At December 31, 1996, Davis Inc. awaits judgment on a lawsuit for a competitor's infringement of Davis' patent. Legal counsel believes it is probable that Davis will win the suit and indicated the most likely award together with a range of possible awards. How should the lawsuit be reported in Davis' 1996 financial statements?
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A. B. C. D. E.Explanation
A loss contingency is recognized but not a gain contingency following the principle of conservatism. A gain contingency is only disclosed in the notes until the settlement is realized.
In order to determine how the lawsuit should be reported in Davis Inc.'s 1996 financial statements, we need to consider the information provided in the question.
The question states that Davis Inc. is awaiting judgment on a lawsuit for a competitor's infringement of Davis' patent. The legal counsel believes that it is probable that Davis will win the suit and has provided the most likely award along with a range of possible awards.
In financial reporting, the general principle is to recognize and report events and transactions that are probable and can be reliably measured. The key considerations in this case are the probability of winning the lawsuit and the range of possible awards.
Option A states that none of the answers are correct, so we can eliminate that option.
Option B states that the lawsuit should neither be disclosed in the notes nor be accrued. However, this contradicts the information provided, which states that the legal counsel believes it is probable that Davis will win the suit. Therefore, we can eliminate option B.
Option C suggests that the lawsuit should be reported in note disclosure only. Note disclosure is typically used when an event or transaction is material but does not meet the criteria for recognition in the financial statements. However, given that the legal counsel believes it is probable that Davis will win the suit, it would be appropriate to recognize the potential outcome of the lawsuit in the financial statements, rather than just disclosing it in the notes. Therefore, we can eliminate option C.
Option D suggests that the lawsuit should be accrued for the lowest amount of the range of possible awards. However, the legal counsel has indicated the most likely award together with a range of possible awards. Accrual for the lowest amount would not be appropriate in this case because it does not reflect the most likely outcome. Therefore, we can eliminate option D.
Option E states that the lawsuit should be accrued for the most likely award. This option aligns with the principle of recognizing and reporting events that are probable and can be reliably measured. If the legal counsel has provided the most likely award, it would be appropriate to accrue the estimated amount associated with that award. This would reflect the potential outcome of the lawsuit in the financial statements. Therefore, option E is the most appropriate choice.
In conclusion, the lawsuit should be reported in Davis Inc.'s 1996 financial statements by accrual for the most likely award.