Accounting Standard (Ind AS 37) defines and specifies the accounting for and disclosure of provisions, contingent liabilities, and contingent assets.
A contingent liability is a liability that may occur depending on the outcome of an uncertain future event. It is a possible obligation that may or may not arise depending on how a future event unfolds. GAAP recognizes three categories of contingent liabilities namely, probable, possible, and remote.
Probable contingent liabilities can be reasonably estimated and the same must be reflected within financial statements. When deciding upon the appropriate accounting for a contingency, the basic concept is that you should only record a loss that is probable, and for which the amount of the loss can be reasonably estimated. If the amount of liability/loss can be reasonably estimated, the entity should set aside that amount separately to be paid out when the liability arises. If the probable loss is inestimable, such contingent liability is not reflected in the balance sheet but appears in the footnote of the financial statement.
Possible contingent liabilities are conceivable liabilities not likely to occur (not probable that a loss will be incurred). The possible contingent liability is disclosed in the financial statement footnotes and should not be reflected on the balance sheet, even though it is possible to estimate the possible amount of a loss. Here, you need only to disclose the circumstances of the contingency, without accruing a loss. Remote contingent liabilities are extremely unlikely to occur and they need not be included in financial statements at all.
Potential lawsuits, product warranties, and pending investigations are some examples of contingent liability. For instance, pending lawsuits are considered contingent because the outcome is unknown. A warranty is considered contingent because the number of products that will be returned under a warranty is unknown. If the amount can be estimated, the entity sets aside that amount separately to be paid out when the liability arises.
For example, a lawsuit is pending against the bank and it is not known at present whether the bank wins or loses the lawsuit. Under the above circumstance, suppose, the bank’s legal department thinks that the plaintiff has a strong case against the bank, and estimates about ‘Rupees fifty lakh’ losses to the bank if the bank loses the case. Here, the bank has to recognize the estimated loss and set aside the amount to be paid out when the liability arises. This action of the bank would affect the profit and loss account of the bank as the bank debits the amount to the ‘legal expenses account’ for the probable loss and credits the amount to ‘accrued expense’. This procedure is adapted according to accounting standards is to ensure that the financial statement of the bank is more accurate and meets GAAP or IFRS requirements. However, if the legal department of the bank is confident that the bank would win the case, in such occasions, even though it is possible to estimate the possible amount of a loss if the bank loses the case, the bank needs to disclose the circumstances of the contingency in the footnote of the financial statement, without debiting the amount to the expenses.
A contingent asset is a possible asset that arises from past events the existence of which will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events that are not under an entity’s control.
The treatment of a contingent asset is not consistent with the treatment of a contingent liability, which should be recorded when it is probable. As per the accounting standards, a business does not recognize a contingent asset even if the associated contingent gain is probable. A contingent asset can be recorded on a business’s balance sheet only when the realization of cash flows associated with it becomes relatively certain. When it is not known at present the possible gains will materialize or being able to determine their precise economic value, such assets cannot be recorded on the balance sheet. However, a business may disclose the existence of a contingent asset in the notes accompanying footnotes of financial statements, so as to reveal to the readers the probability of inflow of benefits to the business.
As earlier discussed the ‘lawsuit’ example explains the procedure involved in both sides of a contingent asset and contingent liability. When the litigant company is confident of winning the case and receiving a monetary award, it may record the circumstances of the contingency in the footnote of the financial statement till the lawsuit has been settled, without recognizing inflow of profit (contingent asset) in the company’s accounting records. Conversely, the opposite party is convinced that the company probably going to lose the lawsuit must record a provision for the contingent liability as soon as the loss becomes probable, and it should not wait until the lawsuit has been settled to do so. Thus, recognition of the contingent liability comes before recognition of the contingent asset.