Financial Compensation in Lawsuits: Accounting Guidelines to Follow

The US has long had a reputation for being a litigious culture. People are aware of the legal pathway to resolving conflicts and don’t hesitate to pursue it. 

When someone has been harmed in these connected times, with social media and artificial intelligence creating new opportunities, more people are thinking about taking legal action.

In a lawsuit, it can be comforting and empowering to receive just compensation. For a lot of us, it gives us the confidence to move on with our personal and professional lives, attempting to move past the past. 

That’s why in this blog post, we are going to explore how one should account for these settlements while ensuring they stay in the good books of the law.

Let’s begin!

Key Takeaways

• Understanding the GAAP framework for financial reporting 
• Looking at the recording compensation
• Decoding legal fees and tax deductions 

The GAAP Framework for Financial Reporting

In the US, generally accepted accounting principles (GAAP) are used to account for compensation related to lawsuits.  The Financial Accounting Standards Board, a reputable standard-setting organization, is the one issuing these rules. They are subject to edits from time to time, which necessitates continued professional oversight.

The GAAP framework ensures compliance and transparency by establishing guidelines for managing financial reporting related to legal matters.

Certain organisations might employ alternative standards, like Polish Accounting Standards (PAS) or International Financial Reporting Standards (IFRS). Generally, GAAP is stricter and more prescriptive, while IFRS allows for more flexibility of judgment. Many international firms use the latter, making it non-negotiable for businesses with overseas operations to remain updated.

Interesting Facts
Financial compensation in lawsuits is primarily awarded through settlements, which occur in the vast majority of cases (over 95% of personal injury claims), or through jury verdicts.

Recording Compensation Upon Confirmation of Receipt

If you are a plaintiff in a lawsuit, you might have a general notion of the amount of money you might be awarded. Your legal representation may have a ballpark estimate because the firm has worked on cases similar to yours in the past. 

However, you need to record the amount as an asset only when the court has reached a formal settlement. It implies that the amount is now confirmed for collection. You have to record the settlement in your cash flow statement as a business owner or as an individual. 

“Contingent liability,” or a liability that could arise depending on how a lawsuit turns out, is explained by Deloitte. The involved entities must record them when the loss is probable and is also possible to estimate with reasonable accuracy.

In case you make an error, you should adjust the financial statements retrospectively. To do so, you may have to restate the previous timeframe’s financial statements. 

Tax Deduction for Your Settlement

Assessing the tax treatment of your compensation is a crucial aspect of accounting. It may require professional guidance. Certain forms of compensation might be taxable while others are not, which could cause confusion.

Generally speaking, any money you get for medical care associated with physical injuries is not taxable. 

For example, consider the Bard Power Port lawsuit, which raises allegations against Bard Access Systems, the US-based manufacturer of ports for vascular access. Many patients have complained that these catheters degrade inside the body, causing serious complications. 

According to TorHoerman Law, the plaintiffs in this case may be eligible for financial compensation for their pain and emergency surgeries. These amounts are unlikely to be taxable. On the other hand, you will need to pay taxes on compensation for emotional suffering or lost wages.

The IRS clearly notes that compensation for mental and emotional distress is not excluded from gross income. The only exception is if the amount is received due to physical injury or illness.

Legal Fees: Taxable or Not?

Finally, what about the fees you pay for the legal services that make all these compensations possible? 

The fact is that this area can be complicated. 

Until you win the case, many law firms don’t charge you any fees. The outcome may affect their payments (and taxability). In such scenarios, the lawyer deducts fees and expenses from the gross proceeds and shares the balance with the client. 

The New York State Bar Association explains that legal professionals used to deduct legal fees under miscellaneous itemised deductions, which were suspended in the 2018 Tax Cuts and Jobs Act. Presently, after the introduction of the One Big Beautiful Bill Act, this suspension has become permanent. 

These developments are complicating the taxable or non-taxable aspects of legal fees. It doesn’t seem fair to many plaintiffs that they must pay taxes on recovery proceeds that they never received.

For assistance with the financial aspects of court settlements, think about working with a specialized accountant or outside service provider. They can determine whether the legal fees owed to your lawyers will be subject to taxes and how best to handle them for your company’s or your own financial gain.

Receiving a sizable sum in a legal settlement can be reassuring for people and businesses that have experienced substantial suffering. These figures usually attract news headlines, inspiring many to also compete for  “a share in the pie.” In reality, legal payouts can take time and gruelling effort, even with the best legal teams by your side.

Once you receive compensation for your claims, work closely with your accountant. They will be able to guide you through the associated complexities to ensure you don’t face non-compliance risks.