ABC Corporation is involved in a class-action lawsuit for defective products. Management believes that the company will lose and pay significant damages. The company does not have to disclose a liability related to the lawsuit in its financial statements. True or False?

• A. True
• B. False
• C. Not enough information
• D. Depends on accounting policy

Answer: (B)

The main idea here is how loss contingencies are recognized under GAAP. If a loss is probable and the amount can be reasonably estimated, a company must record a liability and an accompanying expense, and it must disclose the nature and amount of the contingency. In a class-action lawsuit alleging defective products, management’s belief that a loss and significant damages are likely meets the criteria for recognition and disclosure. Therefore, the statement that the company does not have to disclose a liability is incorrect. Even if the exact amount isn’t crystal clear, you would still disclose the contingency (and recognize if estimable). The only situation where disclosure wouldn’t be required is if the loss were remote, which isn’t the case here.