As a business owner, it is crucial to be aware of your contractual obligations when entering into agreements with third parties. When signing a contract, both parties have an immediate or ‘present’ obligation to deliver on the agreed terms.  However, you should also understand the extent of your obligations, which may arise in the future. These are contingent liabilities. This article will explore how the law defines contingent liability and the types of situations where contingent liabilities exist.

How Is ‘Contingent Liability’ Defined at Law?

The Australian Accounting Standards Board is responsible for managing the expectations of financial disclosure at a Federal level. They define contingent liability in two ways:

  1. a possible obligation that arises from past events, and characterised by uncertain future events outside the control of the parties; or
  2. a present obligation that arises from past events, but it is not possible to provide a reliable estimate of the amount of the obligation.  

There may be a requirement to disclose any contingent liabilities in the following commercial situations:

It is good practice to record contingent liabilities in your financial statements. As a business owner, you should work out a range of possible liability issues which may arise from a contract. Consequently, you can determine the best financial estimates accordingly. You can estimate how much you may need to settle a present obligation by finding a quote for how much an entity would rationally pay. Often, business managers who have experience with similar transactions determine this amount.

Types of Contingent Liability

A contingent liability is primarily within business contracts through the indemnity, warranty or guarantee provisions. 

Indemnity

An indemnity provides you with the right for compensation for a specific loss. In ‘worst case’ scenarios, where you suffer a loss, the other party providing the indemnity must provide compensation. The compensation is given in the spirit of satisfying the contract, rather than as a penalty for breaching the contract terms.

Generally, indemnities are appropriate for matters which fall outside the responsibility of the customer or buyer. If you are the party providing the indemnity, you should carefully consider how you will fund the compensation in the event it is called on.

Warranty

A warranty is an assurance by the seller or supplier of goods and services. The party providing the warranty frames the warranty as a statement of fact. In the context of a business sale, the buyer will seek as many warranties as the seller will provide. 

If you are a manufacturer, the Australian Consumer Law sets out mandatory wording when providing warranties to consumers.

For example, a manufacturer of goods must provide customers with a warranty in the following wording: You are entitled to a replacement or refund for a major failure and compensation for any other reasonably foreseeable loss or damage. You are also entitled to have the goods repaired or replaced if the goods fail to be of acceptable quality and the failure does not amount to a major failure.

The obligation of the manufacturer only arises when the customer claims the goods are not of acceptable quality.

More generally, you may be a business owner providing a warranty on the condition of a product or service. If your product or service falls short of your statement of fact, you run the risk of the customer claiming you have made an untrue statement. The obligation will arise at the time the customer initiates a claim for damages due to a breach of the contract.

You should consider a warranty provided under a contract as a contingent liability, particularly when considering your insurance cover.

Guarantee

A guarantee, in the context of a contract, is a promise by a third party to compensate for future losses.

Suppose you are a business owner supplying goods or services valued under $40,000 or for household use. In that case, you cannot contract out of your obligation to provide basic consumer guarantees set by the Australian Consumer Law.

For example, a customer can expect an automatic guarantee that products purchased must:

  • be of acceptable quality (safe, lasting, with no faults);
  • match descriptions made by the salesperson and in advertising;
  • be fit for the advertised purpose and fit for any purpose the customer intended as communicated before purchase; and
  • meet any extra promises made about performance, condition and quality (such as lifetime guarantees).

Similarly, a customer can expect an automatic guarantee that services they engage must:

  • be provided with acceptable care, skill or technical knowledge;
  • be fit for the purpose or give the results agreed between both parties; and
  • be delivered within a reasonable time.

Managing Your Business Insurance Risk 

The contractual liabilities you accrue as a business owner can have an impact on your insurance policies and your assets. You should check to have the appropriate insurance which covers your contract liabilities. In the case of contingent liabilities, you may need to obtain some additional insurance for your business.

In some cases, it may not be commercially possible to obtain insurance cover for more onerous clauses in your contracts. However, it is vital to be well aware of these risks before you enter into the contract.

Key Takeaways

Before entering into a new contract, ensure you understand the extent of any contingent liabilities which may exist. These can appear in your contract in the form of an indemnity, warranty or guarantee provision. If future possibilities arise, the cost of not understanding the full extent of any contingent liability can be significant. 

As a business owner, be sure to: 

  • record future obligations; and 
  • review your insurance policy at the time you enter into a new contract. 

If you need assistance understanding your contract liabilities, get in touch with LegalVision’s dispute resolution lawyers on 1300 544 755.

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