In business, contingencies come in two forms. First, contingencies come in the transaction between two stakeholders. An example is real estate contracts with a clause that says that a sale is only complete after certain conditions are met. A more common example is in hiring. You may extend a conditional offer to a candidate, contingent on their references checking out.
The second form which contingencies come in is in business planning. Contingency planning can be seen in risk management. This gives the business with some direction in the form of a plan when disruptive events occur.
Definition of contingent
Something is contingent when it occurs or exists only if certain circumstances are the case. This means that something is dependent on or conditional to another event.
Why make a transaction contingent
The main reason that businesses use contingent clauses in transactions is to ensure that all conditions are satisfied before the executing the contract. Using such clauses allow businesses to communicate to transaction parties that something is likely going to occur. This puts the onus back on the other party of the transaction to follow up with meeting the conditions.
Example of contingent transactions
In the mergers and acquisitions world, contingent consideration occurs when there is a discrepancy between the buyer’s price and the seller’s price. For example, if the buyer believes the business is worth $20 million but the seller believes it is worth $25 million, the buyer may create use contingent consideration to bridge the gap. They will propose to pay $20 million upfront and the remaining $5 million if they meet the conditions. The remaining $5 million is the contingent consideration.
Contingency planning for an organization
While contingent clauses in transactions can help businesses reduce foreseeable risk, contingency planning responds to possible scenarios that have not happened yet. This is akin to having a plan B. The main objective of a contingency plan is to maintain and or restore business continuity.
Businesses create contingency plans for the possible scenarios that can potentially lead to significant destruction of value. The plan contains a set of procedures that outlines what is to be done in the case of an event. Some organizations refer to these plans as disaster response plans. Common scenarios that businesses create contingency plans for are natural disasters, such as a tsunami or an earthquake, or law suits, such as a customer suing for a faulty product.
A great example of an organization that exercises strong contingency planning is the diner chain, Waffle House. With many of their diners located in Southern United States, the business has built strong capabilities on how to handle natural disasters. There is even a famous Waffle House Index that some use as a gauge on how detrimental a disaster actually is.
Creating contingency plans is beneficial for businesses in many ways. First, it forces businesses to brainstorm practical solutions to improbably scenarios that cause significant destruction. This exercise is beneficial for helping teams develop the skills for working through uncertainty.
Second, having a contingency plan will ensure that the business can respond accordingly when an uncertain event occurs. It outlines what to do to restore operations for business as usual.
Businesses carrying significant risk may have to account for this risk in their financial statements. Liabilities that reflect probable business events are contingent liabilities.
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Contingent liabilities
A contingent liability is an accounting posting that represents a potential liability that is likely to occur. The most common examples of contingent liabilities are warranties and or pending lawsuits. Because these events are probably and easy to estimate, GAAP compliance requires that they financial statements reflect these liabilities.
For businesses that are public, finance and accounting departments may have to provide an estimate for contingent liabilities as part of GAAP compliance. For example, businesses that provide warranties for their products estimate the potential cost of the warranty and book it as a warranty expense.
Key takeaways
- Business create contingent transactions to reduce risk and ensure fulfillment of all conditions
- Businesses should create contingency plans to ensure business continuity during a disruptive event
- Practicing and reviewing contingency plans will equip employees with the skills to navigate through uncertainty
