Every business incurs liabilities during the course of its business operations. Understanding the nature and amount of liabilities are important to gauge the true financial position of any business.
This article looks at meaning of and differences between two different types of liabilities based on when they arise – actual liability and contingent liability.
Definitions and meanings
An actual liability is an obligation of an entity that has accrued and is outstanding as on the date of the balance sheet. Actual liabilities arise as a result of past transactions of an entity.
For example, an entity purchases raw materials of $10,000 from its supplier in December 2019. The supplier allows a credit period of 60 days for making the payment against these purchases. As on the balance sheet date (December 31, 2019), the amount is still payable to the supplier and will appear as an actual liability in the balance sheet.
The accounting entry passed for this would be:
Purchases a/c 10,000 – [Dr.]
Creditor a/c 10,000 – [Cr.]
Actual liabilities may be classified as current and non-current liabilities based on when they are due for payment or settlement.
A contingent liability is an obligation that may accrue to an entity in the future on the occurrence or non-occurrence of certain events. A contingent liability is not payable or outstanding by the entity as on the balance sheet date but may become so at a subsequent date in the future.
As a contingent liability does not have any immediate monetary impact it is not accounted for in the books of accounts. It however may still be reported in the financial statements for disclosure purposes, often by way of an explanatory note appended to the balance sheet.
A contingent liability is reported in the financial statements if there is a reasonable probability of the future event occurring and if the liability amount can be reasonably estimated.
For example, a customer of a manufacturing company has filed a suit against it for allegedly supplying defective goods. The proceedings in the suit are underway as on the balance sheet date. As per the contract with the customer, the company will be liable to pay a compensation of $10,000 in case of supply of defective goods. This default amount would however accrue as an actual liability only if the suit is decided against the company. Accordingly, as on date the amount of $10,000 can qualify as a contingent liability and may be reported in the financial statements by way of an explanatory note.
Difference between actual and contingent liability:
The differences between an actual and a contingent liability have been detailed below:
- An actual liability is liability that has in fact accrued to the entity and is actually payable on the date of the balance sheet.
- A contingent liability represents a liability that may become payable by an entity in the future depending on the outcome of specific events.
2. Time factor
- An actual liability accrues due to transactions undertaken in the past by an entity.
- A contingent liability arises as a result of a probable future event.
3. Outstanding as on balance sheet date
- An actual liability is outstanding as on the balance sheet date i.e., the entity owes the amount of the actual liability to an external party on the balance sheet date.
- A contingent liability is not outstanding as on the balance sheet date i.e., the external party does not have an outstanding claim against the entity as on the balance sheet date.
4. Monetary impact
- An actual liability has immediate monetary impact on the finances of the entity.
- A contingent liability does not have immediate monetary impact but may have monetary impact in the future.
- Actual liabilities are accounted for by journal entries on the related transaction date.
- Contingent liabilities are not accounted for by journal entries until they get converted into actual liabilities.
6. Reporting in financial statements
- Actual liabilities are reported and classified as current or non-current liabilities in the balance sheet.
- Contingent liabilities are reported only for disclosure purpose by way of a note appended to the balance sheet. They may also be reported in the directors’ report and audit report.
- An actual liability is quantified at the actual transaction value that has been incurred by the entity. Accordingly, its quantification is more or less certain.
- The value of a contingent liability is estimated on the basis of information available with regards to the future event. Its quantification is thus less certain.
8. Certainty of monetary outflow
- In the case of actual liabilities, there is certainty regarding monetary outflow by the entity.
- In the case of contingent liabilities, monetary outflow by the entity is not certain.
- Examples of actual liabilities include creditors for supply of goods, utility payables, deposits and loans payable etc.
- Examples of contingent liabilities include claim amounts that may arise out of legal proceedings, amounts that may become payable against warranty claims etc.
Actual liability versus contingent liability – tabular comparison
A tabular comparison of actual and contingent liability is given below:
|A liability which has accrued and is outstanding
|Obligations that may result into actual liabilities in the future
|Accrue on account of past transactions
|Accrue due to possible future events
|Outstanding as on balance sheet date
|Not immediate. May occur in the future.
|Journal entries record transactions pertaining to actual liabilities
|Not accounted for in books of accounts
|Reporting in financial statements
|Reported in the balance sheet (liabilities side)
|Reported only for disclosure purposes by way of a note
|By actual values
|By estimated values
|Certainty of monetary outflow
|Creditors, outstanding utility payments, deposits and loans availed etc.
|Legal claims, warranty claims etc.
Conclusion – actual liability vs contingent liability:
Both actual and contingent liabilities are relevant and important to stakeholders in any business. Actual liabilities are essential for gauging the present net worth of a business whereas contingent liabilities are relevant as they indicate probable future impact on finances of the business. Recording and disclosure of actual and contingent liabilities require adherence to accounting standards by accountants and auditors.