What is Contract Liability?
To understand what contract liability is, it’s important to first unpack the meaning of the separate concepts relating to it.
Simply put, a contract is a legally binding agreement that governs the relationship between two or more parties and in terms whereof every party has certain rights and obligations. In turn, liability refers to the responsibility or obligation a party has to perform some act, resulting from contracts, torts, or other bases for legal responsibility.
So, generally, in contract law , contract liability refers to the responsibility of any party to a contract for the claims, obligations, or debts arising from a contract. More specifically, though, contract liability is when one party to a contract agrees to reimburse any damages or losses suffered by another party.
In simple terms, contract liability allows the parties to a contract to transfer risk to another. It’s for this reason that these contracts are often referred to as an indemnity agreement or hold harmless agreements .
This makes it ideal for businesses because they typically enter into many types of contracts from employment contracts to lease agreements and service contracts with different parties. As a result, depending on the circumstances, it might be helpful for them to shift liability to another party.
Here’s an article about contract liability.
How Contractual Liability Works
The best way to understand how contract liability works is by looking at a simple example:
- Let’s assume you own a home construction company, Homebuilders Inc. that specializes in building new homes for clients.
- You’ve entered into a contract with a new client, Mr. Homeowner to build him a new home.
- As part of the construction, Mr. Homebuilder wants the installation of a high-end home theater system.
- To offer this to your client, you’ll work with Bigsound Inc. who will provide and install the necessary equipment after the construction of the home is completed.
- You understand that, during the installation of the equipment, Bigsound Inc. could make a mistake and install the equipment incorrectly and damage Mr. Homeowner’s home. Now, the question arises who would be responsible for this damage if this happens?
- So, to protect yourself should any damage occur, you require Bigsound Inc. to enter into a contract with you that will indemnify you against any losses. In terms of this indemnity agreement, Bigsound Inc. will be held liable for any damages resulting from its negligence.
- In this way, you transfer the risk to Bigsound Inc and protect yourself against any possible damages and subsequent claims by Mr. Homeowner.
Keep in mind that this is a simple example and there are many other cases where contract liability could be used by one party to protect itself in a contract.
Types of Contractual Liability
These types of agreements where one party indemnifies another against damages or loss are fairly common in:
- Property leases . A landlord may require a tenant to provide indemnity against damages should anyone get injured on the premises.
- Construction agreements . This would typically include the example mentioned earlier where a contractor uses a subcontractor to perform certain services.
- Equipment leases . Here, the owner of the equipment may require the lessee to provide indemnity against damages as a result of using the equipment under the equipment lease .
- Easements . Here, the landowner may require the rights holder for indemnification against any damages suffered on the property or as a result of the use of the easement.
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Contract Assets vs Contract Liabilities
Another term you could encounter in a business setting is contract assets. So, what’s the difference between contract assets and contract liability. To understand this difference, it’s important to distinguish between contract liability in a legal sense and contract liability in an accounting sense.
In accounting, it’s important to properly account for transactions in a balance sheet. Here, a party to a revenue-related contract performs its obligation by either delivering goods to a customer in the case of a business or when making payment in the case of a customer.
When either of these parties performs their obligations in terms of the contract, this performance is recorded in the business’s balance sheet as a contract asset or a contract liability. These terms were specifically created in terms of the Accounting Standards Codification (ASC) 606.
Here, they’re given the following meanings:
- A contract asset is a business’s right to receive payment for goods or services it already delivered to the customer if that right is conditional upon some other obligation before being entitled to payment.
- A contract liability, in turn, is a business’s obligation to transfer goods or services to a customer if the customer prepays for the goods or services or if the customer’s payment is due before the delivery of the goods and services.
Based on the above, there’s a significant difference between contract assets and contract liabilities, not only in an accounting sense but also in a legal sense.
Here’s an article about the difference between contract assets and contract liabilities .
Who is Liable in a Contract?
As mentioned earlier, in a general sense, contract liabilities refer to the relevant parties’ responsibilities for the obligations, debts, and legal claims that may arise from the contract. So, based on this, the party responsible for the particular obligation arising out of the contract is liable in terms thereof.
Likewise, the party responsible for any debt or claim arising out of a contract is liable in terms thereof. In this general sense, it’s important to distinguish between the different remedies available to an aggrieved party, or in other words, the party entitled to the payment, reimbursement, or performance.
Firstly, the aggrieved party could claim damages arising out of the contract. Here, the party will typically be compensated in the amount they would have received had the contract been executed. So, in simple terms, if a contracting party would have earned $10,000 profit had the other party performed its obligations in terms of the contract, it would be entitled to damages in this amount.
The other option is a claim for specific performance. In this case, the aggrieved party claims for fulfillment of the other party’s obligations in terms of the contract.
In a more specific instance of contract liability as described in our example earlier, the party to whom liability was transferred, would be liable in terms of the contract.
Here’s an article about liability in terms of a contract .
Are Contractual Obligations Liabilities?
Although contracts between parties contain several rights and obligations, it’s important to remember that these obligations do generally not constitute contractual liabilities. So, for instance, you may enter into a contract in terms whereof you agree to sell your car to another party. In terms of this contract, your obligation will then be the delivery of the car.
If you then fail to deliver the car, you’ll be in breach of contract and your liability will come into existence. As mentioned earlier, the other party then has a choice of remedies.
Conversely, in the case of contract liability where you transfer liability to another party as in the mentioned example, that constitutes an obligation in terms of the contract which is also a liability, albeit dependent upon damages or loss occurring.
Here’s an article on contractual obligations .
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