Contingent liabilities are serious future obligations like lawsuits, warranties, etc. that may or may not be a problem. For example, if your parents guarantee your home loan, then if you make all your payments on time and do not default on your mortgage, there is no contingent liability on your parents. If you fail to make the payments, your parents will incur a liability.
Maybe its not a problem yet, but it appears the Indian IT companies are getting into riskier contracts in search of revenue. It used be that Indian IT companies were predominantly “body shops”, i.e., most of the contracts were labor based. An hourly or monthly labor rate was assigned to different skill levels and the contract outlined the total labor anticipated and quality of service goals. However, over the last 3-4 years, there has been a significant uptick in “gain sharing” contracts where the service provider obtains a share in the savings when outsourcing creates permanent cost savings. A gain-sharing contract better motivates the provider to innovate and to reduce operating costs.
The problem is that these contracts are not transparent to investors. How much of the anticipated revenue has been booked upfront? What if there are no “gains”? What if provider has a windfall year and the client decides to renegotiate the formula? Also, are investors aware of the risk-mismatch in contracts between what the provider has with its employees and its clients?
Investors should demand greater disclosure of these contingent liabilities before taking revenue numbers at face value.