It’s the perennial question among investors.
What is a contingency?
A contingency is a possible event that may occur in the future. Investors and businesspeople identify and prepare contingency plans for a broad range of events that could impact them, including natural disasters, terrorist attacks or fraudulent activity. A contingent liability is a potential debt or obligation that may result from a negative event in the future.
Advanced preparations are required for companies to effectively withstand negative contingencies, and thoughtful planning can mitigate losses and damage. Companies that have effective contingency plans are more likely to stay in operation after a negative event.
Contingency plans frequently include procedures for returning a company to normal operations after a natural disaster, a scandal or a man-made event, and they nearly always sketch out a public relations response to mitigate any damage to the company’s reputation. Contingency plans often include cash reserves to ensure a company has strong liquidity or insurance policies to cover losses.
The requirements for reporting contingent liabilities differ based on factors such as the dollar amount and probability that the contingency will occur. These requirements are designed to protect investors. Contingent liabilities are typically disclosed in a companies regular mandated financial reports, either on the balance sheet or in the footnotes.
One job of corporate accountants is to calculate the total amount of contingent liabilities a company could face — such as lawsuits and product warranties — but only those that can be reasonably estimated. This are reported on the balance sheet. Contingent liabilities without a total price tag may also be disclosed financial statements footnotes, or may not be reported at all.
Contingency clauses are contractual provisions that require a specified event or action to take place for a contract to be considered valid. Another term for a contingency clause is an escape clause. Contingency clauses enable one of the parties to cancel the contract if the requirements are not met.
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Contingency plans may include:
- A bank purchasing and installing a backup generator in case of a power outage.
- A financial management company keeping secure records offsite in case of theft or loss of data.
- A technology company building an offsite data center in case of a natural disaster.
A contingency clause would include a buyer’s offer to purchase a home contingent upon the home passing an inspection. Or the buyer may require that the seller fix problems that were listed on the inspection report as a contingency to purchasing the home.