Lawsuits Payable

The most common type of loss contingencies have to do with litigation, claims and assesments. The following factors, among others, must be considered in determining whether accrual and/or disclosure is required with respect to pending or threatened litigation and or actual or possible claims or assessments:

a. The period in which the underlying cause (ie. the cause for action) of the pending or threated litigation or the actual or possible claim or assessment occured.
b. The degree of probability of an unfavorable outcome.
c. The ability to make a reasonable estimate of the amount of the loss.

The first factor tells us that threatened or pending litigation should only be recognized if the event that led to the possible litigation occured before the financial statement date. For example, if a lawsuit for damages was initiated after an accident that occured before the financial statement date, that litigation should be recognized or disclosed, even if management was not aware of the litigation until after the financial statement date. On the other hand, if the accident that forms the basis of the litigation did not occur until after the balance sheet date, it should not be accrued on the financial statements for the period.

The second factor reitirates that the liability should only be accrued if future costs are probable. When looking at the probability of litigation, management should consider the nature of the litigation, the progress of the case, the opinion of legal counsel and other advisors, the experience of the company (and others in similar cases) as well as the costs the lawsuit threatens to impose on the company, even in the event that the company is able to succesfully defend it. This is because even when a company can succesfully defend against a lawsuit, litigation may present a significant demand on a company's employees time in addition to legal fees incurred.

The second and third factor also tell us that just because a lawsuit or formal assertion of a claim or assessment has been filed, doesn't necessarily mean that the company should recognize a loss and accrue the liability. If an adverse outcome is estimated to be reasonably possible, but not probable, or if the amount of the loss cannot be reasonably estimated, than accrual would be inappropriate (but disclosure may still be required).

Reference:

1. FASB Statement No. 5

BrainMass