Accounting Guidelines for Contingent Liabilities

accounting for litigation settlements

The lawyer has an obligation not knowingly to participate in any violation by the client of the disclosure requirements of the securities laws. In appropriate circumstances, the lawyer also may be required under the Code of Professional Responsibility to resign his engagement if his advice concerning disclosures is disregarded by the client. In response to an auditor’s request for disclosure of loss contingencies of a client, it is appropriate for the lawyer’s response to indicate that the response is limited to items which are considered individually or collectively material to the presentation of the client’s financial statements. Please specifically confirm to our auditors that our understanding is correct.

Statement Notes

Consequently, a lawyer may not be able to form a conclusion with respect to such matters. In such circumstances, the auditor ordinarily will conclude that the financial statements are affected by an uncertainty concerning the outcome of a future event which is not susceptible of reasonable estimation, and should look to the guidance in AS 3105.28 through .32 to determine the effect, if any, of the lawyer’s response on the auditor’s report. A contingent liability is an existing condition or set of circumstances involving uncertainty regarding possible business loss, according to guidelines from the Financial Accounting Standards Board(FASB). In the Statement of Financial Accounting Standards No. 5, it says that a firm must distinguish between losses that are probable, reasonably probable or remote.

The company must provide the disclosures required by GAAP, even if the information is not provided it by their attorney. The art of disclosure, then, is for the company to provide sufficient disclosure to inform its users and comply with GAAP, while their attorney helps protect the company from disclosing information which may be harmful to the company’s position in the litigation. If a company determines that a loss is only “reasonably possible” or that a loss is “probable,” but the amount is not reasonably estimable, the company need not establish a reserve, but it still must disclose the nature of the possible loss and give an estimate of the possible loss or range of loss. At a minimum, disclose the nature of the claims asserted and amount of damages sought. If the litigation is in its early stages, it may be appropriate to state that an estimate of reasonably possible loss cannot be made.

There are strict and sometimes vague disclosure requirements for companies claiming contingent liabilities. Loss contingencies can refer to contingent liabilities that may arise from discounted notes receivable, income tax disputes, or penalties that may be assessed because of some past action or failure of another party to pay a debt that a company has guaranteed. Unlike gain contingencies, losses are reported immediately as long as they are probable and reasonably estimated. They do not have to be realized in order to report them on the balance sheet. For losses that are material, but may not occur and their amounts cannot be estimated, a note to the financial statements disclosing the loss contingency is reported.

Therefore, one should carefully read the notes to the financial statements before investing or loaning money to a company. LARRY MAPLES, CPA, DBA, is COBAF Professor of Accounting at Tennessee Technological University in Cookeville. he tax treatment of contingent liabilities transferred in a corporate sale or restructuring is often a problem for the parties involved. (A contingent liability is one that depends on an uncertain event, such as the settlement of a lawsuit.) Common examples of pending claims are suits against a company by a government agency, a customer or an employee, all of which can significantly affect the economics of a transaction.

On the other hand, if it is only reasonably possible that the contingent liability will become a real liability, then a note to the financial statements is required. Likewise, a note is required when it is probable a loss has occurred but the amount simply cannot be estimated. Normally, accounting tends to be very conservative (when in doubt, book the liability), but this is not the case for contingent liabilities.

As the litigation progresses, disclose a range of possible loss, possibly aggregated with other loss contingency disclosures. Keep in mind that the SEC has increasingly taken the position that it is not enough that a possible loss or range of loss cannot be determined “with precision and confidence,” and has indicated that it may ask companies to provide support for an assertion that an estimate cannot be made, particularly as litigation progresses.

accounting for litigation settlements

When the auditor is aware that a client has changed lawyers or that a lawyer engaged by the client has resigned, the auditor should consider the need for inquiries concerning the reasons the lawyer is no longer associated with the client. .10 In special circumstances, the auditor may obtain a response concerning matters covered by the audit inquiry letter in a conference, which offers an opportunity for a more detailed discussion and explanation than a written reply. A conference may be appropriate when the evaluation of the need for accounting for or disclosure of litigation, claims, and assessments involves such matters as the evaluation of the effect of legal advice concerning unsettled points of law, the effect of uncorroborated information, or other complex judgments. The auditor should appropriately document conclusions reached concerning the need for accounting for or disclosure of litigation, claims, and assessments.

The disclosure by the company, and concurrence by its attorney and auditor, about these contingencies can be difficult to achieve. The company relies on its attorney to provide the judgments of possibility and loss, all while also protecting the company’s position with regard to the litigation. The auditor is also reliant on the attorney’s expertise and, to some extent, has the benefit of hindsight if the litigation is resolved in the intervening subsequent period. However, the requirements agreed to in the attorney’s replies to auditor’s requests by the American Bar Association is not part of, nor bound by, the accounting guidance, while the company in reporting its potential losses is so bound. In other words, if questioned on the disclosure or lack thereof, the company cannot pass responsibility to its attorney.

