A general ledger account called "lawsuit payable" holds the sum owing to the defendant in a lawsuit. Only when it is both plausible and possible to estimate the amount due, are liabilities entered in this account. Due to the fact that court-related settlements are frequently paid within a year, the account is typically categorized as a current liability. In the absence of this, the account is classified as a long-term liability.
Let's say you are the subject of a lawsuit that is still pending. Even though you haven't been compelled to pay damages yet, the problem might need to be noted in your bookkeeping. The loss is referred to as a contingent liability in accounting speak. There are numerous flavors of these:
- You have a "remote," or extremely distant, possibility of losing money and paying for it. The risk can be disregarded while preparing your financial statements.
- You know how much money you'll most likely have to pay out. You must note the projected cost. On the balance sheet, you record it as a liability, and on the income statement, it appears as a loss contingency.
- You could lose money, but it's not likely. You don't include the amount in your statements, but you mention it in the notes to the financial statement.
- Although you don't know how much, you'll probably lose money. Declare it once more in the notes.
- These rules apply to any contingent liabilities, such as a warranty that an IRS auditor must pay for.
Even if you believe your insurance will fully cover the reimbursement, you should nevertheless mention the loss in your financial statements. The most appropriate way to represent your circumstance is to enter the projected loss and the anticipated insurance payment as distinct entries. Remember that insurance companies could delay writing you a check or even differ on whether you are covered.
It doesn't appear on the books until you actually receive compensation if the shoe is on the other foot and you're suing someone else for damages. Even if you believe that obtaining damages will be a piece of cake, you cannot list the litigation as income or an account receivable in the financial statements. The conservative attitude to prospective contingent gains is encouraged by accounting standards. You declare the money as income once you have it in your possession.
- Read the legal records provided by the business. The estimated loss amount should be highlighted.
- To document the estimated loss, enter it in your journal. Legal fees are debited. Lawsuit liability estimated by credit. For both portions of the entry, use the highlighted amount.
- Increase the "Lawsuit Expense" account by entering the monetary value in the main ledger. To increase the "Estimated Lawsuit Liability" account, enter the monetary value in the general ledger.
- Add the "Lawsuit Expense" account to the company's income statement and to the computation of net income.
- Add the "Estimated Litigation Liability" account in the balance sheet's liabilities section.
Remember that there are various accounting systems available. The amount of financial information you must disclose may be more flexible if your business is privately held rather than publicly traded. International standards and accepted U.S. practices can occasionally diverge. Check to see if you need to record your contingencies differently for investors outside of the country. Example, if your company is expanding abroad.