A contingent liability is a potential cost a company may or may not incur in the future. A contingent liability could be a guarantee on a debt to another entity, a lawsuit, a government probe, or even a product warranty. Any of these circumstances could cost a company money, but the amount of that cost is unknown. It could be zero, or it could be billions.
Understanding the accounting treatment of contingent liabilities can help investors fully vet the risks of a potential investment.
The accounting of contingent liabilities
In the U.S., accountants adhere to the rules and standards defined by the Generally Accepted Accounting Principles, commonly referred to as GAAP.
Per GAAP, contingent liabilities can be broken down into three categories based on the likelihood of those liabilities actually occurring. A "high probability" contingency is a liability that is both probable of actually occurring and one where the costs can be reasonably estimated. For high probability contingent liabilities, the company must disclose the estimated amount of the potential loss and also describe the contingency in the footnotes of its financial statements.
A "medium probability" contingency is one that falls short of either but not both of the parameters of a high probability liability. These liabilities must be disclosed in the footnotes of the financial statements if either of two criteria are true. First, if the contingency is probable but the company cannot estimate the loss, or second, if the contingency the contingency is reasonably possible, although not necessarily probable.
Last, GAAP qualifies other contingent liabilities as "low probability." The likelihood of these contingent liabilities actually triggering a cost is very low, and therefore accountants are not required to report them in the financial statements.
What this means for investors
The accounting rules regarding contingent liabilities are, as you can see above, very subjective. If a loss from one of these liabilities is imminent, then the company will disclose the liability, but otherwise there is a lot of wiggle room for companies to disclose at their discretion.
Sometimes a contingent liability can arise suddenly, catching both management and investors by surprise. The billions in liabilities for BP related to the Deep Horizon oil spill and Volkswagen's massive liabilities from its 2015 emissions scandal are two such scenarios.
However, in other cases, management can hide certain known contingent liabilities from investors until the very last minute. A lawsuit, for example, doesn't necessarily need to be disclosed as a contingent liability if the company believes the suit is frivolous and will be dismissed. It's only later when a settlement or trial is imminent that this contingency would qualify as a medium or high probability occurrence.
Understanding this, investors should watch a company's contingent liabilities with a skeptical eye. Most companies will be forthcoming and present their affairs fairly and with transparency. But there will be bad actors who intentionally mislead investors within the rules of GAAP's contingent liability treatment. In those cases, investors will be glad to have relied on other sources like news reports, press releases, and independent assessments of legal proceedings to make their own determination of a company's contingent liabilities.
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