Accounting — Contingent Assets and Contingent Liabilities
Learning Outcomes
- Understand the meaning of the terms 'Contingent Assets' and 'Contingent Liabilities'.
- Distinguish 'Contingent Liabilities' with 'Liabilities' and 'Provisions'.
4.1 Contingent Asset
- A contingent asset may be defined as a possible asset that arises from past events and whose existence will be confirmed only after occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise.
- It usually arises from unplanned or unexpected events that give rise to the possibility of an inflow of economic benefits to the business entity.
- For example, a claim that an enterprise is pursuing through legal process, where the outcome is uncertain, is a contingent asset.
KNOWLEDGE NUGGET
- Contingent Asset: Possible asset from past events — existence confirmed by uncertain future events
- Prudence Concept: Enterprise should not recognise a contingent asset
- Disclosure: Usually disclosed in the report of approving authority if inflow is probable
- Recognition: When realisation becomes virtually certain, asset and related income are recognised
- As per the concept of prudence as well as the present accounting standards, an enterprise should not recognise a contingent asset.
- These assets are uncertain and may arise from a claim which an enterprise pursues through a legal proceeding. There is uncertainty in realisation of claim.
- It is possible that recognition of contingent assets may result in recognition of income that may never be realised.
- However, when the realisation of income is virtually certain, then the related asset no longer remains as contingent asset.
- A contingent asset need not be disclosed in the financial statements. A contingent asset is usually disclosed in the report of the approving authority, if an inflow of economic benefits is probable.
- Contingent assets are assessed continually and if it has become virtually certain that an inflow of economic benefits will arise, the asset and the related income are recognised in the financial statements of the period in which the change occurs.
CONTINGENT ASSET — KEY POINTS
- Definition: Possible asset from past events
- Treatment: Not recognised in financial statements
- Disclosure: In approving authority's report if inflow is probable
- Recognition: When realisation becomes virtually certain
- Example: Legal claim with uncertain outcome
4.2 Contingent Liabilities
The term 'Contingent liability' can be defined as:
- (a) a possible obligation that arises from past events and the existence of which will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise; or
- (b) a present obligation that arises from past events but is not recognised because:
- (i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
- (ii) a reliable estimate of the amount of the obligation cannot be made.
EXAMPLE 1
Mr. X sells a machine to Mr. Y. Any damages incurred by Mr. Y while using the machine need to be compensated by Mr. X. A few days later from the date of sale of machine, Mr. X received a notice from Mr. Y who is claiming damages of ₹20 lac. The notice mentioned that a worker met with an accident during the use of the machine and is required to be compensated.
The receipt of this notice does not suggest that Mr. X is liable to pay the amount, although this needs to be investigated and confirmed, as whether the damage arose due to any defect in the machine or it is due to negligence while operating the machine. Although, the receipt of the notice results into an event which requires recognition of a contingent liability since there is a possible obligation, and that can only be confirmed in future.
EXAMPLE 2
Let us assume Mr. AB sells cars to its customers. One of the cars caught fire due to malfunctioning of a faulty part during the test drive by one of the customers. The customer has filed a court case seeking a claim of ₹50 lac due to the incidence.
While Mr. AB acknowledges that there is a present obligation, it is not certain that whether he is expected to pay for any damages. The final outcome will only be known during the court proceedings.
- A contingent liability is a possible obligation arising from past events and may arise in future depending on the occurrence or non-occurrence of one or more uncertain future events [part (a) of the definition].
- A contingent liability may also be a present obligation that arises from past events [(part (b) of the definition)].
- An enterprise should not recognise a contingent liability in balance sheet, however it is required to be disclosed in the notes to accounts, unless possibility of outflow of a resource embodying economic benefits is remote.
- These liabilities are assessed continually to determine whether an outflow of resources embodying economic benefits has become probable.
- If it becomes probable that an outflow or future economic benefits will be required for an item previously dealt with as a contingent liability, a provision is recognised in financial statements of the period in which the change in probability occurs except in the extremely rare circumstances where no reliable estimate can be made.
