Importance of recognising contingent liabilities

Updated: 23rd November 2021

What is a contingent liability?

A contingent liability is a debt that could be payable by a business in the future if certain circumstances or situations materialise. Contingent liabilities can constitute considerable sums, and may need to be disclosed in the notes of a company’s financial statements depending on their potential value and likelihood of materialising.

Including contingent liabilities when necessary in this way helps to provide a more accurate picture of a company’s financial situation, and complies with the UK’s accounting standards framework.

So what are some examples of contingent liabilities, and do you need to consider them when carrying out day-to-day business dealings?

Examples of contingent liabilities

These are just a few examples of potential contingent liabilities:

  • Ongoing or expected litigation against a company, including employment tribunal awards made against the company to employees the tribunal determined were unfairly dismissed
  • Claims made against the company by customers with regard to product warranties
  • When a company acts as guarantor for a loan obtained by a third party, such as one of their suppliers

Two potential issues with regard to contingent liabilities

Solvent liquidations

If a company is to close down via Members’ Voluntary Liquidation (MVL) – a process only open to solvent companies – its directors must sign a Declaration of Solvency. The possibility that a business might hold one or more contingent liabilities should be considered when determining the solvency of the business.

If a contingent liability materialises and changes to an actual liability, the solvent liquidation process may need to be converted to a Creditors’ Voluntary Liquidation (CVL), if the company’s liabilities then exceed its assets.

Declaring dividends

Declaring a dividend without giving consideration to contingent liabilities can render the dividends unlawful. There must be sufficient distributable profits within a company before dividends can legally be declared and paid.

Directors should officially record their assessment of the company’s financial position via a board meeting prior to declaring a dividend, including consideration of whether contingent liabilities exist and the possibility they may expose the company to the risk of insolvency. This helps to protect the directors from accusations of misconduct should the company enter liquidation at a later date.

So what are the potential consequences for limited company directors of failing to take contingent liabilities into account?

Repercussions of failing to recognise contingent liabilities

In some instances, directors face significant repercussions if contingent liabilities are ignored or their importance in various situations is not understood. As a director you could face personal liability if a contingent liability results in the insolvency of your business when you have declared a dividend or paid yourself a salary the company is unable to support.

Depending on the circumstances, apart from being held personally liable for some or all of the business’ debts, you may also be disqualified from holding the office of director for up to 15 years.

Contingent liabilities do not always become actual liabilities, but they must be taken into account in various situations to ensure the company and its directors operate within UK company law.

This can be a complex area of business, and if you need further information or advice about contingent liabilities in your company, please call our team of experts. Real Business Rescue is a large part of Begbies Traynor Group, and can provide the reliable unbiased guidance you need.

We operate from an extensive network of offices around the UK, and offer free same-day consultations. Please contact our partner-led team to arrange an appointment at a location near you.

Keith Tully

Partner

0800 644 6080
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