Accounting for Litigation Settlements
Accounting for a lawsuit incorrectly can add insult to injury. The business world is litigious, and it can be difficult to determine how likely it is that your company is going to have to pay or get paid. The Accounting Standards Codification provides clear guidance on how to account for litigation, as a plaintiff and a defendant, that is in process and settled. The problem is that it comes down to probability.
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Settled
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When a lawsuit is settled, there are no more appeals, and the company has determined it will be required to pay a judgment to another party, the company will record the liability in the accounting records. When determining the date the liability is recorded, the company looks to the date at which the actionable offense occurred. For example, if a company is sued in 2009, but the case is settled in 2010, before the financial statements are issued, the company would record the liability as of the end of 2009. In all cases, the company would disclose the nature of the loss in the financial statements as well.
Probable
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For lawsuit activity the company has deemed to be probable, and that can be reasonable estimated, the company must disclose the nature and range of possible losses expected due to the litigation and book the lowest estimate of the range of losses. As legal contingencies are often difficult to estimate, the range of the estimate could be very large. The liability recorded is subject to the materiality threshold, so estimates with a small lower range are not always recorded.
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Reasonably Possible
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Litigation that has been considered possible to result in a loss is to be disclosed in the financial statements, but a liability is not to be recorded. As the definition of "reasonably possible" is only "less than likely" but "more than remote," there is substantial diversity in the application of this standard. Management and auditors must come to a conclusion as to the classification of these contingencies.
Remote
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Lawsuits that are considered by management to have a remote chance of loss do not need to be disclosed or recorded in the entity's financial records. For many companies, frivolous lawsuits are a cost of doing business and would fall into this category.
Gain Contigencies
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When a company is to get paid for winning a lawsuit, the rules say that you may not record the contingency in the financial records. This is in order to preserve conservatism in financial reporting. However, you may disclose the gain contingency in the footnotes to the financial statements, but you must take care to not mislead users on the ability of your company to realize the contingency.
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References
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