A Debt That Might Not Exist
Most of what a business owes is easy to pin down. The supplier invoice is £2,400. The VAT return says £8,100. The loan statement shows £46,000 outstanding.
A contingent liability is different. It is a possible obligation that depends on something that has not happened yet. A former customer says your work caused them a loss and has threatened to sue. Your company has guaranteed a sister company's bank loan. A buyer of your old business could claim under a warranty you gave when you sold it.
None of these are debts today. Some of them never will be. But any one of them could turn into a real bill, and anyone relying on your accounts has a right to know they exist.
This guide explains what counts as a contingent liability, how it differs from a provision, what the accounts need to say, how tax treats it, and where we see small companies get it wrong.
What Is a Contingent Liability?
UK accounting standards give a contingent liability two meanings. Under FRS 102 Section 21, which most UK private companies follow, and IAS 37, the international equivalent, a contingent liability is either:
- A possible obligation arising from past events, whose existence will only be confirmed by one or more uncertain future events that are not wholly within the company's control. A court case that has not been decided is the classic example.
- A present obligation that is not recognised on the balance sheet because either a payment is not probable, or the amount cannot be measured reliably.
In plain terms, it is a liability that fails one of the tests for going on the balance sheet, but is still too likely to ignore.
The key point is that a contingent liability is not recorded as a liability. There is no journal entry and nothing in the profit and loss account. It lives in the notes to the accounts, unless the chance of paying out is remote, in which case it does not appear at all.
Contingent Liability Examples
These are the ones we see most often in small and medium sized UK companies.
- Legal claims. A customer, supplier or member of the public has made a claim against the company, and your solicitor thinks you will probably win, but might not.
- Employment tribunal claims. A former employee has brought an unfair dismissal or discrimination claim.
- Guarantees. The company has guaranteed another company's borrowing, often a sister company in the same group, or a cross guarantee in favour of the bank covering every company under the same owners.
- Warranties given on a sale. When you sell a business or a trade, the buyer usually asks for warranties and indemnities, for example that there are no hidden tax liabilities.
- Disputed tax. HMRC has opened an enquiry and a point is in dispute, but there is a reasonable argument either way.
- Performance bonds and retentions. Construction companies often give bonds guaranteeing they will complete a contract, and could have to pay out if they do not.
- Environmental or regulatory issues where a fine or clean up cost is possible but not yet likely.
Some things that sound like contingent liabilities are not. A two year warranty on products you sell is usually a provision, because across all your customers some claims are more likely than not. A supplier invoice you simply have not received yet is an accrual, covered in our guide to accruals and prepayments.
Contingent Liabilities vs Provisions
This is the distinction that matters most, and the one exam questions and year end reviews are built around.
A provision is a liability of uncertain timing or amount that does go on the balance sheet. Under FRS 102 Section 21, you recognise a provision when all three of these are true:
- The company has a present obligation at the reporting date as a result of a past event.
- It is probable, meaning more likely than not, that the company will have to pay.
- The amount can be estimated reliably.
If all three are met, you recognise a provision. If one fails, you look at whether the item is a contingent liability. The simplest way to picture it is a ladder based on how likely a payment is.
| Likelihood of paying out | What you do |
|---|---|
| Probable (more likely than not) and reliably measurable | Recognise a provision on the balance sheet and charge it to profit |
| Probable, but no reliable estimate is possible | Disclose as a contingent liability (this is rare) |
| Possible, but less than probable | Disclose as a contingent liability in the notes |
| Remote | No provision and no disclosure |
Standards do not put numbers on these words, but in practice "probable" means above 50%. "Remote" means the chance is slight, and most accountants treat it as something like 5% or less. Everything in between is "possible", and that middle band is where contingent liabilities live.
The words also have to be judged honestly. We have seen directors describe a claim their own solicitor rated as 60% likely to succeed as "possible", because a disclosure note looks better than a £30,000 hit to profit. That is not a judgement call, it is a misstatement.
A note on the word "provision"
Accountants use "provision" for two different things, and it causes confusion. A provision for a legal claim is a liability. A provision for bad debts or for slow moving stock is a reduction in an asset. HMRC's own manual flags this at BIM46510 and applies different tax rules to each. This guide is about the first kind.
What Goes in the Notes
For each class of contingent liability, FRS 102 asks for a brief description of its nature and, where practicable, an estimate of its financial effect, an indication of the uncertainties about the amount or timing, and the possibility of any reimbursement, such as an insurance recovery.
A typical note in a small company's accounts looks something like this:
Contingent liabilities. A former customer has brought a claim against the company alleging defective workmanship, seeking damages of £38,000 plus costs. The directors, having taken legal advice, consider that the claim can be successfully defended and no provision has been made. The company has also guaranteed the bank loan of a related company, Oakmere Solar Ltd, which stood at £60,000 at 31 March 2027.
There is a limited exemption. If disclosing the details would seriously prejudice the company's position in a dispute, FRS 102 lets you give only the general nature of the dispute and explain why the rest has been left out. It is meant for genuine cases, such as not handing a claimant your own estimate of what you would pay to settle.
