Lawsuits are a pain for accountants because they're unpredictable. You can estimate company expenses and income for the next quarter, but you can't say for certain someone won't up and sue you. When you pay legal damages or receive them, you report the result as income or loss on the income statement. In some cases, you have to report the loss before it happens.
How to Account for Potential Lawsuit Liability
Suppose you've been sued and the court case is ongoing. Even though you haven't been ordered to pay damages yet, your bookkeeping may have to acknowledge the issue. In accounting jargon, the loss is a contingent liability. These come in several flavors:
- The chance you'll lose and pay money is "remote" AKA a very long shot. You can ignore the risk when writing your financial statements.
- You'll probably pay out money and you have a good idea how much. You have to record the anticipated expense. You list it as a liability on the balance sheet and a loss contingency on the income statement.
- It's possible but not probable you'll lose money. You disclose it in the notes on the financial statement, but you don't include the amount in your statements.
- You'll probably lose money but you've no idea how much. Once again, disclose it in the notes.
These guidelines apply to any contingent liability, such as an IRS auditor having to pay out for a warranty.
Even if you think your insurance will cover the entire payout, you should still acknowledge the loss in your statements. Entering the anticipated loss and anticipated insurance payment as separate items is the most accurate way to portray your situation. Don't forget that insurers may not cut you a check right away, or may disagree about whether you're covered.
How to Account for Potential Lawsuit Gains
If the boot is on the other foot and you're suing someone else for damages, it doesn't go on the books until you actually collect. You can mention the lawsuit in notes to the financial statements, but you can't include it as income or an account receivable, even if you think winning damages is a slam-dunk. Accounting standards favor a conservative approach to potential contingent gains. When you finally have the cash in hand, then you report it as income.
Don't forget that there's more than one accounting system out there. If you're a privately held company rather than one listed on the stock exchange, you may have more flexibility in what financial information you have to divulge. Accepted U.S. practices are sometimes different from international standards. If, say, your company's branching out overseas, check whether you need to report your contingencies differently for investors outside the country.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com