1.9       Query

Classification and Definition of “Contingent

Liability”—1.

It is observed from published accounts of many a company that the following item is appended under the head “Contingent Liabilities”.

“In respect of guarantee and counter-guarantee given by the  Company against guarantee given by a Bank on behalf of the                         Company……”

The arrangement is that Bankers of the Company furnish guarantee to the third parties for the due performance of the contract by the Company, for which they in turn demand counter-guarantee form the Company.

To us, it appears that mention of the same as contingent liability of the Company is inappropriate. It would be the contingent liability of the Bank and not the Company, and as such, should have properly occurred in the Accounts of the Bank. In the event of breach of performance of the contract on the part of the Company, it would be an accrued and crystallized liability and not nearly a contingent liability.

What is the correct accounting procedure to be adopted in such case for the purpose of preparation of accounts of the Company in accordance with the requirements of the Companies Act, 1956?

                                                     Opinion                                                              July 15, 1962

The Committee is of the view that a contingent liability in respect of guarantees arises when a company issues guarantees to another person on behalf of a third party e.g. when it undertakes to guarantee the loan given to a subsidiary or to another company or gives a guarantee that another company will perform its contractual obligations. However, where a company undertakes to perform its own obligations, and for this purpose issues, what is called a “guarantee”, the Committee is of the view that this does not represent a contingent liability and it is misleading to show such items as contingent liabilities in the Balance Sheet.

  Section 126 of the Indian Contracts Act, 1872, defines a contract of guarantee as “a contract to perform the promise or discharge the liability, of a third person in case of his default”. It is clear from this that the transactions of the kind referred to in the query are not guarantees.

For various reasons, it is customary for guarantees to be issued by Bankers e.g. for payment of insurance premia, deferred payments to foreign suppliers, letters of credit etc. For this purpose, the company issues a “counter-guarantee” to its Bankers. Such “counter-guarantee” is not really a guarantee at all, but is an undertaking to perform what is in any event the obligation of the company, namely, to pay the insurance premia when demanded or to make deferred payments when due.

If, as a result of any such “guarantees” or undertakings given, an obligation has actually arisen, a provision should be made there against in the accounts e.g. if a company has “guaranteed” that a product manufactured and sold by it will give a certain performances, and the customer has claimed compensation because that level of performance has not been achieved, a provision for such liability should be made in the accounts. Again, if a company has “guaranteed” a loan given by bankers to a subsidiary company and the subsidiary has become insolvent, the Company should make a provision in the accounts for the amount it may be called upon to pay. To take another example, it is customary for automobile manufacturers to “guarantee” the performance of the car for a period of time and to replace defective parts during that period.  Such companies usually make a provision for contractual guarantee obligations in their accounts.

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