Situations when a company is involved in event where uncertainty exists about whether an obligation to transfer cash or other assets has arisen are called contingencies. The criteria established by Financial Accounting Standards Board (FASB) in SFAS No. 5, “Accounting for Contingencies” require that the likelihood of loss be determined as follows:
- Probable. The future event or events are likely to occur.
- Reasonably possible. The chance of the future event or events occurring is more than remote but less than likely.
- Remote. The chance of the future event or events occurring is slight.
Because the reason of litigation for the company occurred before the date of the financial statements according to the SFAS No. 5 it has to report this contingence as liability in its financial reports if the loss is both probable and estimable. Company records the loss by increasing a loss account and increasing a liability such as Lawsuit Liability. To evaluate the probability of an unfavorable outcome, a company should consider following: the nature of the litigation, the progress of the case, the opinion of legal counsel, its own and others’ experience in similar cases. Usually company can rarely predict the outcome of pending lawsuit, however, with any assurance. And even if some information is available, it is not reasonable for company to report in its financial statements a dollar estimate of the probable negative outcome. Such specific disclosures might weaken the company’s position in the dispute and encourage the petitioner to increase its efforts.
But, if the loss is either probable or estimable but not both, and if there is at least a reasonable chance that a company may have incurred a liability, it must disclose the following information in the notes: 1) the nature of the contingency and 2) an estimate of the possible loss or range of loss or a statement that an estimate cannot be made.