Litigation provision

What it means

A litigation provision is a provision for a probable future payment arising from a pending or threatened dispute, such as damages, a fine, the other side's lost profit or legal costs. It is recognised at an estimated amount once losing is probable and the sum can be reliably estimated.

If losing is merely possible rather than probable, no provision is made and the dispute is disclosed as a contingent liability in the notes to the financial statements. If losing is remote, the dispute need not be disclosed unless it is significant.

The estimate is a typical accounting estimate requiring judgement. It is based on the lawyer's opinion, the stage of proceedings, case law and experience with similar disputes. The provision is reassessed as the dispute develops.

How it works in practice

At the annual closing, the accountant asks the legal adviser for an overview of disputes with an assessment of probability and amount. On that basis the provision is created, increased, reduced or released. This includes an employment dispute over unlawful dismissal with compensation in lieu of wages.

When the dispute ends, the provision is used for the payment, and any difference between the provision and the actual payment goes to that year's result. If the company wins, the provision is released to income and any costs awarded are recorded as a receivable.

The tax treatment is specific: generally only the amount actually paid is deductible, and the provision is added back when calculating the tax base. For particular types of dispute, however, the tax position is worth checking with an adviser.

What to watch out for

Disclosing disputes is sensitive, because the other side may read the financial statements. Accounting standards allow details to be withheld in exceptional cases where disclosure would seriously prejudice the company's position, but basic information must remain.

Understating litigation risk distorts profit and can lead to dividends being paid out of profit that does not exist. Overstating it needlessly depresses profit. The provision should reflect the best estimate, neither optimism nor excessive caution.