  • This approach with respect to unasserted claims and assessments is necessitated by the public interest in protecting the confidentiality of lawyer-client communications.
  • The lawyer’s responsibilities with respect to his client’s disclosure obligations have been a subject of considerable discussion and there may be, in due course, clarification and further guidance in this regard.
  • The auditor obtains sufficient evidential matter to satisfy himself concerning reporting for those unasserted claims and assessments required to be disclosed in financial statements from the foregoing procedures and the lawyer’s specific acknowledgement of his responsibility to his client in respect of disclosure obligations (see paragraph .09g).

These contingencies are regarded by management of the Company as material for this purpose (management may indicate a materiality limit if an understanding has been reached with the auditor). Your response should include matters that existed at (balance sheet date) and during the period from that date to the date of your response. .11 In some circumstances, a lawyer may be required by his Code of Professional Responsibility to resign his engagement if his advice concerning financial accounting and reporting for litigation, claims, and assessments is disregarded by the client.

If the underlying cause of the litigation, claim, or assessment is an event occurring before the date of an enterprise’s financial statements, the probability of an outcome unfavorable to the enterprise must be assessed to determine whether the condition in paragraph 8(a) is met. The fact that legal counsel is unable to express an opinion that the outcome will be favorable to the enterprise should not necessarily be interpreted to mean that the condition for accrual of a loss in paragraph 8(a) is met.

2FASB Statement No. 5 [AC section C59], also describes the standards of financial accounting and reporting for gain contingencies. The auditor’s procedures with respect to gain contingencies are parallel to those described in this auditing standard for loss contingencies. It is reasonable to assume that the Statement of Policy will receive wide distribution and will be readily available to the accounting profession. Specifically, the Statement of Policy has been reprinted as Exhibit II to the Statement on Auditing Standards, “Inquiry of a Client’s Lawyer Concerning Litigation, Claims, and Assessments,” issued by the Auditing Standards Executive Committee of the American Institute of Certified Public Accountants. Accordingly, the mechanic for its incorporation by reference will facilitate lawyer-auditor communication.

Under ASC , a contingent loss must be categorized as remote, reasonably possible or probable. Depending on the categorization, the company may have to disclose the nature of the contingency and estimated loss, or record the estimated loss or the best estimate from within a range of losses as a charge to income. As a condition for accrual of a loss contingency, paragraph 8(a) requires that information available prior to the issuance of financial statements indicate that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. .14 A lawyer may be unable to respond concerning the likelihood of an unfavorable outcome of litigation, claims, and assessments or the amount or range of potential loss, because of inherent uncertainties. Factors influencing the likelihood of an unfavorable outcome may sometimes not be within a lawyer’s competence to judge; historical experience of the entity in similar litigation or the experience of other entities may not be relevant or available; and the amount of the possible loss frequently may vary widely at different stages of litigation.

Accounting for Lawsuit Settlements

The lawyer’s responsibilities with respect to his client’s disclosure obligations have been a subject of considerable discussion and there may be, in due course, clarification and further guidance in this regard. The auditor obtains sufficient evidential matter to satisfy himself concerning reporting for those unasserted claims and assessments required to be disclosed in financial statements from the foregoing procedures and the lawyer’s specific acknowledgement of his responsibility to his client in respect of disclosure obligations (see paragraph .09g). This approach with respect to unasserted claims and assessments is necessitated by the public interest in protecting the confidentiality of lawyer-client communications.

The amount of these liabilities will influence price negotiations and help determine the buyer’s basis and the seller’s gain or loss. Paragraph 5 of the Statement of Policy summarizes the categories of “loss contingencies” about which the lawyer may furnish information to the auditor. The term loss contingencies and the categories relate to concepts of accounting accrual and disclosure specified for the accounting profession in Statement of Financial Accounting Standards No. 5 (“FAS 5”) issued by the Financial Accounting Standards Board in March, 1975. fn 6 For example, disclosure shall be made of any loss contingency that meets the condition in paragraph 8(a) but that is not accrued because the amount of loss cannot be reasonably estimated (paragraph 8(b)).

The incorporation is intended to include not only limitations, such as those provided by Paragraphs 2 and 7 of the Statement of Policy, but also the explanatory material set forth in this Commentary. Paragraph 7 also recognizes that it may be in the client’s interest to protect information contained in the lawyer’s response to the auditor, if and to the extent possible, against unnecessary further disclosure or use beyond its intended purpose of informing the auditor.

LEGAL

For example, the response may contain information which could prejudice efforts to negotiate a favorable settlement of a pending litigation described in the response. It is believed that the suggested standard of twenty days advance notice would normally be a minimum reasonable time for this purpose. Moreover, it is unlikely, absent relevant extrinsic evidence, that the client or anyone else will be in a position to make an informed judgment that assertion of a possible claim is “probable” as opposed to “reasonably possible” (in which event disclosure is not required). In light of the legitimate concern that the public interest would not be well served by resolving uncertainties in a way that invites the assertion of claims or otherwise causes unnecessary harm to the client and its stockholders, a decision to treat an unasserted claim as “probable” of assertion should be based only upon compelling judgment.

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