CONTINGENT LIABILITY — KEY POINTS
- Definition: Possible obligation from past events OR present obligation not recognised
- Treatment: Not recognised in balance sheet — Disclosed in notes to accounts
- Exception: Not disclosed if outflow of resources is remote
- Conversion: If outflow becomes probable → recognised as provision
- Examples: Claims not acknowledged as debts, guarantees, bills discounted, statutory liabilities under dispute
4.3 Distinction Between Contingent Liabilities and Liabilities
- The distinction between a liability and a contingent liability is generally based on the judgement of the management.
- A liability is defined as the present financial obligation of an enterprise, which arises from past events. The settlement of a liability results in an outflow from the enterprises of resources embodying economic benefits.
- On the other hand, in the case of contingent liability, either outflow of resources to settle the obligation is not probable or the amount expected to be paid to settle the liability cannot be measured with sufficient reliability.
EXAMPLES OF CONTINGENT LIABILITIES
- Claims against the enterprise not acknowledged as debts
- Guarantees given in respect of third parties
- Liability in respect of bills discounted
- Statutory liabilities under dispute
- In addition to present obligations that are recognized as liabilities in the balance sheet, enterprises are required to disclose contingent liability in their balance sheets by way of notes.
LIABILITY vs CONTINGENT LIABILITY
- Liability: Present financial obligation — outflow is probable — reliably measurable
- Contingent Liability: Possible obligation — outflow is not probable OR not reliably measurable
4.4 Distinction Between Contingent Liabilities and Provisions
- Provision means "any amount written off or retained by way of providing for depreciation, renewal or diminution in the value of assets or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy".
| Provision | Contingent Liability |
|---|---|
| (1) Provision is a present liability of uncertain amount, which can be measured reliably by using a substantial degree of estimation. | A Contingent liability is a possible obligation that may or may not crystallise depending on the occurrence or non-occurrence of one or more uncertain future events. |
| (2) A provision meets the recognition criteria. | A contingent liability fails to meet the same. |
| (3) Provision is recognised when (a) an enterprise has a present obligation arising from past events; an outflow of resources embodying economic benefits is probable, and (b) a reliable estimate can be made of the amount of the obligation. | Contingent liability includes present obligations that do not meet the recognition criteria because either it is not probable that settlement of those obligations will require outflow of economic benefits, or the amount cannot be reliably estimated. |
| (4) If the management estimates that it is probable that the settlement of an obligation will result in outflow of economic benefits, it recognises a provision in the balance sheet. | If the management estimates, that it is less likely that any economic benefit will outflow the firm to settle the obligation, it discloses the obligation as a contingent liability. |
EXAMPLE — PROVISION vs CONTINGENT LIABILITY
The Central Excise Officer imposes a penalty on Alpha Ltd. for violation of a provision in the Central Excise Act. The company goes on an appeal.
- If the management of the company estimates that it is probable that the company will have to pay the penalty, it recognises a provision for the liability.
- On the other hand, if the management anticipates that the judgement of the appellate authority will be in its favour and it is less likely that the company will have to pay the penalty, it will disclose the obligation as a contingent liability instead of recognising a provision for the same.
PROVISION vs CONTINGENT LIABILITY — SUMMARY
- Provision: Present liability — Probable outflow — Reliably measurable — Recognised in balance sheet
- Contingent Liability: Possible obligation — Not probable OR not reliably measurable — Disclosed in notes
Summary
- A contingent asset may be defined as a possible asset that arises from past events and whose existence will be confirmed only after occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise.
- A contingent liability is a possible obligation arising from past events and may arise in future depending on the occurrence or non-occurrence of one or more uncertain future events.
- A liability is the present financial obligation of an enterprise, which arises from past events whereas contingent liability is a possible obligation arising from past events.
- Provision is a present liability of uncertain amount, which can be measured reliably by using a substantial degree of estimation whereas Contingent liability is a possible obligation that may or may not crystallise depending on the occurrence or non-occurrence of one or more uncertain future events.