Guarantees get extra attention under company law. The Companies Act 2006 and the accounts regulations require small companies to disclose guarantees and other financial commitments not shown on the balance sheet. Section 413 separately requires disclosure of guarantees entered into on behalf of directors. So a guarantee is often disclosed even when the chance of it being called is low.
Micro-entities
Companies filing micro-entity accounts under FRS 105 follow the same recognition rules for provisions, but there are no full notes. Instead, the total amount of financial commitments, guarantees and contingencies not included in the balance sheet has to be stated, usually at the foot of the balance sheet. It is a single number, but it still has to be right, and it is easy to forget when the accounts are prepared from the bank feed alone.
Contingent Assets
The mirror image is a contingent asset: a possible asset that depends on an uncertain future event, such as a claim you have brought against someone else.
The rules are deliberately lopsided. A contingent asset is never recognised on the balance sheet until the inflow is virtually certain, at which point it is no longer contingent. It is only disclosed when an inflow is probable. You cannot book the £50,000 you expect to win in court, even if your solicitor is confident.
That asymmetry is prudence at work. Accounts are allowed to anticipate bad news that is likely, but not good news.
Worked Example: Oakmere Electrical Ltd
Oakmere Electrical Ltd is a commercial electrical contractor in Reading with a 31 March year end and turnover of £1.2 million. At 31 March 2027, the directors and their accountant work through five open items before finalising the accounts in July 2027.
1. A customer's damages claim, £38,000. A restaurant claims a rewiring job caused a fire and is seeking £38,000. The company's solicitor thinks the fire started elsewhere and puts the chance of losing at about 30%. That is possible, not probable. Treatment: disclose as a contingent liability, no provision. The company's insurer may also cover part of any payout, which the note mentions, but an insurance recovery can only be recognised as an asset when it is virtually certain.
2. An employment tribunal claim. A former site supervisor has claimed unfair dismissal. At 31 March, the solicitor advises that the company will probably lose and estimates £9,000. Then, on 12 May 2027, before the accounts are approved, the claim settles for £10,500. A settlement after the year end that confirms a condition existing at the year end is an adjusting event under FRS 102 Section 32. Treatment: provision of £10,500.
3. A guarantee of a sister company's loan, £60,000. Oakmere has guaranteed the bank loan of Oakmere Solar Ltd, owned by the same directors. Oakmere Solar is trading profitably and has never missed a repayment. The chance of the guarantee being called is low, but the Companies Act requires guarantees to be disclosed anyway. Treatment: disclose, no provision.
4. Workmanship warranty. Oakmere gives a two year warranty on its installations. Any single job is unlikely to need remedial work, but over hundreds of jobs some will. Past records show remedial costs of about 0.5% of revenue. When there are many similar obligations, the probability test is applied to the class as a whole. Treatment: provision of £6,000 (0.5% of £1.2 million).
5. A competitor's letter about a trading name. A competitor wrote in 2025 complaining about Oakmere's branding, then went quiet. Nothing has been heard for 18 months. Treatment: remote. No provision, no disclosure.
Here is how it comes together.
| Item | Treatment | Profit and loss charge |
|---|---|---|
| Restaurant claim | Contingent liability, disclosed | £0 |
| Tribunal claim | Provision (adjusting event) | £10,500 |
| Sister company guarantee | Disclosed | £0 |
| Installation warranties | Provision | £6,000 |
| Competitor letter | Remote, ignored | £0 |
| Total | £16,500 |
The journal for the provisions is straightforward. Debit the relevant expense account in the P&L and credit a provisions account in liabilities on the balance sheet. When the tribunal settlement is paid in May, debit the provision and credit the bank. If you want to see how the double entry works in more detail, our guide to double entry bookkeeping covers it.
What it means for dividends
Before the review, Oakmere's directors had planned a £60,000 dividend against retained earnings of £70,000. The provisions, net of the tax saving below, take about £12,100 off retained earnings, leaving roughly £57,900. The planned dividend is now more than the company can lawfully pay under section 830 of the Companies Act 2006, which only allows distributions out of accumulated realised profits.
The £38,000 restaurant claim does not reduce distributable reserves, because it is not recognised. But directors still owe duties to the company, and paying out nearly all the reserves while a claim that size is live is not something we would advise. If the claim went the wrong way, the company could be left unable to pay it. We suggested a £35,000 dividend with the rest reviewed once the claim is resolved.
How Contingent Liabilities Are Taxed
Corporation tax
A contingent liability is not in the P&L, so there is no tax deduction for it. Relief comes if and when the cost is actually recognised, either as a provision or when it is paid.
Provisions are different. HMRC's guidance at BIM46510 says a provision for a liability is allowable for tax if:
- it relates to revenue expenditure, not capital,
- it is in accordance with generally accepted accounting practice,
- no specific statutory rule overrides the timing, and
- it is estimated with sufficient accuracy.
Oakmere's two provisions pass these tests, so the £16,500 is deductible in the year to 31 March 2027. With profits in the marginal relief band, the effective rate on that slice of profit is 26.5%, a saving of about £4,370. You can check your own position with our corporation tax calculator, and our guide to corporation tax explains the bands.
