I have to advise Amalia about how to account for the lawsuit.
I have to support my advice by citing any applicable accounting standards. And briefly talk about ethical issues from AICPA code of professional conduct for “integrity and Objectivity “Please can you help me to find applicable standards ? THIS IS THE CASE Gadget, Inc. is a publicly-traded company with annual revenue of $250 million and a December 31 yearend. Gadget is the leading manufacturer and distributor of products intended to make life easier for society. Amelia Emerson, a CPA and the Controller of Gadget, requests advice from your accounting firm about a problem she is facing. Gadget’s most popular product is the Whatchamacallit. There is not anything that this device cannot do. As a result, Gadget has experienced enormous demand for this product with unfilled back orders totaling six months. In only a short time, sales have surpassed Gadget’s previously most popular product, the Super Widget.
Amelia’s problem arose over a lawsuit brought against Gadget by Doodad & Gizmo, Inc. Doodad is a company that manufactures the Thingamabob, which is very similar to the Whatchamacallit. Doodad alleged in a federal complaint filed on February 15 of the current year in the U.S. District Court for the Northern District of California that Gadget’s Whatchamacallit infringed on Doodad’s intellectual property: its patent, user interface, and style. A serious weakness in Gadget’s legal defense is that the design engineer who developed the Whatchamacallit for Gadget was previously employed by Doodad when the Thingamabob was being developed. In late November, Gadget’s attorney, General Counsel Lee Gill, advised Gadget’s management that the case could take over a year to litigate, not including appeals. Even though the case is only in the early stages of the discovery phase, Lee Gill believes that, based on evidence collected to complete these initial discovery requests, it is “likely” that Gadget will ultimately have some liability. Lee Gill also estimates that a judgment for as much as $20 million could be rendered against Gadget. Lee Gill also estimates that the case could be settled out of court for $9 million, saving both parties the cost of litigation.
Further, Lee Gill estimates that $9 million is likely the least amount Gadget would have to pay in damages to Doodad if the case goes to trial. In a meeting with Gadget’s CEO and CFO in early December, Amelia explained that Doodad’s lawsuit might require an accrual in Gadget’s financial statements for the current year of all or part of any estimated future judgment against Gadgets. The CEO asked Amelia what she means by the word “accrual.” Amelia explained that a judgment in the future against Gadget would need to be accrued and accounted for as a loss in the current year, which would reduce Gadgets’ net income. The CEO, growing visibly upset and hardly able to contain himself, responded by exclaiming: “Are you serious? This is a lawsuit that will take years, and we might prevail regardless of what our attorney tells us. If we settle the case or even lose it, that won’t happen this year. And do you have any idea what reducing our bottom line by millions of dollars this year would do to the value of our stock, not to mention the bonuses we all get, including you? Next year or the following year we could absorb this loss with the number of new projects we have in development. But not this year. Definitely not this year.” The CFO offered what she thought could be a possible compromise by asking: “Why not just disclose the existence of the lawsuit in Gadget’s financial statements and wait to see what the outcome is later?” The CEO expressed that this might work, but strongly suggested to Amelia that she needed to do more research and be absolutely 100% certain before they discussed this issue further.
However, the CEO made it very clear that disclosure was the most that he would find acceptable. Amelia disagrees with both executives, but did not want to argue at the meeting until she could support her position with absolute certainty. Amelia thinks she knows how to account for the lawsuit, but wants you to provide her with your recommendation. Amelia was only recently hired as the Controller of Gadget and doesn’t want to upset the CEO and CFO in case she is wrong. Even though it’s Amelia’s responsibility to decide how to account for the lawsuit, Amelia is tempted to let the CEO and CFO do what they want. However, she does not want to become involved with financial statements that violate GAAP.