Contingent liability
An obligation that may or may not arise, depending on the outcome of an uncertain future event — a lawsuit, a tax dispute, a guarantee — disclosed in the notes rather than booked in the accounts.
In plain language
A company fighting a court case may lose it. If it does, it will owe money; if it wins, it owes nothing. Until the case is decided, that possible bill is a contingent liability.
It is not recorded in the company's accounts — it sits in the notes to accounts. That is exactly why an analyst has to go looking for it. A balance sheet can look clean while the notes describe claims larger than the company's entire net worth.
How it works
Section 8.7.2 lists the prominent examples:
- outstanding lawsuits
- disputes with tax authorities
- bank guarantees provided
- product warranty claims
- pending investigations or cases
- changes in foreign exchange rates, government policies and the like
How to read them. Management will almost always say it does not expect the liability to settle against it. The workbook's advice is to look at the quantum in comparison to the size of the P&L and the balance sheet; if contingent liabilities are large relative to them, exercise caution.
Where it sits among related items. Contingent liabilities are one kind of off-balance sheet item — any asset or liability that does not appear on the balance sheet, which also covers operating leases and derivative contracts. Contrast a provision (section 8.3.1): an amount actually set aside, on the balance sheet, for a specific obligation whose exact size is not yet known, such as retirement benefits, warranties or a legal liability yet to be adjudicated.
The Chapter 13 checklist asks the analyst to note important observations from the notes to accounts, including guarantees.
A worked example
Illustrative figures, Rs crore. An infrastructure company:
| Net worth | 2,400 |
| Profit after tax | 300 |
| Contingent liabilities (from the notes) | |
| Income tax and GST disputes | 900 |
| Bank guarantees given for group companies | 1,500 |
| Claims by contractors under arbitration | 200 |
| Total | 2,600 |
The total is 108% of net worth and nearly 9 years of profit (2,600 ÷ 300 = 8.7).
Suppose only the tax disputes go against the company. Rs 900 crore is three years of profit and 37.5% of net worth — gone, from an item that never appeared on the balance sheet.
The guarantees are the harder question. If a group company defaults, the lender calls on the guarantee, and the listed company pays for a business its shareholders do not own. None of that is visible in the ratios computed from the face of the accounts.
Why NISM asks about it
Chapter 8 (Company Analysis – Financial Analysis) covers contingent liabilities and off-balance sheet items in section 8.7, under notes to accounts. Questions ask where they are disclosed, which items are examples, and how an analyst should weigh them against the size of the business. Chapter 13's checklist makes the same point in practice.
Common exam traps
- They are not recorded in the accounts. They are disclosed in the notes. An option placing them among current liabilities on the balance sheet is wrong.
- A contingent liability is not a provision. A provision is set aside on the balance sheet for a specific obligation; a contingent liability depends on an uncertain event and is only disclosed.
- Bank guarantees given count, even though no money has moved.
- Management optimism is not evidence. The workbook tells you to judge the quantum against the P&L and balance sheet, not the company's assurance.
- All contingent liabilities are off-balance sheet items, but not all off-balance sheet items are contingent liabilities — operating leases and derivative positions are off-balance sheet too.
Where this is taught
Free preparation for NISM Series XVRelated terms
- Corporate governanceThe rules, processes and procedures followed in running a company, judged by an analyst against a checklist of board, audit and related-party tests rather than by reputation.
- Off-balance sheet itemAn asset, liability or exposure that does not appear on a company's balance sheet, such as certain leases, contingent liabilities or derivative contracts disclosed only in the notes.
- ProvisionAn amount a company sets aside on its balance sheet for a liability that is probable but whose exact amount is not yet known, such as a warranty or a pending legal claim.
- Related party transactionA deal between a company and a party connected to its controllers — promoters, their relatives, group firms. Watched because it can enrich the promoter group at minority shareholders' cost.
- Return on EquityProfit after tax as a percentage of shareholders' net worth — what the company earned on the money its owners have left in it.
- Deferred revenueA liability representing the value of a future obligation owed for revenue already collected in advance — money received but not yet earned.
- Financial creditorUnder the Insolvency and Bankruptcy Code, a creditor who receives consideration against the time value of money — in other words, one who earns interest on the amount outstanding.