The warranty provision is worth a comment. HMRC will want to see that the 0.5% is based on real history, not a round number chosen to reduce the bill. Keep the records that support it. A general "rainy day" provision with no basis will be disallowed, and it should not be in the accounts in the first place.
Warranties when you sell a business
The tax angle most business owners meet is on a sale. When you sell your shares, the buyer's lawyers will ask for warranties and indemnities, which give the buyer the right to claim money back if something turns out to be wrong.
Section 49 of the Taxation of Chargeable Gains Act 1992 says that, in the first instance, no allowance is made in the capital gains computation for a contingent liability under a warranty or representation made on a sale. You pay capital gains tax on the full price. If the buyer later enforces a warranty claim and you pay out, you can claim an adjustment and get back the tax on the amount repaid.
In practice, that means a seller can pay tax on proceeds they later have to hand back, and wait for the adjustment. It is one reason we push clients preparing for a sale to get their accounts and tax affairs clean well in advance. A tidy history means fewer warranty claims, and it also supports the price in the first place. Our guides to how to value a business and Business Asset Disposal Relief cover the rest of the picture.
Personal Guarantees: The Director's Own Contingent Liability
When a director personally guarantees a company's bank loan, overdraft or lease, the contingent liability belongs to the director, not the company. It usually does not appear in the company's accounts at all.
We think this is one of the most underestimated risks in small business. A director with a £150,000 personal guarantee on the company's borrowing has, in effect, a £150,000 contingent debt that sits on no balance sheet anywhere. If the company fails, the bank can come after their house. We made the same point in our guide to the gearing ratio: a business that looks lightly borrowed can be heavily geared once the guarantees are counted.
Our advice is simple. Keep a list of every guarantee you have signed, personally and on behalf of the company, with the lender, the amount and the date. Many directors cannot tell us how many they have given. Mortgage lenders ask about them, and so do the buyers of a business.
Our View
The disclosure note is read more closely than you think. Directors often treat the contingent liabilities note as boilerplate. Banks reviewing a lending application do not. Neither do buyers in due diligence, credit reference agencies or larger customers vetting suppliers. A note that says "none" when there is a live claim is a problem that surfaces at the worst possible time, usually when you are trying to borrow or sell.
Get the solicitor's view in writing. The whole classification turns on how likely a payment is, and your lawyer is the person best placed to say. A short email saying "we assess the prospects of the claim succeeding as low" is enough evidence for most small company accounts. Auditors of larger companies send formal letters to the company's solicitors for exactly this reason. If your company is near the audit thresholds, expect that question.
Don't use "possible" to avoid bad news. The temptation to keep a likely loss off the balance sheet is real, especially if a bank covenant or a dividend depends on the profit figure. It usually backfires. If the claim settles soon after the year end, the settlement is an adjusting event, and the accounts have to show it anyway.
Remember the insolvency angle. Section 123 of the Insolvency Act 1986 takes contingent and prospective liabilities into account when deciding whether a company can pay its debts, as we explain in our guide to the accounting equation. A company with thin reserves and a large live claim needs to think carefully before it takes on more trade payables or pays dividends.
Group guarantees need checking every year. Banks often ask every company in a group to cross guarantee the others. The directors sign it once, and then forget it. Each year, look at the other companies' results. A guarantee of a healthy sister company is a disclosure. A guarantee of a sister company that is struggling may be a provision.
How IAK Can Help
We help limited companies deal with uncertain liabilities properly, from deciding whether an item is a provision or a disclosure, to making sure the tax treatment holds up.
Our accounting team prepares year end accounts under FRS 102 and FRS 105, including provisions and contingent liability notes backed by working papers. Our management reporting service keeps open claims, guarantees and warranty costs visible through the year, so the year end holds no surprises. Our tax planning team reviews provisions for deductibility and supports clients through HMRC enquiries.
We work with limited companies, small businesses and construction companies, where bonds, retentions and disputed final accounts make contingent liabilities part of normal trading. If you have a claim, a guarantee or a sale on the horizon and want to know how it affects your accounts, get in touch for a free consultation.
Sources
- FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland, Financial Reporting Council, Section 21 on provisions and contingencies and Section 32 on events after the end of the reporting period.
- IAS 37 Provisions, Contingent Liabilities and Contingent Assets, IFRS Foundation, the international standard on which Section 21 is based.
- Technical factsheet: Provisions and contingencies, ACCA, a practical summary of the recognition and disclosure rules.
- Business Income Manual BIM46510, HMRC, on when provisions are allowable for tax and the difference between liability provisions and asset impairments.
- Taxation of Chargeable Gains Act 1992, section 49, legislation.gov.uk, on contingent liabilities under warranties given on a disposal.
- Capital Gains Manual CG14800, HMRC, on HMRC's approach to contingent liabilities on disposals.
- Companies Act 2006, section 413, legislation.gov.uk, on disclosure of advances, credits and guarantees involving directors.
- Companies Act 2006, section 830, legislation.gov.uk, on distributions only being made out of profits available for the purpose.