Meaning
Provisioned capital secures a portion of a company’s balance sheet to cover the potential costs and settlements of ongoing legal disputes. A litigation reserve is an accounting entry that reflects a probable future outflow of resources. The amount is determined based on the best estimate of the legal team and external auditors regarding the likely outcome of the case.
Liability Estimation
Probabilities of loss are assessed at each reporting date to ensure the figure remains accurate. Establishing a litigation reserve is a requirement under major accounting standards when the loss is both probable and can be reasonably estimated.
Financial Impact
Statements must disclose the nature of the dispute and the uncertainty surrounding the timing of the payment. A litigation reserve reduces the reported net income of the company for the period in which it is created. This ensures that shareholders and investors are not surprised by a sudden large payment when a judgment is finally handed down by the court or a settlement agreement is reached between the parties.
Managing Cash
Handling the actual liquidity to pay for these liabilities involves coordinating with the treasury department. A litigation reserve does not always involve setting aside physical cash in a separate account, but it does restrict the amount of profit available for dividends. It provides a realistic view of the financial obligations facing the business in the medium term.
