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Smith Co. filed suit against Western, Inc., seeking damages for patent infringement. Western�s legal counsel believes it…
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Smith Co. filed suit against Western, Inc., seeking damages for patent infringement. Western�s legal counsel believes it is probable that Western will settle the lawsuit for an estimated amount in the range of $75,000 to $175,000, with all amounts in the range considered equally likely. How should Western report this litigation?
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2023-03-15T10:00:11+00:00
2023-03-15T10:00:11+00:00 1 Answer
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Western, Inc. should report this litigation as a contingent liability. A contingent liability is a potential obligation that depends on the outcome of a future event that is uncertain. In this case, the potential obligation is the estimated settlement amount of $75,000 to $175,000, which will depend on the outcome of the patent infringement lawsuit.
Under U.S. GAAP, a contingent liability should be accrued if it is both probable (more likely than not) that a liability has been incurred and the amount of the liability can be reasonably estimated. In this case, Western’s legal counsel believes it is probable that Western will settle the lawsuit, and an estimated settlement range of $75,000 to $175,000 is provided. Therefore, Western should recognize a contingent liability for the estimated settlement amount.
The amount of the contingent liability recognized should be the best estimate within the range of estimated settlement amounts. Since all amounts within the range are considered equally likely, Western should recognize the midpoint of the range, which is ($75,000 + $175,000) / 2 = $125,000.
Western should record the following journal entry:
Debit – Contingent liability: $125,000
Credit – Legal expense: $125,000
The contingent liability account should be disclosed in the notes to the financial statements, including the nature of the contingency and the range of possible outcomes.