A potential legal claim which is probable and the amount can be reasonably estimated should be:
A recorded in the financial statements as a contingent liability.
B disclosed in the notes while the lawsuit is outstanding.
C disclosed in the notes when the lawsuit is settled.
D is a potential liability that has arisen because of a past event or transaction.
The correct answer and explanation is :
The correct answer is B: disclosed in the notes while the lawsuit is outstanding.
Explanation:
A contingent liability refers to a potential obligation that may arise depending on the outcome of an uncertain future event. The key here is that the liability is probable and the amount can be reasonably estimated.
According to accounting standards such as IAS 37 – Provisions, Contingent Liabilities, and Contingent Assets (or ASC 450 under US GAAP), when a company faces a potential legal claim that is both probable and the amount can be reasonably estimated, the situation requires special attention.
In this case, the following actions are required:
- Disclosed in the notes: If the likelihood of the legal claim resulting in a future outflow of resources is probable, and the amount of the liability can be reasonably estimated, it should not be recorded as a liability on the balance sheet. Instead, it should be disclosed in the financial statement notes. This is because contingent liabilities are not recognized in the financial statements unless both conditions are met: the event is likely to occur (probable) and the amount can be reliably measured.
- Why not recorded as a liability: Recording a contingent liability as a full-fledged liability on the balance sheet would only occur if the liability is certain or recognized — which is not the case here, as the legal outcome remains uncertain. Therefore, the potential liability is simply disclosed in the notes to the financial statements, providing transparency to the users of the financial statements without overstating the company’s financial position.
- When the lawsuit is settled (Answer C): If the lawsuit is eventually settled, the related liability would need to be updated based on the settlement amount, and the financial statements would reflect the actual liability. However, until the lawsuit is settled, disclosure in the notes is the correct approach.
Option A is incorrect because contingent liabilities are not recorded in the financial statements unless they are both probable and estimable, and only under specific conditions (such as a “reasonably estimable” amount).
Option D defines a contingent liability, but it doesn’t indicate the proper accounting treatment in this scenario.