A contingent liability or contingent liabilities are potential debts that could be owed by a business in the future based on certain unpredictable events or conditions. Depending on their value and likelihood of occurring, such liabilities can represent huge amounts of money and may need to be recognized in the company’s financial statement notes.
By including liabilities whenever necessary, companies can accurately portray their financial state and stay within the framework of UK’s accounting standards.
Are contingent liabilities something you need to factor in when dealing with day-to-day business activities? If so, what are some examples of these potential hidden costs that could arise unexpectedly?
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Examples of a contingent liability
Here are only a few examples of possible contingent liabilities:
- Potential and current legal proceedings taken against a company, such as employment tribunal awards won by individuals who were found to be wrongfully terminated.
- Allegations of customers concerning the company’s product warranties
- When a company acts as a guarantor for a loan obtained by a third party, such as a supplier
Two potential issues with regard to contingent liabilities
Solvent liquidations
When deciding if a business is solvent enough to take part in a Members’ Voluntary Liquidation (MVL), directors must sign a Declaration of Solvency. It’s essential for them to consider the potential that one or more contingent liabilities might exist before signing this document, as it will impact on their decision-making process.
If a potential liability suddenly turns into an actual expense, the liquidation process could be replaced with Creditors’ Voluntary Liquidation (CVL) if the company’s liabilities are greater than its assets.
Declaring dividends
Before declaring dividends, companies must take into account potential liabilities – failure to do so can result in the dividend being declared illegal. For a dividend to be considered valid and paid out, there must first be sufficient distributable profits within the company.
Before announcing a dividend, directors must formally document their evaluation of the financial standing of the company via board meeting. This includes examining if contingent liabilities are present and whether they could place the company in jeopardy of insolvency. By doing this, it safeguards directors from being charged with misconduct should liquidation arise in future.
What could be the repercussions for company directors who disregard their contingent liabilities?
Repercussions of failing to recognise contingent liabilities
Directors who neglect or fail to recognise the importance of contingent liabilities can suffer drastic consequences. As a director, you may be personally liable for any debt resulting from contingencies if your organization is declared bankrupt due to dividend payouts, salary payments, and other commitments that exceed its capacity.
Depending on the situation, you may not only be held personally accountable for some or all of your business debts, but additionally barred from holding a director’s position up to 15 years.
It can be difficult to comprehend contingent liabilities and how they might impact your business. However, these potential responsibilities must always be considered in order to adhere with UK guidelines and regulations. Should you need additional information or advice concerning contingent liabilities for your company, our team of experts at Company Doctor are available to answer any questions you may have.
