Companies must account for lawsuit settlements when a loss is reasonably probable and the amount of the loss is reasonably estimated. If the lawsuit is not reasonably probable or the amount of the loss is reasonably estimated, then the company will most likely have to disclose the amount as a footnote disclosure.
Until the lawsuit is settled, the company cannot record any gain. This has to do with the accounting principle of conservatism. Since the gain is not known and has not yet been realized, the company cannot yet report one. Accountants can make financial statement disclosures for gains before the company settles the lawsuit.
In order to report a loss, the accountant must estimate the outcome of the lawsuit settlement before the lawsuit settles. The accountant will classify the lawsuit loss as either probable, reasonably probable or remote. The lawsuit must be probable in order for the accountant to report the loss. If the loss is reasonably probable, the accountant only needs to make a financial statement disclosure. If the outcome is remote, then the accountant does not need to report anything.
In addition to being probable, the amount of the lawsuit settlement must also be estimated. For example, an accountant asks the lawyer what he thinks the outcome of a case will be. The lawyer discloses they will probably lose the case so they will try to settle it for $500,000. The $500,000 is an estimated amount for the lawsuit, so they will report a contingency loss.
If the events change between the date of compiling the financial statements and when the company issues them, whether this is a change in the estimated outcome or amount, the company can make a disclosure on its financial statements.
If the amount is estimated and the result is a probable loss, then the company must report the loss. The company would debit "Lawsuit Loss" and credit "Lawsuit Liability." When the company pays the settlement, the journal entry will debit "Lawsuit Liability" and credit "Cash."
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