Our team is given the task to account for a pending litigation. We are to determine how pending litigation should be reported on the current and future financial statements. M Corporation was sued for patent infringement and we will present whether M Corporation should accrue a liability, disclose a liability, do both, or do nothing. The case accounting for the litigation and the subsequent overturned verdict was ongoing for four years between M Corporation and W Corporation and, as litigation is unpredictable, changes will have to be made accordingly.
We will present how M Corporation should
- account for the pending litigation in 2007 – the year the claim was filed by W
- account for the verdict and judgment in 2009
- account for the overturned verdict in 2010
- account for the closure of the litigation in 2011
- account for any prior period adjustments if needed.
We will compare and contrast FASB Codification, SEC Rulings, real world financials, and utilize conceptual framework to demonstrate our accounting method for this case.
Because litigation is unpredictable and complex, M Corporation should not accrue a liability on the 2007 financial statements. Management determined a loss was probable and estimated the loss to be in the range of $15-20 million with $17 million being the most likely amount of loss. According to FASB Codification 450-20-25-6, losses that are reasonably estimable shall not be accrued because the losses relate to a future period rather than current or prior period. Also, per FASB Codification 450-20-25-8, general or unspecified business risks do not meet the conditions for accrual in 450-20-25-2, so no accrual for a future loss will be made.
Additionally, Fordham Journal of Corporate & Financial Law, volume 15, issue 2, article 3, states that 64% of SEC registrants sampled reported being sued, only 9.5% of them accrued any liability for pending litigation on their financial statement. A footnote in the same SEC report indicates that approximately 97% of the $23,761 billion of potential legal contingent losses disclosed for the entire sample relate to instances where no liability was reported as being recognized to the balance sheet.
Based on this information, only an immaterial amount of companies actually accrue a liability in their financial statement. Therefore, M Corporation will simply provide disclosure of the contingency and an estimate of the possible loss or range of loss for the future pending litigation in its 2007 financial statement under Note: Contingencies and Commitments. If M Corporation accrued a liability on its 2007 financial statements, then the company becomes too transparent to opposing counsel and it could have serious adverse effects on M’s operations.
Considering real world practices, as well as in accordance with the conceptual framework from the textbook, accrual of a loss from ongoing litigation is rare. Companies usually do not record a loss until after the ultimate settlement has been reached. For example, the Las Vegas Sands Corporation, in a recent quarterly report, disclosed but did not accrue damages from a lawsuit it lost, even after the award was affirmed by the trial court, because the company believe that it has valid bases in law and fact to overturn or appeal the verdict.
Consequently, M corporation should not accrue the contingency loss but continually disclose the matter even when a judgment was reached against the corporation to pay $18.5 million in 2009, given that the corporation later decides to appeal the decision reached by the trial court. If M corporation accrues the liability in 2009, it means that the company agrees to the judgment reached as well as overturning the decision made in 2007, and as a result, it would not have filed an appeal after the judgment.
In 2010, M Corporation will not record a reduction of loss as we did not accrue a loss in 2007 or 2009, but disclose the matter. Therefore, M Corporation will disclose the Court of Appeal’s decision in favor of M’s appeal, which reversed the lower courts verdict of the $18.5 million judgment against M. If we had accrued the liability in 2009 for the judgment reached, then in 2010 M Corporation would record a reduction (of $1.5 million) of the previously recorded loss contingency after the appeal was issued, which overturned the 2009 verdict.
In 2011, even though W filed a petition against the reversal of the ruling by the Court of Appeals, it was insignificant in material to be accounted for, M corporation will do nothing, since the petition was later declined and management of M, along with in-house legal counsel, determined that this litigation came to a final closure. Alternatively, M corporation could disclose the final settlement in the 2010 financial statement to state the events happened, even though the corporation was not materially affected.