Definition
A contingent liability is a liability that could potentially become an actual liability. This is dependent on the occurrence of a future event. Companies record contingent liabilities by a journal entry, stating as part of a disclosure in their financial statements, or they may not record them at all.
Example
One of Vareto’s associate companies is unable to get a bank loan. As part of its business relationship practices, Vareto agrees to be the guarantor for the associate company’s bank loan. Once the bank grants the loan, Vareto will have a contingent liability. If the borrowing company pays back the loan, Vareto has no liability. If it fails to repay the loan, Vareto will have an actual liability.
Why it matters
Contingent liabilities can adversely affect a company’s balance sheet position and profitability. It is therefore important to keep track of contingencies and commitments. These should also be disclosed in financial statements for the knowledge of stakeholders. It helps in clarifying the potential movement of resources of cash flows in the future. Potential lenders would also want to know if the company has any contingent liabilities.