

Contingent Liabilities and the Audit

The audit of contingent liabilities involves:

• Inquiry of management about known claims, disputes, and guarantees
• Confirmation from legal advisers about the status and likely outcome of litigation
• Review of board minutes for references to potential liabilities
• Review of correspondence with regulators, tax authorities, and legal advisers
• Bank confirmation letters to identify guarantees and indemnities

Auditors assess whether the disclosure is complete and whether any contingent liability should be reclassified as a provision.

Contingent Liabilities and Corporation Tax

A contingent liability is not recognised in the accounts and therefore has no direct corporation tax impact. Tax implications arise only when:

• The contingent liability crystallises and a payment is made – the payment may be tax-deductible if it relates to a trading activity
• A provision is recognised – HMRC may not allow the provision as a tax deduction until the payment is actually made (timing difference)
• Deferred tax arises from the difference between accounting treatment and tax treatment of provisions and contingent liabilities

Managing Contingent Liabilities

Risk Assessment

Directors should maintain a register of contingent liabilities, reviewed at least quarterly, covering:

Reducing Exposure

• Contractual protections – include limitation of liability clauses in contracts
• Insurance – product liability, professional indemnity, and directors’ and officers’ insurance
• Compliance programmes – reduce the risk of regulatory action
• Dispute resolution – mediation or early settlement may be cheaper than litigation
• Legal advice – take professional advice on exposure and strategy

Contingent Liabilities in Small and Micro Companies

Small companies filing under the Companies Act 2006 reduced disclosure requirements may provide less detail in their notes, but they are still required to disclose material contingent liabilities. Micro-entity accounts prepared under FRS 105 have a simplified approach: contingent liabilities are disclosed unless the possibility of outflow is remote.

Contingent Assets

FRS 102 also addresses contingent assets, which are the mirror image:

Contingent assets are disclosed only when an inflow of economic benefits is probable. They are never recognised on the balance sheet unless the inflow is virtually certain. For a detailed treatment, see the guide to contingent assets.