Test Your Knowledge
True and False
- 1. A contingent liability need not be disclosed in the financial statements. False
- 2. A Provision fails to meet the recognition criteria. False
- 3. A claim that an enterprise is pursuing through legal process, where the outcome is uncertain, is a contingent liability. False
- 4. When it is probable that the firm will need to pay off the obligation, this gives rise to Contingent liability. False
- 5. Present financial obligation of an enterprise, which arises from past event is termed as contingent liability. False
Multiple Choice Questions
| 1. Contingent asset usually arises from unplanned or unexpected events that give rise to | (a) The possibility of an inflow of economic benefits to the business entity. (b) The possibility of an outflow of economic benefits to the business entity. (c) Either (a) or (b). |
| 2. If an inflow of economic benefits is probable then a contingent asset is disclosed | (a) In the financial statements. (b) In the report of the approving authority. (c) In the cash flow statement. |
| 3. In the case of _____, either outflow of resources to settle the obligation is not probable or the amount expected to be paid to settle the liability cannot be measured with sufficient reliability. | (a) Liability (b) Provision (c) Contingent liabilities |
| 4. Present liability of uncertain amount, which can be measured reliably by using a substantial degree of estimation is termed as _____. | (a) Provision. (b) Liability. (c) Contingent liability. |
| 5. In the financial statements, contingent liability is | (a) Recognised. (b) Not recognised. (c) Adjusted. |
High-Yield Interactive Quiz — Contingent Assets and Contingent Liabilities
Q1. A contingent asset is defined as a possible asset that arises from:
Correct Answer: B. A contingent asset arises from past events and its existence will be confirmed only after occurrence or non-occurrence of uncertain future events.
Q2. As per the concept of prudence, a contingent asset should be:
Correct Answer: B. As per the concept of prudence, an enterprise should not recognise a contingent asset as it may result in recognition of income that may never be realised.
Q3. When does a contingent asset get recognised in the financial statements?
Correct Answer: B. When the realisation of income becomes virtually certain, the related asset no longer remains as contingent asset and is recognised in the financial statements.
Q4. A contingent liability is defined as:
Correct Answer: B. A contingent liability is a possible obligation that arises from past events and whose existence will be confirmed only by uncertain future events.
Q5. A contingent liability is required to be:
Correct Answer: B. An enterprise should not recognise a contingent liability in the balance sheet, but it is required to be disclosed in the notes to accounts, unless the possibility of outflow is remote.
Q6. A provision is a:
Correct Answer: B. A provision is a present liability of uncertain amount, which can be measured reliably by using a substantial degree of estimation.
Q7. Which of the following is an example of a contingent liability?
Correct Answer: C. Guarantees given in respect of third parties is an example of a contingent liability. Salary, rent, and loan payable are liabilities.
Q8. If the management estimates that it is probable that settlement of an obligation will result in outflow of economic benefits, it recognises:
Correct Answer: B. If the management estimates that it is probable that settlement will result in outflow of economic benefits, it recognises a provision in the balance sheet.
Q9. A contingent liability fails to meet the recognition criteria because:
Correct Answer: B. A contingent liability fails to meet the recognition criteria because either it is not probable that settlement will require outflow of economic benefits, or the amount cannot be reliably estimated.
Q10. A claim that an enterprise is pursuing through legal process, where the outcome is uncertain, is classified as:
Correct Answer: B. A claim that an enterprise is pursuing through legal process, where the outcome is uncertain, is a contingent asset as it may result in an inflow of economic benefits.
Q11. In the case of contingent liability, the possibility of outflow of resources is:
Correct Answer: C. In the case of contingent liability, either outflow of resources to settle the obligation is not probable or the amount cannot be measured with sufficient reliability.
Q12. When a contingent liability becomes probable that an outflow will be required, it is converted into:
Correct Answer: B. If it becomes probable that an outflow of future economic benefits will be required for an item previously dealt with as a contingent liability, a provision is recognised in the financial statements.