A reader asks, "How do you handle disputed short-term liabilities? Would you record an expense, even though it will probably go to litigation for resolution? Does it stay on the books until an actual resolution is reached?"
This is known as a loss contingency. You should recognize the expense when you can reasonably estimate the amount of the loss and it is probable that a liability has been incurred at the date of the financial statements. Do not delay accruing an expense until there is complete certainty regarding its amount. Instead, you should accrue some amount as soon as the expense can be estimated within a range. If there is a range of potential expenses associated with the loss contingency, accrue that amount that appears to be a better estimate than any other amount within the range. If no amount within the range appears better than another, accrue the minimum amount in the range.
If a loss contingency is related to litigation, there may be no clearly defined point at which you should record an expense. Consider the following factors when determining whether to record the expense:
- The degree of probability that the outcome of the litigation will be unfavorable (based on the progress of the case, the views of your attorney, the company's experience with similar cases, and how management plans to respond to the lawsuit, such as with an out-of-court settlement).
- Your ability to make a reasonable estimate of the amount of the prospective loss.
You should disclose the existence of the litigation if it is reasonably possible, but not probable, that there will be an unfavorable outcome, or if you cannot determine the amount of the loss.