Company-wrecking contingent liabilities may lurk in the small print of an annual report.
Towards the back of many a set of company accounts lurks a beast (and it's not the South African loosehead prop forward!). Rather than sinking the British Lions' scrum, this beast has brought down many companies and goes by the name of "contingent liabilities".
It is often said that when reading a set of company accounts you should start with the notes at the back and continue to read backwards, just as if you were reading a Japanese manga comic book, stopping when you have finished the consolidated financial statements. In doing so, one of the first things you will come across is the note concerning the company's contingent liabilities.
A bit of accountancy
International Accounting Standards (IAS) are not exactly what you would call light reading. IAS37 defines a contingent liability as being "a possible obligation depending on whether some uncertain future event occurs, or a present obligation but payment is not probable or the amount cannot be measured reliably." Benjamin Graham in the 1937 edition of The Interpretation of Financial Statements has a simpler definition, "liabilities indefinite as to either their amount or their occurrence".
Either way, if there is any uncertainty as to the size of a liability and/or whether it will arise then it becomes a contingent liability.
One example of a contingent liability is where a company has to guarantee the debts of its subsidiary businesses. Another is where a firm sells a business and guarantees to pay the buyer a certain amount if the business underperforms in the next few years.
For practical purposes a contingent liability can be treated as being similar to an insurance contract; the company becomes liable for a relatively large sum of money if a low probability event occurs within a certain timeframe.
The big question for investors is whether the contingent liability has been fairly valued, or has the company been far too optimistic. Where contingent liabilities usually cause problems it is because the company has been far too optimistic in its assumptions regarding the odds of its having to make good on its promises.
A failure to take account
The failure of banks and other lenders to accurately account for contingent liabilities was a major cause of the credit crunch. Mortgages were given to people who could not realistically afford the payments. The lenders then sprinkled these dodgy loans with pixie dust to magically turn then into triple-AAA rated collateralised debt obligations (how else could they have done this?).
These loans were then sold them to investors and other lenders. That they were surprised when they evolved into "toxic assets" tells me that in order to believe that lending money to people who cannot pay you back is good business you need to be an investment banker, a madman or a loan shark!
Unfortunately these loans have come back onto the issuers' balance sheets and, because the issuers did not account for any contingent liabilities, their balance sheets have been wrecked. The faulty assumption made by these lenders (and the buyers of the debt and the presenters of many property makeover programmes) was that house prices never fall.
An example from history is British & Commonwealth which collapsed in 1990 thanks to its computer leasing subsidiary Atlantic Computers. Atlantic's accounting treatment assumed that no customer would ever exercise their option to cancel their lease part-way through the term because the equipment had become obsolete. The result was that the company was hit with a torrent of contingent liabilities which they had completely ignored. It was game over, or as cricket's David "Bumble" Lloyd would say, "start the car."
Proper accounting
Happily in most cases contingent liabilities are properly acknowledged and are well documented in the accounts. One such example comes from a firm that is familiar to many who like the odd flutter, the high street bookmaker Ladbrokes (LSE: LAD).
Ladbrokes used to own a massive hotel business which it sold to Hilton International in 2006 and, as a condition of the sale, Ladbrokes gave guarantees against certain leases -- the contingent liabilities in Ladbroke's accounts represent these guarantees.
Such guarantees are not unusual thanks to the peculiar manner in which English land law treats leases. When a lease is sold the ultimate liability to pay for the lease remains with whoever took out the lease in the first place, regardless of how many times the lease has subsequently been resold. This seems to be the case here as Ladbrokes received a counter-indemnity from Hilton International in respect of these guarantees. Many of these leases were almost certainly first taken out by Hilton International -- Ladbrokes and Hilton International have historically been very closely connected businesses (Ladbrokes used to be called "Hilton plc").
In 2008 Ladbrokes' maximum contingent liability was £943.1 million with these liabilities being valued in the balance sheet at only £9 million. This value shows management's expectation that the guarantees are unlikely to be called upon and the strength of Hilton International's indemnity.
Summary
Investors should be aware of the existence of contingent liabilities. The key issue is not that the liabilities exist but whether they are fairly valued in the accounts. Unfortunately some companies take an overoptimistic view of these liabilities which can wreak havoc upon the business if they are triggered.
So the next time you're thinking of buying some shares you might be well served by having a quick peek at the notes in the company's accounts to see if anything naughty is lurking in the undergrowth of contingent liabilities.
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