The Definition of Contingent Debt

Contingent debt is an unusual kind of debt that is dependent on uncertain future developments. In legal terms, the word "contingent" means something that might or might not happen. A contingent debt is not a definitive liability because it is based on the outcome of an event, such as a court verdict.

Debt is money borrowed with an expectation that it will be repaid in a specific period of time. In most cases, a document in the form of a loan note, a mortgage or a bond is proof of an existing debt and the terms under which it was given. While that kind of liability is certain, contingent debt is dependent on doubtful circumstances. If two corporations or individuals are locked in a legal dispute over debt, for instance, the payment of such liability is not certain because the outcome of a court case might not be predictable.

In accounting terms, things such as payable notes, interests, accounts and sales taxes payable are a clear indication an obligation to pay exists. Contingent debt existence is tentative. If, for instance, a company is embroiled in a dispute with the Internal Revenue Authority (IRS) over outstanding tax payments, it might not be easy to definitively predict the outcome. But then, how does a firm record such debt on its financial statements?

Just because it is not possible to foretell a debt that might or might not occur does not mean it should not be disclosed. Disclosure requirements exist. The debtor, or creditor, is supposed to take into account the probability of a contingent debt. Health insurance companies, for instance, usually have a rough idea of how much they will pay in liabilities unless there is a sudden outbreak of an epidemic. A reasonable estimate should be recorded in the accounts of the expected liabilities.

If it is determined that there is a slight possibility the the liability could actually be incurred, it should be indicated in notes and attached to financial statements. When it is clear there is no chance a contingent debt will happen, there is no need to record it.

Product warranties are contingent liabilities that are probable. Manufacturers can extrapolate from previous experiences to reasonably estimate liabilities. Such contingent debt is relatively easy to handle. But there are times when warranties can also result in a huge unforeseen debt--such as in the April 2010 case of Toyota vehicles having problems with break peddles. Before the problem, the company could not foresee it was going to spend hundreds of millions of dollars recalling and repairing defective break peddles in millions of Toyota vehicles and paying punitive penalties to authorities and in legal suits.

Put most concisely, a contingent debt is a debt that might not or might be, depending on future circumstances.