Lawsuit Payable

Lawsuit payable, also called litigation payable, estimated litigation liability or accrued legal settlement, is a liability account used to record amounts a business owes as a result of a lawsuit or other legal claim. It arises either when a court has issued a judgment or the parties have agreed a settlement that has not yet been paid, or, before that point, when accounting rules require the business to accrue an estimated loss from pending litigation. Depending on when payment is expected, it is shown among current liabilities or noncurrent liabilities on the balance sheet.

Lawsuits are one of the most common sources of contingent liabilities, whose existence or amount depends on future events, such as a court ruling. The accounting is governed by ASC 450 in US GAAP and IAS 37, Provisions, Contingent Liabilities and Contingent Assets, under IFRS.

Under US GAAP, a contingent loss from litigation must be accrued when two conditions are met: it is probable that a liability has been incurred at the balance sheet date, and the amount of the loss can be reasonably estimated. "Probable" means the future event is likely to occur. If the loss is only reasonably possible, or probable but not estimable, no liability is recorded, but the nature of the claim and an estimate of the possible loss or range of loss, or a statement that an estimate cannot be made, must be disclosed in the notes. If the chance of loss is remote, disclosure is generally not required.

When a range of possible losses exists and no amount within it is a better estimate than any other, US GAAP requires the minimum of the range to be accrued, with disclosure of the possible additional loss. IFRS takes a different approach: a provision is recognized when an outflow is more likely than not, and when a range of equally likely outcomes exists, the midpoint is used. As a result, IFRS companies may recognize litigation liabilities earlier and at higher amounts than US GAAP companies in similar situations.

A food manufacturer is sued by a distributor claiming $3 million in damages for breach of contract. At the 31 December year end, the company's lawyers advise that a loss is probable and that a settlement between $800,000 and $1,400,000 is likely, with no amount in the range more likely than another.

• Under US GAAP, the company accrues the minimum of $800,000 by debiting litigation expense (or loss) and crediting lawsuit payable, and discloses that the loss could be up to $600,000 higher.
• Under IFRS, it would recognize a provision at the midpoint, $1,100,000.
• In March, the parties settle for $1,000,000, payable in April. The US GAAP company records an additional $200,000 of expense and increases lawsuit payable to $1,000,000, then debits lawsuit payable and credits cash when it pays.

If the company's insurance will cover part of the settlement, the expected recovery is recorded as a separate receivable when it is probable, rather than netted against the liability.

The rules are deliberately asymmetrical. A company that expects to win a lawsuit against another party does not record the expected gain until it is realized, such as when a settlement is paid or a final judgment cannot be appealed. If a lawsuit is settled after the balance sheet date but before the financial statements are issued, the settlement usually provides evidence about a condition that existed at year end, so the liability is adjusted to the settlement amount.

Because lawsuits depend on legal judgment, auditors send letters of inquiry to the company's lawyers asking them to describe pending and threatened litigation and evaluate likely outcomes. Lawyers are often reluctant to give firm predictions, which makes estimates difficult. Companies also worry that disclosing an estimate could be used against them by the other side. Regulators have nonetheless pushed for clearer disclosures, especially after large, sudden litigation charges surprised investors. For the income statement, litigation expense is usually reported within operating expenses, and major settlements are often disclosed separately because they are unusual. Alternative routes such as arbitration follow the same accounting rules. Readers of the income statement should check the notes for ranges of possible additional loss.